CHAPTER 1

FIXED-INCOME SECURITIES: DEFINING ELEMENTS

Moorad Choudhry, PhD, FRM, FCSI

Stephen E. Wilcox, PhD, CFA

LEARNING OUTCOMES

The candidate should be able to:

• describe basic features of a fixed-income security;

• describe content of a bond indenture;

• 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.

1. INTRODUCTION AND OVERVIEW OF A FIXED-INCOME SECURITY

• describe basic features of a fixed-income security

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.

1.1. Overview of a Fixed-Income Security

A bond is a contractual agreement between the issuer and the bondholders. Three important elements that an investor needs to know about when considering a fixed-income security are:

• The bond's features, including the issuer, maturity, par value, coupon rate and frequency, and currency denomination. These features determine the bond's scheduled cash flows and, therefore, are key determinants of the investor's expected and actual return.

• The legal, regulatory, and tax considerations that apply to the contractual agreement between the issuer and the bondholders.

• The contingency provisions that may affect the bond's scheduled cash flows. These contingency provisions are options providing either issuers or bondholders certain rights affecting the bond's disposal or redemption.

This section describes a bond's basic features and introduces yield measures. The legal, regulatory, and tax considerations and contingency provisions are discussed in subsequent sections.

1.1.1. Basic Features of a Bond

All bonds, regardless of issuer, are characterized by the same basic features, which include maturity, par or principal amount, coupon size, frequency, and currency.

1.1.1.1. Issuer

Many entities issue bonds: private individuals, such as the musician David Bowie; national governments, such as Singapore or Italy; and companies, such as BP, General Electric, or Tata Group.

Bond issuers are classified into categories based on the similarities of these issuers and their characteristics. Major types of issuers include the following:

• Supranational organizations, such as the World Bank or the European Investment Bank;

• Sovereign (national) governments, such as the United States or Japan. As sovereign bonds are backed by the full faith and credit of each respective government, they usually represent the lowest risk and most secure bonds in each market;

• Non-sovereign (local) governments, such as the State of Minnesota in the United States, the Catalonia region in Spain, or the City of Edmonton in Alberta, Canada;

• Quasi-government entities (i.e., agencies that are owned or sponsored by governments), such as postal services in many countries-for example, Correios in Brazil, La Poste in France, or Pos in Indonesia;

• Companies (i.e., corporate issuers). A distinction is often made between financial issuers (e.g., banks and insurance companies) and non-financial issuers; and

• Special legal entities (i.e., special purpose entities) that use specific assets, such as auto loans and credit card debt obligations, to guarantee (or secure) a bond issue known as an asset-backed security that is then sold to investors.

Market participants often classify fixed-income markets by the type of issuer, which leads to the identification of three bond market sectors: the government and government-related sector (i.e., the first four types of issuers just listed), the corporate sector (the fifth type listed), and the structured finance sector (the last type listed).

While several major local fixed-income markets, such as China and Japan, are dominated by government issuers, a significant portion of the US bond market consists of corporate issuance and asset-backed securities in addition to US treasury securities issued by the federal government.

Asset-backed securities (ABS) are created from a process called securitization, which involves moving assets from the owner of the assets into a special legal entity. This special legal entity then uses the securitized assets as guarantees to back (secure) a bond issue, leading to the creation of ABS. Assets that are typically used to create ABS include residential and commercial mortgage loans (mortgages), automobile (auto) loans, student loans, bank loans, and credit card debt. Many elements discussed in this chapter apply to both traditional bonds and ABS. Considerations specific to ABS are discussed in a separate chapter on asset-backed securities.

Bondholders are exposed to credit risk-that is, the risk of loss resulting from the issuer failing to make full and timely payments of interest and/or repayments of principal. Credit risk is inherent to all debt investments. Bond markets are sometimes classified into sectors based on the issuer's creditworthiness as judged by credit rating agencies. The three largest credit rating agencies are Moody's Investors Service, Standard & Poor's, and Fitch Ratings. One major distinction is between investment-grade and non-investment-grade bonds, also called high-yield or speculative bonds. For example, bonds rated Baa3 or higher by Moody's and BBB- or higher by Standard & Poor's and Fitch are considered investment grade. Although a variety of considerations enter into distinguishing the two sectors, the promised payments of investment-grade bonds are perceived as less risky than those of non-investment-grade bonds because of profitability and liquidity considerations. Some regulated financial intermediaries, such as banks and life insurance companies, may face explicit or implicit limitations of holdings of non-investment-grade bonds. The investment policy statements of some investors may also include constraints or limits on such holdings. From the issuer's perspective, an investment-grade credit rating generally allows easier access to bond markets and at lower interest rates than does a non-investment-grade credit rating.

1.1.1.2. Maturity

The maturity date of a bond refers to the date when the issuer is obligated to redeem the bond by paying the...