FIXED INCOME SECURITIES –

DEFINING ELEMENTS
TERMS ASSOCIATED WITH BONDS
• Face Value
• Coupon
• Periodicity or Frequency
• Tenure or Maturity
• Present Value or Market Value
• Yield to Maturity
• Bond Issuer
• Rating
• Currency denomination
3
4
5
Fixed income securities promises to make a series of coupon payments and repays the principal on maturity.

E.g. 5 year, 8% coupon paying bond, and a face value of $1000, will pay – 80$ at the end of each year for the next 5 years and
will pay you back $1000 at the end of 5th year.

Characteristics of a Fixed Income Security -

❑ Issuers: Corporations, Government and Govt sponsored entities, Supranational entities (world bank)
❑ Maturity date: Date on which principal will be repaid back. Till then coupon payments will be made.
• Tenor is term remaining until maturity. Perpetual bonds have no maturity date.
• Money market securities have maturities of one year or less.
• Capital market securities have maturities of more than one year.
❑ Par Value: Principal amount that will be repaid on the maturity date. Bonds are always quoted as a percentage of par
– A bond with a par value of $1000, quoted at 97.5 is trading at a price of $975.
• Bond selling for more than its par value is trading at a Premium.
• Bond selling for less than its par value is trading at a Discount.
❑ Coupon rate: quoted on annual terms and can be paid annually, semi-annually, quarterly or monthly. A 8% bond
paying semi-annual coupon pays $40 every six months.
• Zero coupon bonds are pure discount bonds that pay no coupon. E.g. 5 year ZCB is trading for $750 and will pay
$1000 upon maturity.
❑ Currency denomination: bonds can be issued in local or foreign currency. Dual currency bond makes coupon
payments in one currency and principal repayment in another.
 New Debt Segment – Reporting, Settlement and Trading

-- is Bonds of 9.65% ARKA FINCAP LIMITED

https://www.worldgovernmentbonds.com/country/united-states/
Municipal Bonds issued in India –

Long term bonds with maturities around 10 years.

There is no explicit guarantee unlike Treasury Bonds, but there is an implicit guarantee that the state govt. will
honor their obligations (state govt and municipalities can’t print currency).

Munis may be General Obligation Bonds (GO bonds) or revenue bonds. The former are backed by the taxing
power and other regular incomes of the municipalities, while the latter are backed by the revenue of a specific
project – building highways, railways, airports, etc.

Though these bonds are listed, the liquidity is low and it takes time to exit these investments.

Interest is taxable and if bonds are sold before the maturity date, there could be capital gains as well.

Perpetual Bonds in India –

• Are mostly issued by Banks – Bank of Baroda (7.95%), Canara Bank (8.05%), SBI (7.55%)
• Are quasi equity instruments as they don’t have a maturity date
• Are callable after every 5 year period
• Available in secondary market
• MF’s and HNIs invest in these bonds when equity markets are unattractive.
Trust Deed or Bond Indenture
• Legal contract between the issuer (borrower) and the investor (lender).
• Defines the obligations of and restrictions on the borrower.
• Contains info about – issuer, assets pledged as collateral, credit enhancements and covenants.

Covenants – are conditions in a loan/bond issue that requires the borrower to fulfill some conditions and/or
prevent the borrower from undertaking certain actions.

Covenants are split into -

• Negative covenants prohibits the borrower from taking certain actions. They intend to protect the bond
holders from the risk of default – selling assets pledged as collateral, using the same asset as collateral
twice, restrictions on additional borrowings.
• Affirmation covenants are the actions the borrower promises to perform. They do not intend to restrict the
operating decisions of the issuer – make timely payments, insure assets, comply with regulatory laws,
furnish audited statements to lender.
Yield refers to the return earned by the investor by purchasing the bond and holding it for some period of time.
• It is also the discount rate that determines the present value of the Bond, using the series of periodic cash flows.
• If the risk involved is high, yield required is also high.
• Thus there is a direct relationship between risk and yield.
• If the investor holds the bond till maturity date, the yield generated is known as Yield to maturity. YTM is the rate that
equates the present value of the bond (outflow) and the present value of all future expected cash inflows.
E.g. 5 year, 8% coupon paying bond, and a face value of $1000, will pay – 80$ at the end of each year for the next 5
years and will pay you back $1000 at the end of 5th year.

Year 1 2 3 4 5
$80 $80 $80 $80 $1,080
PV 980 (1+r)^1 (1+r)^2 (1+r)^3 (1+r)^4 (1+r)^5

R= 8.5%

Calculator Tip –

N = 5 (Annual Payments) PMT = 80 FV = 1000 PV = -980 I/Y CPT → _________

 ❖ We can also calculate the Present Value of the Bond (Current Market Price) given the –
• Coupon rate
• Maturity
• Face value
• Periodicity of coupon payment
• Yield (Current market interest rates)

What is the PV of a 5-year bond that pays an annual coupon of 8% if the market interest rates are 9%?

Calculator Tip –

N = 5 (Annual Payments) PMT = 80 FV = 1000 I/Y = 9 PV CPT → _________

Year 1 2 3 4 5
$80 $80 $80 $80 $1,080
PV ($961.10) (1.09)^1 (1.09)^2 (1.09)^3 (1.09)^4 (1.09)^5
Trading at Par, Premium and Discount

• If the YTM = Coupon rate of the Bond, then the bond will trade at Par
• If the YTM < Coupon rate of the Bond, the bond will trade at Premium
• If the YTM > Coupon rate of the Bond, the Bond will trade at a Discount

Question

N = 5 (Annual Payments) PMT = 80 FV = 1000 I/Y = 8 CPT PV → _________

N = 5 (Annual Payments) PMT = 80 FV = 1000 I/Y = 9 CPT PV → _________

N = 5 (Annual Payments) PMT = 80 FV = 1000 I/Y = 7 CPT PV → _________

Questions 1-3 for class work and 4-6 for homework

1. If a bond with a face value of 2500, maturity of 3 years, and coupon of 10% paid semi-annually is
currently trading at a price of 2600 what is the YTM for the investor.

2. If a bond with face value of 1000, maturity of 6 years, and coupon of 7.5% paid quarterly is currently
trading at a price of 985, what is the YTM for the investor.

3. What is the current price of a bond with face value of 5000, maturity of 4 years, and coupon of 8% paid
semi-annually, if the current market interest rates are 7.5%

4. If a bond with a face value of 3000, maturity of 7 years, and coupon of 6% paid quarterly is currently
trading at a price of 3050 what is the YTM for the investor?

5. If a bond with face value of 100, maturity of 4 years, and coupon of 7% paid semi-annually is currently
trading at a price of 96.5, what is the YTM for the investor?

6. What is the current price of a bond with face value of 2 lacs, maturity of 5 years, and coupon of 8.5%
paid semi-annually, if the current market interest rates are 8.75%
If the price is higher (Premium), the yield is lower
and
If the price is lower (Discount), the yield is higher.

There is an INDIRECT Relationship between Price

and Yield.
GEOGRAPHICAL CLASSIFICATION OF BONDS

• Domestic Bonds – issued and trades within India and is denominated in INR.

• Foreign Bonds – issued by Microsoft or US Govt and trading on the Bond market of Japan and are denominated in YEN.
• Yankee Bonds – issued by firms incorporated outside US, that trades in US Markets and are denominated in USD.

• Eurobonds – bonds issued by a UK firm, denominated in USD and trades in China.

• These are subject to less regulations than domestic bonds and were introduced to avoid US regulations.
• These bonds are termed by the currency they are denominated in. (The above bond will be known as a Euro-Dollar
Bond).
• Issued in Bearer form – person in possession of the bond will receive the payments. Ownership is not recorded and
usually used to avoid taxes.

A London headquartered-firm purchased a US Dollar-denominated bond issued by a German aeronautical Co. This bond
pays interest (coupon) in US dollars. This is a Eurodollar bond.

It is important to understand that there are three different countries here. The bond is sold by the issuer in one country
(Germany) to the investor in another country (Britain) issued in the currency of the third country (USA).

The first Eurodollar bonds were issued in the Netherlands and sold to investors in Luxembourg to generate funds for
construction in Italy.
ISSUING BONDS THROUGH SPECIAL PURPOSE ENTITIES (SPE)
ABC Bank that issues mortgage loans will create a separate and distinct legal entity (SPE or SPV) that will issue bonds at
some coupon rate and use this proceeds to buy the mortgage loans from the Bank. The SPE will use the loans as a collateral
and will make periodic payments to the bond holders using the periodic cash flows received from the mortgage loans.

The SPE is now the owner of the loans, and even if ABC Bank runs into some financial trouble, the payments to be made to
the bondholders are not affected. Thus SPEs are Bankruptcy Remote Vehicles.

The value of MBS fell from $941bn to $187bn within a span

of 1 year in the US.
• Loans were adjustable-rate mortgage loans i.e. variable rate loans and were available at rates as low as 1%.
• Housing values were increasing at rates of 14-15% during before 2008.
• A credit default swap (CDS) is a contract between two parties in which one party purchases protection from
another party against losses from the default of a borrower for a defined period of time.
• A CDS is written on the debt of a third party, called the reference entity, whose relevant debt is called the
reference obligation, typically a senior unsecured bond.
• The two parties to the CDS are the credit protection buyer, i.e. the holder of the bond and the credit
protection seller, the party providing the insurance or credit protection.
• The credit protection buyer need not be an actual creditor, but someone speculating on the change in
credit quality of the reference entity.
• The notional amount refers to the size of the contract. Total notional amount of all contracts can exceed the
amount of debt outstanding of the reference entity.
• The typical maturity is from 1-10 years with 5 years being the most actively traded.
• The buyer of a CDS pays a periodic premium to the seller, referred to as the CDS spread. The spread now
ranges from 1-5%. 1% is for investment grade issues and 5% is for high yield issues.
• The CDS pays off upon occurrence of a credit event, which includes bankruptcy and/or failure to repay.
• Settlement can be physical settlement (not common) or cash settlement.
• E.g. A French Co. has defaulted on its obligations and its bonds are currently trading at 30% of par value. Mr.
A is holding 10mn worth of bonds. In physical settlement he can deliver the bond and get 10mn cash from
the protection seller. In case of cash settlement, he will get 7mn from the protection seller and he can sell
his bond in the market for 3mn and receive 10mn in total. The protection buyer is usually indifferent
between the type of the settlement.
https://www.youtube.com/watch?v=SyjMz5Sf02Y&ab_channel=BusinessCasual

Before the financial crisis of 2008, there was more money invested in credit default swaps than in other pools.
The value of credit default swaps stood at $45-60 trillion compared to $22 trillion invested in the stock market,
$7.1 trillion in mortgages and $4.4 trillion in U.S. Treasuries. During the financial crisis of 2008, the value of CDS
was hit hard, and it dropped to $26.3 trillion by 2010 and $25.5 trillion in 2012. There was no legal framework to
regulate swaps, and the lack of transparency in the market became a concern among regulators.

On September 16, 2008, the Federal Reserve Bank of New York, part of the U.S. central bank, made an
extraordinary $85 billion loan to American International Group (AIG). AIG, the largest insurance company in the
world, was on the verge of collapse because it had sold roughly $500 billion worth of credit default swaps.
Task - Refer to CRISIL Rating Symbols online.
SOURCES OF REPAYMENT
• Sovereign bonds – using tax receipts
• Non-sovereign bonds – using general taxes, revenue from projects, etc.
• Corporate bonds – using cash generated from firm’s operations.
• Securitized bonds – using cash flows from financial assets owned by the SPE.

COLLATERAL
Assets pledged to support a Bond or loan is a Collateral.

❑ Unsecured Bonds – claim on overall assets and cash flows of issuer – risk is higher, so yield required is higher too
❑ Secured Bonds – claim on specific assets owned by the Co. – risk is lower, so yield is lower.

Secured bonds are senior to unsecured (Debentures), and unsecured are senior to subordinated debt.

For securitized debt, there is an underlying pool of assets that serves as the collateral. Mortgage Backed Securities (MBS)
and Asset Backed Securities (ABS) are types of securitized debt.
CREDIT ENHANCEMENTS
❑ Internal – built into the structure of the bond.
• Overcollateralization
• Cash Reserve Fund
• Excess Spread Account - yield on the securitized debt is lower than the yield on the pool of assets
• Tranching – bonds are categorized into different seniority of claims. This is known as Waterfall Structure (Next slide).
• Senior tranche – receive payment first, receive highest credit ratings and offer lower yields.
• Subordinate tranche – receive payment after senior tranche are paid off, absorb losses first, receive lower
credit ratings and offer high yields.

❑ External – provided by 3rd parties

• Surety bonds – insurance Co will make up any shortfall in the cash available to service the debt.
• Bank guarantees – same as above
• Letter of credit – promise to lend money in case of cash shortfall.

All these external credit enhancements increase the credit quality and decrease their yields. But if the credit quality of the
guarantor deteriorates, the credit quality of the covered issue will also get affected.
 The Waterfall
Pool total $300 million
Number of Payments 12 months
Annual Interest Rate 7.50% on the assets
Monthly payments $26.03 million

No. Opening Balance EMI Interest Principal Senior Mezzanine Equity Closing Balance
100mn 100mn 100mn
1 $ 300.00 $ 26.03 $ 1.88 $ 24.15 $ 24.15 275.85
2 $ 275.85 $ 26.03 $ 1.72 $ 24.30 $ 24.30 251.54
3 $ 251.54 $ 26.03 $ 1.57 $ 24.46 $ 24.46 227.09
4 $ 227.09 $ 26.03 $ 1.42 $ 24.61 $ 24.61 202.48
5 $ 202.48 $ 26.03 $ 1.27 $ 24.76 $ 2.48 $ 22.28 177.72
6 $ 177.72 $ 26.03 $ 1.11 $ 24.92 $ 100.00 $ 24.92 152.80
7 $ 152.80 $ 26.03 $ 0.96 $ 25.07 $ 25.07 127.73
8 $ 127.73 $ 26.03 $ 0.80 $ 25.23 $ 25.23 102.50
9 $ 102.50 $ 26.03 $ 0.64 $ 25.39 $ 2.50 22.88 77.12
10 $ 77.12 $ 26.03 $ 0.48 $ 25.55 $ 100.00 $ 25.55 51.57
11 $ 51.57 $ 26.03 $ 0.32 $ 25.70 $ 25.70 25.87
12 $ 25.87 $ 26.03 $ 0.16 $ 25.87 $ 25.87 -0.00
100.00
TAXATION
Interest income is taxed at ordinary income tax rates. However, interest income from govt. bonds could be exempt.

If the bonds are sold before maturity, capital gains might be taxed. Long term capital gains are usually taxed at lower rates
than Short term capital gains.

In case of deep discount bonds (ZCBs), the price movement towards par value are treated as interest income, and might be
taxed even though no cash payments are received.

Task – A 3 year maturity ZCB with par value of $1000 is issued at a discount rate of 12%. What is the issue price? Explain the
taxation of this ZCB for the investor.

Taxable Income
Value Today $711.78
Value at end of 1 year $797.19 $85.41
Value at end of 2 yrs $892.86 $95.66
Value at end of 3 years $1,000 $107.14

If bonds are issued at a premium and redeemed at par, investors are allowed to use part of the premium to reduce the
taxable portion of coupon interest payments.