Fixed-Income Securities: Defining Elements
2023 Curriculum CFA Program Level I Fixed Income
Fixed-income securities constitute the most prevalent means of raising capital globally based on total market value. These instruments allow governments, companies, and other issuers to borrow from investors, promising future interest payments and the return of principal, which are contractual (legal) obligations of the issuer. Fixed-income securities are the largest source of capital for government, not-for-profit, and other entities that do not issue equity. For private companies, fixed-income investors differ from shareholders in not having ownership rights. Payments of interest and repayment of principal (amount borrowed) are a higher priority claim on the company’s earnings and assets compared with the claim of common shareholders. Since fixed-income claims rank above shareholder claims in the capital structure, a company’s fixed-income securities have, in theory, lower risk than their common shares.
Financial analysts who master these and other fixed-income concepts have a distinct edge over their peers for several reasons. First, given the nature of fixed-income cash flows and their preponderance across issuers and regions, these instruments form the basis for risk versus return comparisons both across and within specific jurisdictions. For example, as bonds issued by the US Treasury and other developed market central governments are viewed as having little to no default risk, they serve as building blocks in determining the time value of money for less certain cash flows. Fixed-income securities also fulfill an important role in portfolio management as a prime means by which individual and institutional investors can fund known future obligations, such as tuition payments or retirement obligations. Finally, while the correlation of fixed-income returns with common share returns varies, adding fixed-income securities to portfolios that include common shares can be an effective way of obtaining diversification benefits.
Among the questions to be addressed are the following:
- Which features define a fixed-income security, and how do they determine the scheduled cash flows?
- What are the legal, regulatory, and tax considerations associated with a fixed-income security, and why are they important for investors?
- What are the common interest and principal payment structures?
- What types of provisions may affect the disposal or redemption of fixed-income securities?
Note that the terms “fixed-income securities,” “debt securities,” and “bonds” are often used interchangeably by experts and non-experts alike. We will also follow this convention, and where any nuance of meaning is intended, it will be made clear. Moreover, the term “fixed income” is not to be understood literally: Some fixed-income securities have interest payments that change over time.
The member should be able to:
- describe basic features of a fixed-income security;
- compare affirmative and negative covenants and identify examples of each;
- describe how legal, regulatory, and tax considerations affect the issuance and trading of fixed-income securities;
- describe how cash flows of fixed-income securities are structured;
- describe contingency provisions affecting the timing and/or nature of cash flows of fixed-income securities and whether such provisions benefit the borrower or the lender.
This reading introduces the salient features of fixed-income securities while noting how these features vary among different types of securities. Important points include the following:
- The three important elements that an investor needs to know when investing in a fixed-income security are: (1) the bond’s features, which determine its scheduled cash flows and thus the bondholder’s expected and actual return; (2) the legal, regulatory, and tax considerations that apply to the contractual agreement between the issuer and the bondholders; and (3) the contingency provisions that may affect the bond’s scheduled cash flows.
- The basic features of a bond include the issuer, maturity, par value (or principal), coupon rate and frequency, and currency denomination.
- Issuers of bonds include supranational organizations, sovereign governments, non-sovereign governments, quasi-government entities, and corporate issuers.
- Bondholders are exposed to credit risk and may use bond credit ratings to assess the credit quality of a bond.
- A bond’s principal is the amount the issuer agrees to pay the bondholder when the bond matures.
- The coupon rate is the interest rate that the issuer agrees to pay to the bondholder each year. The coupon rate can be a fixed rate or a floating rate. Bonds may offer annual, semi-annual, quarterly, or monthly coupon payments depending on the type of bond and where the bond is issued.
- Bonds can be issued in any currency. Such bonds as dual-currency bonds and currency option bonds are connected to two currencies.
- The yield-to-maturity is the discount rate that equates the present value of the bond’s future cash flows until maturity to its price. Yield-to-maturity can be considered an estimate of the market’s expectation for the bond’s return.
- A plain vanilla bond has a known cash flow pattern. It has a fixed maturity date and pays a fixed rate of interest over the bond’s life.
- The bond indenture or trust deed is the legal contract that describes the form of the bond, the issuer’s obligations, and the investor’s rights. The indenture is usually held by a financial institution called a trustee, which performs various duties specified in the indenture.
- The issuer is identified in the indenture by its legal name and is obligated to make timely payments of interest and repayment of principal.
- For asset-backed securities, the legal obligation to repay bondholders often lies with a separate legal entity—that is, a bankruptcy-remote vehicle that uses the assets as guarantees to back a bond issue.
- How the issuer intends to service the debt and repay the principal should be described in the indenture. The source of repayment proceeds varies depending on the type of bond.
- Collateral backing is a way to alleviate credit risk. Secured bonds are backed by assets or financial guarantees pledged to ensure debt payment. Examples of collateral-backed bonds include collateral trust bonds, equipment trust certificates, mortgage-backed securities, and covered bonds.
- Credit enhancement can be internal or external. Examples of internal credit enhancement include subordination, overcollateralization, and reserve accounts. A bank guarantee, a surety bond, a letter of credit, and a cash collateral account are examples of external credit enhancement.
- Bond covenants are legally enforceable rules that borrowers and lenders agree on at the time of a new bond issue. Affirmative covenants enumerate what issuers are required to do, whereas negative covenants enumerate what issuers are prohibited from doing.
- An important consideration for investors is where the bonds are issued and traded, because it affects the laws, regulation, and tax status that apply. Bonds issued in a country in local currency are domestic bonds if they are issued by entities incorporated in the country and foreign bonds if they are issued by entities incorporated in another country. Eurobonds are issued internationally, outside the jurisdiction of any single country and are subject to a lower level of listing, disclosure, and regulatory requirements than domestic or foreign bonds. Global bonds are issued in the Eurobond market and at least one domestic market at the same time.
- Although some bonds may offer special tax advantages, as a general rule, interest is taxed at the ordinary income tax rate. Some countries also implement a capital gains tax. There may be specific tax provisions for bonds issued at a discount or bought at a premium
- An amortizing bond is a bond whose payment schedule requires periodic payment of interest and repayment of principal. This differs from a bullet bond, whose entire payment of principal occurs at maturity. The amortizing bond’s outstanding principal amount is reduced to zero by the maturity date for a fully amortized bond, but a balloon payment is required at maturity to retire the bond’s outstanding principal amount for a partially amortized bond.
- Sinking fund agreements provide another approach to the periodic retirement of principal, in which an amount of the bond’s principal outstanding amount is usually repaid each year throughout the bond’s life or after a specified date.
- A floating-rate note, or floater, is a bond whose coupon is set based on a market reference rate (MRR) plus a spread. FRNs can be floored, capped, or collared. An inverse FRN is a bond whose coupon has an inverse relationship to the reference rate.
- Other coupon payment structures include bonds with step-up coupons, which pay coupons that increase by specified amounts on specified dates; bonds with credit-linked coupons, which change when the issuer’s credit rating changes; bonds with payment-in-kind coupons, which allow the issuer to pay coupons with additional amounts of the bond issue rather than in cash; and bonds with deferred coupons, which pay no coupons in the early years following the issue but higher coupons thereafter.
- The payment structures for index-linked bonds vary considerably among countries. A common index-linked bond is an inflation-linked bond, or linker, whose coupon payments and/or principal repayments are linked to a price index. Index-linked payment structures include zero-coupon-indexed bonds, interest-indexed bonds, capital-indexed bonds, and indexed-annuity bonds.
- Common types of bonds with embedded options include callable bonds, putable bonds, and convertible bonds. These options are “embedded” in the sense that there are provisions provided in the indenture that grant either the issuer or the bondholder certain rights affecting the disposal or redemption of the bond. They are not separately traded securities.
- Callable bonds give the issuer the right to buy bonds back prior to maturity, thereby raising the reinvestment risk for the bondholder. For this reason, callable bonds have to offer a higher yield and sell at a lower price than otherwise similar non-callable bonds to compensate the bondholders for the value of the call option to the issuer.
- Putable bonds give the bondholder the right to sell bonds back to the issuer prior to maturity. Putable bonds offer a lower yield and sell at a higher price than otherwise similar non-putable bonds to compensate the issuer for the value of the put option to the bondholders.
- A convertible bond gives the bondholder the right to convert the bond into common shares of the issuing company. Because this option favors the bondholder, convertible bonds offer a lower yield and sell at a higher price than otherwise similar non-convertible bonds.