Zero-coupon bond

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A zero-coupon bond (also discount bond or deep discount bond) is a bond bought at a price lower than its face value, with the face value repaid at the time of maturity.[1] It does not make periodic interest payments, or have so-called "coupons", hence the term zero-coupon bond. When the bond reaches maturity, its investor receives its par (or face) value. Examples of zero-coupon bonds include U.S. Treasury bills, U.S. savings bonds, long-term zero-coupon bonds,[1] and any type of coupon bond that has been stripped of its coupons.

In contrast, an investor who has a regular bond receives income from coupon payments, which are usually made semi-annually. The investor also receives the principal or face value of the investment when the bond matures. Some zero coupon bonds are inflation indexed, so the amount of money that will be paid to the bond holder is calculated to have a set amount of purchasing power rather than a set amount of money, but the majority of zero coupon bonds pay a set amount of money known as the face value of the bond. Zero coupon bonds may be long or short term investments. Long-term zero coupon maturity dates typically start at ten to fifteen years. The bonds can be held until maturity or sold on secondary bond markets. Shortterm zero coupon bonds generally have maturities of less than one year and are called bills. The U.S. Treasury bill market is the most active and liquid debt market in the world.
Contents [hide]

1 Strip bonds 2 Uses 3 Taxes 4 References

Strip bonds[edit]
Zero coupon bonds have a duration equal to the bond's time to maturity, which makes them sensitive to any changes in the interest rates. Investment banks or dealers may separate coupons from the principal of coupon bonds, which is known as the residue, so that different investors may receive the principal and each of the coupon payments. This creates a supply of new zero coupon bonds. The coupons and residue are sold separately to investors. Each of these investments then pays a single lump sum. This method of creating zero coupon bonds is known as stripping and the contracts are known as strip bonds. "STRIPS" stands for Separate Trading of RegisteredInterest and Principal Securities. [2] Dealers normally purchase a block of high-quality and non-callable bondsoften government issuesto create strip bonds. A strip bond has no reinvestment risk because the payment to the investor occurs only at maturity. The impact of interest rate fluctuations on strip bonds, known as the bond duration, is higher than for a coupon bond. A zero coupon bond always has a duration equal to its maturity; a coupon bond always has a lower duration. Strip bonds are normally available from investment dealers maturing at terms up to 30 years. For some Canadian bonds the maturity may be over 90 years.[citation needed]

In Canada, investors may purchase packages of strip bonds, so that the cash flows are tailored to meet their needs in a single security. These packages may consist of a combination of interest (coupon) and/or principal strips. In New Zealand, bonds are stripped first into two piecesthe coupons and the principal. The coupons may be traded as a unit or further subdivided into the individual payment dates. In most countries, strip bonds are primarily administered by a central bank or central securities depository. An alternative form is to use a custodian bank or trust company to hold the underlying security and a transfer agent/registrar to track ownership in the strip bonds and to administer the program. Physically created strip bonds (where the coupons are physically clipped and then traded separately) were created in the early days of stripping in Canada and the U.S., but have virtually disappeared due to the high costs and risks associated with them.

Uses[edit]
Pension funds and insurance companies like to own long maturity zero-coupon bonds because of the bonds' high duration. This high duration means that these bonds' prices are particularly sensitive to changes in the interest rate, and therefore offset, or immunize the interest rate risk of these firms' long-term liabilities.

Taxes[edit]
In the United States, a zero-coupon bond would have Original issue discount (OID) for tax purposes.[3] Instruments issued with OID generally impute the receipt of interest (sometimes called phantom income), even though these bonds don't pay periodic interest. [4] Because of this, zero coupon bonds subject to U.S. taxation should generally be held in tax-deferred retirement accounts, to avoid paying taxes on future income. Alternatively, when purchasing a zero coupon bond issued by a U.S. state or local government entity, the imputed interest is free of U.S. federal taxes, and in most cases, state and local taxes, too. Zero coupon bonds were first introduced in 1960s, but they did not become popular until the 1980s. The use of these instruments was aided by an anomaly in the US tax system, which allowed for deduction of the discount on bonds relative to their par value. This rule ignored the compounding of interest, and led to significant taxsavings when the interest is high or the security has long maturity. Although the tax loopholes were closed quickly, the bonds themselves are desirable because of their simplicity. In India, the tax on income from deep discount bonds can arise in two ways: interest or capital gains. It is also law that interest has to be shown on accrual basis for deep discount bonds issued after February 2002. This is as per CBDT circular No 2 of 2002 dated 15 February 2002. In finance, a convertible bond or convertible note (or a convertible debenture if it has a maturity of greater than 10 years) is a type ofbond that the holder can convert into a specified number of shares of common stock in the issuing company or cash of equal value. It is ahybrid security with debt- and equity-like features. It

originated in the mid-19th century, and was used by early speculators such as Jacob Littleand Daniel Drew to counter market cornering.[1] Convertible bonds are most often issued by companies with a low credit rating and high growth potential. To compensate for having additional value through the option to convert the bond to stock, a convertible bond typically has a coupon rate lower than that of similar, non-convertible debt. The investor receives the potential upside of conversion into equity while protecting downside with cash flow from the coupon payments and the return of principal upon maturity. These properties lead naturally to the idea of convertible arbitrage, where a long position in the convertible bond is balanced by a short position in the underlying equity. From the issuer's perspective, the key benefit of raising money by selling convertible bonds is a reduced cash interest payment. The advantage for companies of issuing convertible bonds is that, if the bonds are converted to stocks, companies' debt vanishes. However, in exchange for the benefit of reduced interest payments, the value of shareholder's equity is reduced due to the stock dilution expected when bondholders convert their bonds into new shares.
Contents [hide]

1 Types 2 Additional features 3 Structure and terminology 4 Markets and Investor profiles 5 Valuation 6 Uses for investors 7 Redemption options/strategies 8 Uses for issuers 9 2010 U.S. Equity-Linked Underwriting League Table 10 See also 11 References 12 External links

Types[edit]
The underwriters have been quite innovative and provided various variations of the initial convertible structure. Although no clear classification formally exists in the financial market it is possible to segment the convertible universe into the following sub-types:

Vanilla convertible bonds are the most plain convertible structures. They grant the holder the right to convert into certain amount of shares determined according to a conversion price determined in advance. They may offer coupon regular payments during the life of the security and have a fixed maturity date where the nominal value of the bond is redeemable by the holder. This type is the most common convertible type and is typically providing the asymmetric returns profile and positive convexity often

wrongly associated to the entire asset class: at maturity the holder would indeed either convert into shares or request the redemption at par depending on whether or not the stock price is above the conversion price.

Mandatory convertibles are a common variation of the vanilla subtype, especially on the US market. Mandatory convertible would force the holder to convert into shares at maturity - hence the term "Mandatory". Those securities would very often bear two conversion prices, making their profiles similar to a "risk reversal" option strategy. The first conversion price would limit the price where the investor would receive the equivalent of its par value back in shares, the second would delimit where the investor will earn more than par. Note that if the stock price is below the first conversion price the investor would suffer a capital loss compared to its original investment (excluding the potential coupon payments).

Reverse convertibles are a less common variation, mostly issued synthetically. They would be opposite of the vanilla structure: the conversion price would act as a knock-in short call option: as the stock price drops below the conversion price the investor would start to be exposed the underlying stock performance and no longer able to redeem at par its bond. This negative convexity would be compensated by a usually high regular coupon payment.

Packaged convertibles or sometimes "Bond + Option" structures are simply a straight bonds and a call option/warrant wrapped together. Usually the investor would be able to then trade both legs separately. Although the initial payoff is similar to a plain vanilla one, the Packaged Convertibles would then have different dynamics and risks associated with them since at maturity the holder would not receive some cash or shares but some cash and potentially some share. They would for instance miss the modified duration mitigation effect usual with plain vanilla convertibles structures.

Additional features[edit]
Any convertible bond structure, on top of its type, would bear a certain range of additional features as defined in its issuance prospectus:

Conversion price: The nominal price per share at which conversion takes place, this number is fixed at the issuance but could be adjusted under some circumstance described in the issuance prospectus (e.g. Underlying stock split). You could have more than one conversion price for non-vanilla convertible issuances.

Issuance premium: Difference between the conversion price and the stock price at the issuance. Conversion ratio: The number of shares each convertible bond converts into. It may be expressed per bond or on a per centum (per 100) basis. Maturity/redemption date: Final payment date of a loan or other financial instrument, at which point the principal (and all remaining interest) is due to be paid. In some cases, there is no maturity date (i.e. perpetual), this is often the case with preferred convertibles (e.g. US0605056821).

Final conversion date: Final date at which the holder can request the conversion into shares. Might be different from the redemption date. Coupon: Periodic interest payment paid to the convertible bond holder from the issuer. Could be fixed or variable or equal to zero.

Yield: Yield of the convertible bond at the issuance date, could be different from the coupon value if the bond is offering a premium redemption. In those cases the yield value would determine the premium redeption value and intermediary put redemption value.

Convertibles could bear other more technical features depending on the issuer needs:

Call features: The ability of the issuer (on some bonds) to call a bond early for redemption. This should not be mistaken for a call option. A Softcall would refer to a call feature where the issuer can only call under certain circumstances, typically based on the underlying stock price performance (e.g. current stock price is above 130% of the conversion price for 20 days out of 30 days). A Hardcall feature would not need any specific conditions beyond a date: that case the issuer would be able to recall a portion or the totally of the issuance at the Call price (typically par) after a specific date.

Put features: The ability of the holder of the bond (the lender) to force the issuer (the borrower) to repay the loan at a date earlier than the maturity. These often occur as windows of opportunity, every three or five years and allow the holders to exercise their right to an early repayment

Contingent conversion (aka CoCo): Restrict the ability of the convertible bondholders to convert into equities. Typically, restrictions would be typically based on the underlying stock price and/or time (e.g. convertible every quarter if stock price is above 115% of the conversion price). Reverse convertibles in that respect could be seen as a variation of a Mandatory bearing a contingent conversion feature based. More recently some CoCo's issuances have been based on Tier-1 capital ratio for some large bank issuers.

Reset: Conversion price would be reset to a new value depending on the underlying stock performance. Typically, would be in cases of underperformance (e.g. if stock price after a year is below 50% of the conversion price the new conversion price would be the current stock price).

Change of control event (aka Ratchet): Conversion price would be readjusted in case of a take-over on the underlying company. There are many subtype of ratchet formula (e.g. Make-whole base, time dependent...), their impact for the bondholder could be small (e.g. ClubMed, 2013) to significant (e.g. Aegis, 2012). Often, this clause would grant as well the ability for the convertible bondholders to "put" i.e. ask for the early repayment of their bonds.

Structure and terminology[edit]

Due to their relative complexity, the convertible investors could refers to the following terms while describing a convertible bonds:

Parity: Immediate value of the convertible if converted, typically obtained as current stock price multiplied by the conversion ratio expressed for a base of 100. Could be known as Exchange Property. Bond floor: Value of the fixed income element of a convertible i.e. not considering the ability to convert into equities. Premium: Defined as current convertible price minus the parity Exchangeable bond: Convertible bond where the issuing company and the underlying stock company are different companies (e.g. XS0882243453, GBL into GDF Suez). This distinction is usually made in terms of risk i.e. equity and credit risk being correlated: in some case the entities would be legally distinct, but not consider as an exchangeable as the ultimate guarantor being the same as the underlying stock company (e.g. typical in the case of the Sukuk, Islamic convertible bonds, needing a specific legal setup to be compliant with the Islamic law).

Synthetic: synthetically structured convertible bond issued by an investment bank to replicate a convertible payoff on a specific underlying. Most reverse convertibles are synthetics. Please note the Packaged Convertibles (e.g. Siemens 17 DE000A1G0WA1) are not considered to be synthetics since the issuer would not be an Investment Bank: they would only act as underwritter. Similarly, replicated structure using straight bonds and options would be considered as a package structure.

Markets and Investor profiles[edit]

The global convertible bond market is a relatively small with about 400 bn USD (as of Jan 2013, excluding synthetics), as a comparison the straight corporate bond market would be about 14,000 bn USD. Among those 400 bn, about 320 bn USD are "Vanilla" convertible bonds, the largest sub-segment of the asset class. Convertibles are not spread equally and some slight differences exist between the different regional markets:

North America: About 50% of the global convertible market, mostly from the USA (even if Canada is well represented in the Material sector). This market is more standardised than the others with convertible structures being relatively uniform (e.g. Standard Make-Whole take over features, Contigent Conversion @ 130%). Regarding the trading, the American convertible market is "centralised" around TRACE which helps in terms of price transparency. One other particularity of this market is the importance of the Mandatory Convertibles and Preferred especially for Financials (about 10-20% of the issuances in the US regional benchmarks). Most of the trading operation are based in New-York.

EMEA: European, African and Middle-Eastern issuances are trading usually out of Europe, London being the biggest node followed by Paris and to a lesser extend Frankfurt and Geneva. It represents about 25% of the global market and shows a greater diversity in terms of structures (e.g. from CoCoCo's to French OCEANE). Because of that lack of standardisation, it is often considered to be more technical and unforgiving than the American market from a trading perspective. A very tiny amount of the volumes is traded on exchange while the vast majority is done OTC without a price reporting system (e.g. like TRACE). Liquidity is significantly lower than on the Northern American market. Trading convention are NOT uniform: French Convertibles would trade dirty in units while the others countries would trade clean in notional equivalent.

Asia (ex Japan): This region represents about 17% of the total market, with an overall structure similar to the EMEA market albeit with more standardisation across the issuances. Most of the trading is done in Hong-Kong with a minor portion in Singapore.

Japan: This region represents about 8% of the total market as of January 2013 in spite of being in the past comparable in size to the Northern American market. It mostly shrunk because of the low interest environment making the competitive advantage of lowering coupon payment less appealing to issuers. One key specificity of the Japanese market is the offering price of issuance being generally above 100, meaning the investor would effectively bear a negative yield to benefit from the potential equity underlying upside. Most of the trading is done out of Tokyo (and Hong-Kong for some international firms).

Convertible bond investors get split into two broad categories: Hedged and Long-only investors.

Hedged/Arbitrage/Swap investors: Proprietary trading desk or hedged-funds using as core strategy Convertible Arbitrage which consists in, for its most basic iteration, as being long the convertible bonds while being short the underlying stock. Buying the convertible while selling the stock is often referred to as being "on swap". Hedged investors would modulate their differents risks (e.g. Equity, Credit, Interest-Rate, Volatility, Currency) by putting in place one or more hedge (e.g. Short Stock, CDS, Asset Swap, Option,

Future). Inherently, market-makers are hedged investors as they would have a trading book during the day and/or overnight held in a hedged fashion to provide the necessary liquidity to pursue their market making operations.

Long-only/Outright Investors: Convertible investors who will own the bond for their asymmetric payoff profiles. They would typically be exposed to the various risk. Please note that Global convertible funds would typically hedged their currency risk as well as interest rate risk in some occasions, however Volatility, Equity & Credit hedging would typically be excluded from the scope of their strategy.

The splits between those investors differ across the regions: In 2013, the American region was dominated by Hedged Investors (about 60%) while EMEA was dominated by Long-Only investors (about 70%). Globally the split is about balanced between the two categories.

Valuation[edit]
See also Bond option: Embedded options, for further detail. In theory, the market price of a convertible debenture should never drop below its intrinsic value. The intrinsic value is simply the number of shares being converted at par value times the current market price of common shares. The 3 main stages of convertible bond behaviour are:

In-the-money convertible bonds At-the-money convertible bonds In-the-money: Conversion Price is < Equity Price. At-the-money: Conversion Price is = Equity Price. Out-the-money: Conversion Price is > Equity Price. In-the-money CB's are considered as being within Area of Equity (the right hand side of the diagram) At-the-money CB's are considered as being within Area of Equity & Debt (the middle part of the diagram) Out-the-money CB's are considered as being within Area of Debt (the left hand side of the diagram)

From a valuation perspective, a convertible bond consists of two assets: a bond and a warrant. Valuing a convertible requires an assumption of 1. 2. the underlying stock volatility to value the option and the credit spread for the fixed income portion that takes into account the firm's credit profile and the ranking of the convertible within the capital structure. Using the market price of the convertible, one can determine the implied volatility (using the assumed spread) or implied spread (using the assumed volatility). This volatility/credit dichotomy is the standard practice for valuing convertibles. What makes convertibles so interesting is that, except in the case of exchangeables (see above), one cannot entirely separate the volatility from the credit. Higher volatility (a good thing) tends to accompany weaker credit (bad). In the

case of exchangeables, the credit quality of the issuer may be decoupled from the volatility of the underlying shares. The true artists of convertibles and exchangeables are the people who know how to play this balancing act. A simple method for calculating the value of a convertible involves calculating the present value of future interest and principal payments at the cost of debt and adds the present value of the warrant. However, this method ignores certain market realities including stochastic interest rates and credit spreads, and does not take into account popular convertible features such as issuer calls, investor puts, and conversion rate resets. The most popular models for valuing convertibles with these features are finite difference models such as binomial and trinomial trees.

Binomial valuations Since 1991-92, most market-makers in Europe have employed binomial models to evaluate convertibles. Models were available from INSEAD, Trend Data of Canada, Bloomberg LP and from home-developed models, amongst others. These models needed an input of credit spread, volatility for pricing (historic volatility often used), and the risk-free rate of return. The binomial calculation assumes there is a bell-shaped probability distribution to future share prices, and the higher the volatility, the flatter is the bell-shape. Where there are issuer calls and investor puts, these will affect the expected residual period of optionality, at different share price levels. The binomial value is a weighted expected value, (1) taking readings from all the different nodes of a lattice expanding out from current prices and (2) taking account of varying periods of expected residual optionality at different share price levels. The three biggest areas of subjectivity are (1) the rate of volatility used, for volatility is not constant, and (2) whether or not to incorporate into the model a cost of stock borrow, for hedge funds and market-makers. The third important factor is (3) the dividend status of the equity delivered, if the bond is called, as the issuer may time the calling of the bond to minimise the dividend cost to the issuer.

Uses for investors[edit]

Convertible bonds are usually issued offering a higher yield than obtainable on the shares into which the bonds convert.

Convertible bonds are safer than preferred or common shares for the investor. They provide asset protection, because the value of the convertible bond will only fall to the value of the bond floor. At the same time, convertible bonds can provide the possibility of high equity-like returns.

Also, convertible bonds are usually less volatile than regular shares. Indeed, a convertible bond behaves like a call option. Therefore, if C is the call price and S the regular share then

In consequence, since

we get

, which implies that the variation

of C is less than the variation of S, which can be interpreted as less volatility.

The simultaneous purchase of convertible bonds and the short sale of the same issuer's common stock is a hedge fund strategy known as convertible arbitrage. The motivation for such a strategy is that the equity option embedded in a convertible bond is a source of cheap volatility, which can be exploited by convertible arbitrageurs.

In limited circumstances, certain convertible bonds can be sold short, thus depressing the market value for a stock, and allowing the debt-holder to claim more stock with which to sell short. This is known as death spiral financing.

Redemption options/strategies[edit]

Soft put - can be redeemed for cash, stock or notes or a combination of all three at the company's discretion. Hard put - payable only in cash Protective put - buying a put option for the underlying bond security Subordinated put Convertible put - convert to share by paying a charge

Uses for issuers[edit]

Lower fixed-rate borrowing costs. Convertible bonds allow issuers to issue debt at a lower cost. Typically, a convertible bond at issue yields 1% to 3% less than straight bonds.

Locking into low fixedrate long-term borrowing. For a finance director watching the trend in interest rates, there is an attraction in trying to catch the lowest point in the cycle to fund with fixed rate debt, or swap variable rate bank borrowings for fixed rate convertible borrowing. Even if the fixed market turns, it may still be possible for a company to borrow via a convertible carrying a lower coupon than ever would have been possible with straight debt funding.

Higher conversion price than a rights issue strike price. Similarly, the conversion price a company fixes on a convertible can be higher than the level that the share price ever reached recently. Compare the equity dilution on a convertible issued on, say, a 20 or 30pct premium to the higher equity dilution on a rights issue, when the new shares are offered on, say, a 15 to 20pct discount to the prevailing share price.

Voting dilution deferred. With a convertible bond, dilution of the voting rights of existing shareholders only happens on eventual conversion of the bond. However convertible preference shares typically carry voting rights when preference dividends are in arrears. Of course, the bigger voting impact occurs if the issuer decides to issue an exchangeable rather than a convertible.

Increasing the total level of debt gearing. Convertibles can be used to increase the total amount of debt a company has in issue. The market tends to expect that a company will not increase straight debt beyond certain limits, without it negatively impacting upon the credit rating and the cost of debt. Convertibles can provide additional funding when the straight debt window may not be open. Subordination of convertible

debt is often regarded as an acceptable risk by investors if the conversion rights are attractive by way of compensation.

Maximising funding permitted under pre-emption rules. For countries, such as the UK, where companies are subject to limits on the number of shares that can be offered to non-shareholders non-pre-emptively, convertibles can raise more money than via equity issues. Under the UKs 1989 Guidelines issued by the Investor Protection Committees (IPCs) of the Association of British Insurers (ABI) and the National Association of Pension Fund Managers (NAPF), the IPCs will advise their members not to object to non pre-emptive issues which add no more than 5pct to historic non-diluted balance sheet equity in the period from AGM to AGM, and no more than 7.5pct in total over a period of 3 financial years. The pre-emption limits are calculated on the assumption of 100pct probability of conversion, using the figure of undiluted historic balance sheet share capital (where there is assumed a 0pct probability of conversion). There is no attempt to assign probabilities of conversion in both circumstances, which would result in bigger convertible issues being permitted. The reason for his inconsistency may lie in the fact that the Pre Emption Guidelines were drawn up in 1989, and binomial evaluations were not commonplace amongst professional investors until 1991-92.

Premium redemption convertibles such as the majority of French convertibles and zero-coupon Liquid Yield Option Notes (LYONs), provide a fixed interest return at issue which is significantly (or completely) accounted for by the appreciation to the redemption price. If, however, the bonds are converted by investors before the maturity date, the issuer will have benefited by having issued the bonds on a low or even zero-coupon. The higher the premium redemption price, (1) the more the shares have to travel for conversion to take place before the maturity date, and (2) the lower the conversion premium has to be at issue to ensure that the conversion rights are credible.

Takeover paper. Convertibles have a place as the currency used in takeovers. The bidder can offer a higher income on a convertible than the dividend yield on a bid victims shares, without having to raise the dividend yield on all the bidders shares. This eases the process for a bidder with low-yield shares acquiring a company with higheryielding shares. Perversely, the lower the yield on the bidders shares, the easier it is for the bidder to create a higher conversion premium on the convertible, with consequent benefits for the mathematics of the takeover. In the 1980s, UK domestic convertibles accounted for about 80pct of the European convertibles market, and over 80pct of these were issued either as takeover currency or as funding for takeovers. They had several cosmetic attractions.

The pro-forma fully diluted earnings per share shows none of the extra cost of servicing the convertible up to the conversion day irrespective of whether the coupon was 10pct or 15pct. The fully diluted earnings per share is also calculated on a smaller number of shares than if equity was used as the takeover currency. In some countries (such as Finland) convertibles of various structures may be treated as equity by the local accounting profession. In such circumstances, the accounting treatment may result in less pro-

forma debt than if straight debt was used as takeover currency or to fund an acquisition. The perception was that gearing was less with a convertible than if straight debt was used instead. In the UK the predecessor to the International Accounting Standards Board (IASB) put a stop to treating convertible preference shares as equity. Instead it has to be classified both as (1) preference capital and as (2) convertible as well. Nevertheless, none of the (possibly substantial) preference dividend cost incurred when servicing a convertible preference share is visible in the pro-forma consolidated pretax profits statement. The cosmetic benefits in (1) reported pro-forma diluted earnings per share, (2) debt gearing (for a while) and (3) pro-forma consolidated pre-tax profits (for convertible preference shares) led to UK convertible preference shares being the largest European class of convertibles in the early 1980s, until the tighter terms achievable on Euroconvertible bonds resulted in Euroconvertible new issues eclipsing domestic convertibles (including convertible preference shares) from the mid 1980s.

Tax advantages. The market for convertibles is primarily pitched towards the non taxpaying investor. The price will substantially reflect (1) the value of the underlying shares, (2) the discounted gross income advantage of the convertible over the underlying shares, plus (3) some figure for the embedded optionality of the bond. The tax advantage is greatest with mandatory convertibles. Effectively a high tax-paying shareholder can benefit from the company securitising gross future income on the convertible, income which it can offset against taxable profits.

Definition of 'Convertible Debenture'

A type of loan issued by a company that can be converted into stock by the holder and, under certain circumstances, the issuer of the

bond. By adding the convertibility option the issuer pays a lower interest rate on the loan compared to if there was no option to convert. These instruments are used by companies to obtain the capital they need to grow or maintain the business.

Investopedia explains 'Convertible Debenture'

Convertible debentures are different from convertible bonds because debentures are unsecured; in the event of bankruptcy the debentures would be paid after other fixed income holders. The convertible feature is factored into the calculation of the diluted per-share metrics as if the debentures had been converted. Therefore, a higher share count reduces metrics such as earnings per share, which is referred to as dilution.
Floating rate notes (FRNs) are bonds that have a variable coupon, equal to a money market reference rate, like LIBOR or federal funds rate, plus a quoted spread (a.k.a. quoted margin). The spread is a rate that remains constant. Almost all FRNs have quarterly coupons, i.e. they pay out interest every three months. At the beginning of each coupon period, the coupon is calculated by taking the fixing of the reference ratefor that day and adding the spread. A typical coupon would look like 3 months USD LIBOR +0.20%.

Contents [hide]

1 Issuers 2 Variations 3 Risk 4 Trading

4.1 Example

5 Simple margin 6 See also

Issuers[edit]
In the U.S., government sponsored enterprises (GSEs) such as the Federal Home Loan Banks, the Federal National Mortgage Association(Fannie Mae) and the Federal Home Loan Mortgage Corporation (Freddie Mac) are important issuers. In Europe the main issuers are banks.

Variations[edit]
Some FRNs have special features such as maximum or minimum coupons, called "capped FRNs" and "floored FRNs". Those with both minimum and maximum coupons are called "collared FRNs". "Perpetual FRNs" are another form of FRNs that are also called irredeemable or unrated FRNs and are akin to a form of capital. FRNs can also be obtained synthetically by the combination of a fixed rate bond and an interest rate swap. This combination is known as an asset swap.

Perpetual notes (PRN) Variable rate notes (VRN) Structured FRN Reverse FRN Capped FRN Floored FRN Collared FRN Step up recovery FRN (SURF) Range/corridor/accrual notes Leveraged/deleveraged FRN

A deleveraged floating-rate note is one bearing a coupon that is the product of the index and a leverage factor, where the leverage factor is between zero and one. A deleveraged floater, which gives the investor decreased exposure to the underlying index, can be replicated by buying a pure FRN and entering into a swap to pay floating and receive fixed, on a notional amount of less than the face value of the FRN. Deleveraged FRN = long pure FRN + short (1 - leverage factor) x swap

A leveraged or super floater gives the investor increased exposure to an underlying index: the leverage factor is always greater than one. Leveraged floaters also require a floor, since the coupon rate can never be negative. Leveraged FRN = long pure FRN + long (leverage factor - 1) x swap + long (leverage factor) x floor

Risk[edit]
FRNs carry little interest rate risk. An FRN has a duration close to zero, and its price shows very low sensitivity to changes in market rates. When market rates rise, the expected coupons of the FRN increase in line with the increase in forward rates, which means its price remains constant. Thus, FRNs differ from fixed rate bonds, whose prices decline when market rates rise. As FRNs are almost immune to interest rate risk, they are considered conservative investments for investors who believe market rates will increase. The risk that remains is credit risk.

Trading[edit]
Securities dealers make markets in FRNs. They are traded over-the-counter, instead of on a stock exchange. In Europe, most FRNs are liquid, as the biggest investors are banks. In the US, FRNs are mostly held to maturity, so the markets aren't as liquid. In the wholesale markets, FRNs are typically quoted as a spread over the reference rate.

Example[edit]
Suppose a new 5 year FRN pays a coupon of 3 months LIBOR +0.20%, and is issued at par (100.00). If the perception of the credit-worthiness of the issuer goes down, investors will demand a higher interest rate, say LIBOR +0.25%. If a trade is agreed, the price is calculated. In this example, LIBOR +0.25% would be roughly equivalent to a price of 99.75. This can be calculated as par, minus the difference between the coupon and the price that was agreed (0.05%), multiplied by the maturity (5 year).

Simple margin[edit]
The simple margin is a measure of the effective spread of a FRN that is not traded at par. If the FRN trades at par, the simple margin will equal the quoted spread. To calculate the simple margin, first compute the sum of the quoted spread of the FRN and the capital gain (or loss) a investor will earn if the FRN is held to maturity.

Second, adjust the above for the fact that the FRN is bought at a discount or premium to the nominal value:

A more complex measure of the effective spread is a discount margin, which takes into account the "time value of money" of the FRN cash flows. The formula for the calculation of the discount margin is more complex and its calculation generally requires a financial calculator or a computer.
Secured premium notes are nothing but a share warrant which are only issued by the listed companies after getting the approval from the central government

To meet its long term and short term needs of finance, a company may issue various kinds of securities to raise funds from public. A company may decide to issue securities because it needs start up capital or to repay debts or even to expand. It may also need an infusion of new management ideas and know-how. These can be had by a wider ownership base. When an investor buys securities commonly referred to as shares he is enabling the company to carry on its business using the funds provided with little stress. One such financial instrument through which a company can raise capital is secured premium note. The below articles decode what are secured premium notes. SPN and lock-in-period Secured premium notes (SPNs) are financial instruments which are issued with detachable warrants and are redeemable after certain period. SPN is a kind of non-convertible debenture (NCD) attached with warrant. It can be issued by the companies with the lock-in-period of say four to seven years. This means an investor can redeem his SPN after lock-in-period. SPN holders will get principal amount with interest on installment basis after lock in period of said period. However, during the lock in period no interest is paid. Thus, SPNs are nothing but a share warrant which are only issued by the listed companies after getting the approval from the central government. SPN is a hybrid security i.e. it combines both features of equity and debt products. Features of a SPN

SPN instruments are issued with a detachable warrant. These instruments have lock-in-period for 4 to 7 years. No interest is paid during the lock in period.

After the lock-in-period, the holder may sell back the SPN to the company.

The detachable warrants are convertible into equity shares provided the secured premium notes are fully paid. The conversion of detachable warrants into equity has to be done within the specified time. After the lock-in-period, the holder has an option to sell back the SPN to the company at par value. If the holder exercises this option, no interest/premium is paid on redemption. In case the holder keeps his investment further, he is repaid the principal amount along with the additional interest/premium on redemption in installments. SPN were so formulated that the return on investment was treated as capital gain and not regular income. Consequently, the rate of tax applicable was lower. TISCO (Tata Iron and Steel Company) took the lead in July, 1992 by making a mega rights issue of equity shares and secured premium notes aggregating to Rs. 1,212 crore.

- See more at: http://www.flame.org.in/KnowledgeCenter/Whataresecuredpremiumnotes.aspx#sthash.BTIiVa5N.dpuf

Structured note
From Wikipedia, the free encyclopedia

A structured note is a hybrid security that includes several financial products, typically a stock or bond plus a derivative. A simple example would be a five-year bond tied together with an option contract. The addition of the option contract changes the security's risk/return profile to make it more tailored to an investor's comfort zone. This makes it possible to invest in an asset class that would otherwise be considered too risky. [1] From the investor's point of view, a structured note might look like this: I agree to a three-year contract with a bank. I give the bank $100. The money will be indexed to the S&P 500. In three years, if the S&P has gone up, the bank will pay me $100 plus the gain in the S&P. However, if the S&P has gone down, the bank will pay me back the entire $100 - an advantage known as downside protection. (In reality the downside protection is usually "contingent", i.e. it only applies up to a certain threshold amount. For example, with a threshold of 40%, if the S&P has gone down by more than 40%, the bank will no longer pay me back $100, but instead it will pay me the proportional value indexed to the S&P - e.g. $55 if the S&P has gone down by 45%.[2
A Structured Note combines two elements: A bond (that protects your principal) makes up most of the investment (typically 80%), and the rest of your money is put into a derivative. Because the investment bond element in Structured Notes can be designed to give a return that equals your initial investment (as long as you keep the product until maturity), your principal will be protected. And the derivative element offers you the potential to achieve higher returns when compared with a standard deposit. Structured Note terms are generally between 18 months and six years and it is important that you can afford to tie up your money for that period, because your principal is only protected when Structured Notes are held for their full term. Citi International Personal Bank regularly launches new structured products that take advantage of current market conditions and Citi's expert investment advice. This ensures our Structured Notes are always competitive and provide you with the opportunity to benefit in changing markets.

Please note: All structured products such as Structured Notes are subject to Issuer risk and must be held until maturity to ensure your principal is protected.
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Structured Note examples

Please note:These are examples only and actual returns will vary, they are not recommendations or advice. Please talk to your Relationship Manager or Financial Adviser to identify Structured Notes that best suit your needs.
For example, you could choose a two year 100% principal protected Structured Note linked to gold, available in US Dollars / Euros or Sterlings. At maturity, the investor receives 100% of the principal investment, and has the potential to get higher returns subject to the favourable movement in the price of gold over the two-year term. Another option could be a three year Structured Note from Citigroup Funding Inc in Euros. In the first two year the fixed coupon paid 6% per annum in each respective year. At maturity (in the third year), the final amount earned on the Structured Notes depends on the performance of the top 20 stocks of DJ Eurostoxx Index; (Where the contingent

coupon could earn up to 30% if all 20 stocks increased in price. The maturity levels in 2012 will be compared with the initial levels in 2009).

Tailored investment
In addition to the wide range of Structured Notes we offer, we can put together an individual structured product that matches your requirements. So if you want the investment portion to target a particular sector or you would prefer not to 100% protect your principal for the potential of higher returns, this can also be arranged. We regularly provide this service for clients based on their needs combined with our experts' opinions of future growth sectors. You can take out a Structured Note in Euro, US dollars, Sterling or other currencies, minimum investment terms apply. Please speak to your Relationship Manager for full details.

Who do they suit?

Structured Notes are innovative and flexible investment products that suit a wide range of investors.

Investors who want to diversify their portfolio with lower risk products that protect their principal and still offer the opportunity to realise higher rewards than a standard Time Deposit. Those who want the chance to invest in high-risk securities they wouldn't consider direct investment into, such as equities or commodities. Investors who can lock away their money for the term of the particular Structured Note. Those who can meet the minimum investment criteria to invest in a Structured Note. Please speak directly to your Relationship Manager for full details.

Those who accept only receiving back the initial amount invested, if the derivative element of the Structured Note does not perform.

Inflation-indexed bonds (also known as inflation-linked bonds or colloquially as linkers) are bonds where the principal is indexed toinflation. They are thus designed to cut out the inflation risk of an investment.[1] The first known inflation-indexed bond was issued by theMassachusetts Bay Company in 1780.[2] The market has grown dramatically since the British government began issuing inflation-linked Gilts in 1981. As of 2008, government-issued inflation-linked bonds comprise over $1.5 trillion of the international debt market.[3] The inflation-linked market primarily consists of sovereign bonds, with privately issued inflation-linked bonds constituting a small portion of the market. See also: inflation derivatives
Contents [hide]

1 Structure

1.1 Real Yield

2 Global issuance 3 Inflation-indexed bond indices 4 See also 5 References

6 External links

6.1 Print

Structure[edit]
Inflation-indexed bonds pay a periodic coupon that is equal to the product of the inflation index and the nominal coupon rate. The relationship between coupon payments, breakeven inflation and real interest rates is given by the Fisher equation. A rise in coupon payments is a result of an increase in inflation expectations, real rates, or both. For some bonds, such as the Series I Savings Bonds (U.S.), the interest rate is adjusted according to inflation. For other bonds, such as in the case of TIPS, the underlying principal of the bond changes, which results in a higher interest payment when multiplied by the same rate. For example, if the annual coupon of the bond were 5% and the underlying principal of the bond were 100 units, the annual payment would be 5 units. If the inflation index increased by 10%, the principal of the bond would increase to 110 units. The coupon rate would remain at 5%, resulting in an interest payment of 110 x 5% = 5.5 units.

Real Yield[edit]
The real yield of any bond is the annualized growth rate, less the rate of inflation over the same period. This calculation is often difficult in principle in the case of a nominal bond, because the yields of such a bond are specified for future periods in nominal terms, while the inflation over the period is an unknown rate at the time of the calculation. However, in the case of inflation-indexed bonds such as TIPS, the bond yield is specified as a rate in excess of inflation, so the real yield can be easily calculated using a standard bond calculation formula.[4]

Global issuance[edit]
The most liquid instruments are Treasury Inflation-Protected Securities (TIPS), a type of US Treasury security, with about $500 billion in issuance. The other important inflation-linked markets are the UK Index-linked Gilts with over $300 billion outstanding and the French OATi/OATi market with about $200 billion outstanding. Germany, Canada, Greece, Australia, Italy, Japan, Sweden and Iceland also issue inflationindexed bonds, as well as a number of Emerging Markets, most prominently Brazil.[5] [6]

Country

Issue

Issuer

Inflation Index

United States

Treasury Inflation-Protected Securities (TIPS)[7]

US Treasury

US Consumer Price Index

United States

Series I Inflation-Indexed Savings Bonds (I-Bonds - domestic retail bonds)

[8]

US Treasury

US Consumer Price Index

United Kingdom

Index-linked Gilt

UK Debt Management Office

Retail Price Index (RPI)

United Kingdom

Index-linked Savings Certificates (domestic retail bonds)

National Savings and Investments

Retail Price Index (RPI)

France CPI ex-tobacco France OATi and OATi[9] Agence France Trsor (OATi), EU HICPex-tobacco (OATi)

Canada

Real Return Bond (RRB)[10]

Bank of Canada

Canada All-Items CPI

Australia

Capital Indexed Bonds (CAIN series)

Department of the Treasury (Australia)

Weighted Average of Eight Capital Cities: All-Groups Index

Bundesrepublik Germany Bund index. and BO index. Deutschland Finanzagentur EU HICP ex Tobacco

Greece

EU HICP ex Tobacco

Hong Kong iBond (domestic retail bonds)

Hong Kong Government

Composite Consumer Price Index

Italy

BTPi

Department of the Treasury

EU HICP ex Tobacco

India

Reserve Bank of India

Wholesale Price Index

Italy

BTP Italia (domestic retail bonds)

Department of the Treasury

Italy CPI ex tobacco

Japan

JGBi

Ministry of Finance (Japan)

Japan CPI (nationwide, exfresh-food)

Sweden

Index-linked treasury bonds

Swedish National Debt Office

Swedish CPI

Iceland

Inflation-indexed bond indices[edit]

See also: Bond market index Inflation-indexed bond indices include the family of Barclays Inflation Linked Bond Indices,[11] such as the Barclays Inflation Linked Euro Government Bond Indices, and theLehman Brothers U.S. Treasury: U.S. TIPS index.[12]

Definition of 'IndexLinked Bond'

A bond in which payment of income on the principal is related to a specific price index - often the Consumer Price Index. This feature provides protection to investors by shielding them from changes in

the underlying index. The bond's cash flows are adjusted to ensure that the holder of the bond receives a known real rate of return. In Canada, they also referred to as "real return bonds."

Investopedia explains 'Index-Linked Bond'

This type of bond is valuable to investors because the real value of the bond is known from purchase and the risk involved with uncertainty is eliminated. These bonds are also less volatile than nominal bonds and they help investors to maintain their purchasing power. For example, assume that you purchase a regular bond with a nominal return of 4%. If inflation is 3%, you will actually only receive 1% in real terms. On the other hand, if you buy an index-linked bond your cash flow will be adjusted to changes in inflation and you will still receive the full 4% in returns.