Principal and interest are paid when
- interest is paid periodically
- principal is paid at maturity
Three important elements an investor should know when investing in FI securities:
- a bond’s features
- legal, regulatory, and tax considerations
- contingency provisions
Supranational organizations
- international organizations
- the World Bank and IMF
Sovereign governments
- debt of national governments
- United States, Germany, Italy
Non-sovereign goverments
- bonds issued by states, provinces, municipalities
Quasi-government entities
- bonds issued by agencies that are financed either directly or indirectly by the government
- aka agency bonds or sub-sovereign
- ie Ginnie Mae, Fannie Mae, and Freddie Mac
All bonds are exposed to:
credit risk
Credit risk is
- the risk that interest and principal payments will not be made by the issuer as they come due
- the risk of loss resulting from the issuer failing to make full and timely payments of interest
The coupon rate of a floating-rate note that makes payments in June and Dec is expressed as six-month L+50 bps. Assuming that the six-month L is 2% at the end of June and 2.5% at the end of Dec, what is the interest rate that applies to the payment due in December?
- If a semi-annual floating rate bond, the interest rate that applies to the December payment is based on the prior period rate (June)
- 2.5% (2% + 50 bps)
The two types of yield measures
- current yield
- yield to maturity
Current yield
- aka running yield
- current yield = annual coupon $ / current price
Yield to maturity (YTM)
- the IRR of return on a bond’s expected cash flows
- compute on the calculator: I/Y
Bond Indenture has the following information:
- name of the issuer
- all the terms of a bond issue such as type of bond
- its features such as the principal value, coupon rate, dates when interest payments will be made, and maturity date
- issuer’s obligations
- bondholder’s rights
- if the bond is secured or not
- covenants
- contingency provisions
What does the Trustee do for the issuer
- holds the indenture
- admin
- invoices the issuer for interest and principal payments
- holds funds until paid
- calls meetings
- significant role if the issuer defaults
A holding company will have _____ than a firm
- a holding company will have a higher credit risk than a firm BC it has no assets
Credit enhancements
- provisions used to reduce the credit risk of a bond issue using additional collateral, insurance, or third-party guarantee.
- two types: internal and external credit enhancements
Internal credit enhancements
- Senior/junior tranches
waterfall structure - over-collateralization: posting more collateral than is required
- excess spread aka excess interest cash flow: excess amount is deposited into a reserve account which is used to absorb losses on assets
External credit enhancements
- relies on a third party, guarantor,
- surety bonds/bank guarantees (have 3rd party risk)
- letter of credit (have 3rd party risk)
- cash collateral account (no 3rd party risk)
Domestic bonds
- issued and traded in a country and denominated in the currency of that country
- regulated by the authority in that nation (SEC)
Foreign bonds
- issued by a foreign company but traded in the domestic market
- regulated by the authority in that nation
Eurobonds
- issued internationally, outside the jurisdiction of any single country
- denoted in currency other than that of the countries in which they trade
- subject to less regulation than domestic bonds
Bearer Bonds
- the trustee does not maintain a record of who owns the bonds
- most Eurobonds are bearer bonds and bearer bonds are preferred by investors for tax reasons
Sinking Fund Arrangements
- allows for full or partial amortization of a bond prior to its maturity
- a portion of the bond’s principal outstanding will be repaid each year throughout the bond’s life
- three sinking fund arrangements: standard, accelerated, call provision
- a sinking fund results in:
lower credit risk
higher reinvestment risk
Step-up coupons
- coupons increase by specified amounts on specified dates
