CFA Level I

Study Session 15 Reading 52

Reading 53
Reading 54
Reading 55
Features of Debt Securities
Risks Associated with Investing in Bonds
Overview of Bond Sectors and Instruments
Understanding Yield Spreads
 CFA Level I: Fixed Income
LOS 52:
Features of debt securities

• Explain the purpose of bond indentures and describe covenants

• Describe various features of bond, various coupon rate and structure of
floating rate securities
• Describe accrued interest, full price and clean price
• Explain the provisions of redemption and retirement of bonds
• Identify common options embedded in a bond issue and explain their
importance and state whether such options benefit the issuer or bond
holders
• Describe methods used by institutional investors to finance the purchase of
a security
Bond indenture and covenants

A contract that specifies the rights of the bond holders and promises made by the issuer at the time of issue is called
bond indenture.

An indenture has two types of covenants attached to it:

1. Affirmative covenants: pay interest and principal amount on time etc.

2. Negative covenants: it states the restrictions and limitations on issuers like prevention of additional issue of debt.

3
© iPlan Education
Features of Bond

Maturity – period for which bond will remain outstanding

Term of maturity is important because:

1. It indicates the time period over which the holder can expect to receive interest payments
2. Yield offered on bond depends on time to maturity
3. Price of a bond fluctuates as interest rate in the market changes.

Par value – face value that the issuer will repay at then of the maturity

Coupon rate – it is the interest rate that the issuer pays each year to the holders. Interest is calculated as par value
multiplied by coupon rate.

4
© iPlan Education
Coupon rate structures
1. Zero – coupon Bond – bonds do not pay periodic interest pavements. Interest is realised at the end of
the maturity as difference between the par value and issue value.

2. Step-up notes – coupon rate increases over time.

3. Deferred – coupon bonds – interest is deferred for some no. of years.

4. Floating rate securities – coupon rate is not fixed. Also called variable rate securities. It resets
periodically according to some reference rate.
coupon rate = Reference rate + Quoted margin

Issues whose coupon rate moves in the opposite direction from the change in the reference rate are
called inverse floater

5
© iPlan Education
Coupon rate structures

Example: Identify the coupon rate structure

A. Coupon rate = 20% - 1.5 * (3 year treasury rate)

B. Coupon rate = 1 month LIOBOR + 50 basis points

C. Coupon structure Year 1 to 3 5%

Year 4 to 7 5.5%
Year 7 to 10 6%

6
© iPlan Education
Accrued interest

Accrued interest is the interest that the buyer(new owner) of the bond owes to the seller (old owner) of the bond
when the bond trades between the coupon dates.

Eg: Mr A is the owner of Bond X receives interest payments annually. He is entitled to receive interest on 31st
December, 2012. But he sold bond X to Mr B on 1st July, 2012.
Accrued interest for Mr A is from 1st Jan to 30th June. Mr B will receive interest on 31st December and owes interest to
Mr A from 1st Jan to 30th June.

The amount that Mr B will pay to Mr A to purchase the bond is called clean price.

The amount that Mr B will pay to Mr A to purchase the bond plus the accrued interest is called the full(or dirty) price.

7
© iPlan Education
Redemption & Retirement of Bonds

Issuer can opt for bullet maturity or amortisation of bonds.

 Call and refunding provisions

 Prepayments

 Sinking fund provisions

Note: non callable bond has protection against a call prior to maturity
non refundable bond can be called for any reason apart from refunding.

8
© iPlan Education
Embedded options
It is referred to as embedded option because they are rooted in the issue.

Embedded option granted to issuers:

1. Right to call the issue
2. Right of the underlying borrowers in a pool of loans to repay principal above scheduled principal payment
3. Accelerated sinking fund provision
4. Cap on a floater

Embedded option granted to bond holders:

1. Conversion privilege
2. Right to put the issue
3. Floor on a floater

9
© iPlan Education
Importance of understanding embedded options

To value a fixed income security with embedded options, it is necessary to:

• model the factors that determine whether or not an embedded option will be exercised over the life of the
security; and
• in the case of options granted to the issuer/borrower, model the behaviour of issuers and borrowers to determine
the conditions necessary for them to exercise an embedded option.

Analysing securities with embedded options exposes an investor to modelling risk.

10
© iPlan Education
Borrowing funds to purchase bonds

Institutional investors use following two methods :

1. Margin buying: funds are borrowed from the broker and bank pays the broker. Broker charges call
money rate plus service charge from the investor.

2. Repurchase agreements: sale of a security by the seller with a promise to buy it back from the
purchaser at a specified date in future.

11
© iPlan Education