Concepts Description
Fixed income securities : Defining elements
Basic features of a fixed income 1. Issuer of bond : Corporation (Coca Cola) ; Sovereign national government (US, Vietnam) ; Nonsovereign national government (state of California) ; Quasi‐government entities
securities (Federal National Mortgage Association) or Supranational entities (World bank, IMF)
2. Maturity date of the bond : Bond with original maturities ≤ 1 year → money market securi es ; Bond with original maturi es > 1 year → capital market securi es
3. Par value
4. Coupon rate and payment frequency
5. Currency of the payment : usually denominated in EUR or USD
‐ Dual‐currency bond : Currency of interest payment is different from currency of principal payment
‐ Currency option bond : bondholders could choose which of 2 currencies they would like to receive payments in
Bond indenture (trust deed) Definition : legal contract between the bond issuer and bondholders. Bond indenture specifies :
‐ Bond's features
‐ Souce of funds for repayment
‐ Assets pledged as collateral
‐ Credit enhancements (if any)
‐ Covenants (if any)
Affirmative (positive) covenant / Covenant : provisions of bond indenture, to protect bonholders' interest
Negative covenant Affirmative covenant: actions that the issuers must perform (e.g.: comply with laws and regulations, make payment timely, etc.)
Negative covenant : restriction on issuer's actions (e.g.: prohibit the issuer from issuing additional debt, prohibit the issuer from selling assets pledged, etc.)
Legal, regulatory and tax ‐ Bond's legal and regulations are subjected to the place of issuance and trading:
considerations of fixed income + Domestic bonds : traded in the issuer's home country and currency
securities + Foreign bonds : from foreign issuers, but denominated in the currency of the country where they are traded
+ Eurobonds : issued outside the jurisdiction of any single country, denominated in a currency other than that of the countries in which they trade
‐ Issuing entities : might be government or agency; corporation, holding company, subsidiaries or special‐purpose entities
‐ Source of repayment:
+ Sovereign bonds : Tax
+ Nonsovereign bonds : Tax or project's revenue
+ Corporate bonds : funds from firm's operation
+ Securitised bonds : CF from a pool of financial assets
‐ Secured bonds : being backed by specific collateral ; Unsecurd bonds : represent an overall claim against the issuer's CF and assets
‐ Credit enhancement :
+ Overcollateralisation ‐ internal : Value of pledged collaterals > par value
+ Excess spread ‐ internal : bond yield < yield of the assets supporting the asset‐backed securities
+ tranches with different claim seniority ‐ internal :
+ Surety bonds ‐ external : issued by insurance company, promise to make up any shortfall in cash available to repay the debt
+ Bank guarantees ‐ external : issued by bank, promise to make up any shortfall in cash available to repay the debt
+ Letter of credit ‐ external: Promise to lend money o the issuer if it does not have enough cas to make the payment
‐ Taxation : Interest income is taxed at same rate as ordinary income ; gains / losses from selling bond are taxed at capital gain tax rate
**** Purely discount bond : increase in value toward par is considered interest income
Structure of cash flow ‐ fixed 1. Bullet structure : coupon interests are paid periodically, and principal is repaid at maturity
income securities 2. Bond with amortising structure : repay part of its principal at each payment date
‐ Fully amortising structure : make equal payments throughout the bond life
‐ Partially amortising structure : has balloon payment at maturity, which repay the remaining principal as a lump sum
3. Sinking fund provision : require the issuer to retire a portion of bond issue at specified time during the bond's life
Floating rate notes : coupon rate adjust based on a reference rate (e.g.: LIBOR + 2%). Floating rate notes may have a cap (upper limit of the coupon rate) and/or floor (lower limit of
the coupon rate)
4. Step‐up coupon bond : coupon rate increase over time according to a predetermined schedule
5. Credit‐linked coupon bond : coupon rate will go up if the credit rating of issuer falls, and vice versa
6. payment in kind bond : allow issuer to make coupon payment by increasing the principal amount of outstanding bonds
7. Deferred coupon bond (split coupon bond) : regular coupon payments do not begin until a period of time after issuance
8. Index‐linked bond : coupon payment and/or principal paymet is based on an index (e.g.: CPI index)
Embedded options (contingency Definition : describe an action might be taken if an event actually occurs.
provision) in bond indentures Bonds with no embedded option are Straight bond or Option‐free bond
Most common embedded option bonds are:
‐ Callable bonds
‐ Putable bonds
‐ Convertible bonds
‐ Warrants : give warrants holders the right to buy firm's common share at a given price over a given period of time
‐ Contingent convertible bonds : Bonds that would be converted to common equity automatically if special events occurs. Usually issued by banks (e.g.: if bank's equity falls below
the required level)
, Concepts Description
Fixed‐income markets : issuance, trading and funding
Classification of fixed income ‐ By type of issuers : Government and government‐related bonds / Corporate bonds (issued by financial corporation or non‐financial corporation) / Structured finance
market ‐ Credit quality : Investment grade bonds (highest bond rating ‐ AAA, AA, A, and BBB) / speclative bonds (lower credit rating bonds)
‐ Original maturities : Money market securities (original maturities ≤ 1 year) / capital market securities (original maturities > 1 year)
‐ Coupon structure : Fixed rate bonds / Floating rate bonds
‐ Currency denomination : USD / EUR / VND
‐ Geography : domestic mond markets / foreign bonds / eurobonds ; developed markets / emerging markets
‐ Indexing : bonds might be based on index (e.g.: CPI)
‐ Tax status : tax exempt bonds / taxable bonds
Use of interbank offered rates as Interbank offered rates (e.g.: LIBOR) are published daily, for several currencies, and maturities of 1 day to 1 year
reference rates in floating rate Interbank offered rates are used as reference rates for floating rate debt
debt An appropriate reference rate must match the frequency with which the coupon rate is reset (time between 2 payments)
Mechanism for issuing bonds in Bond might be issued in primary markets via : public offering or private placement
primary markets 1. Public offering :
‐ Underwritten : Investment bank (or syndicate of investment banks) purchase the entire issue and sell the bonds to the dealers
‐ Best‐effort : investment bank sells the bonds on commission
‐ Auction : commonly used to issue government debt
2. Private placement : sale of an entire issue to qualified investor (or group of investors)
Bonds secondary markets Secondary markets : trading of previously issued bonds. Bonds are traded via:
‐ exchanges : some government bonds and corporate bonds are traded on exchanges
‐ Dealers (or OTC) markets : most bonds are traded in secondary markets via dealers. Dealers post bid prices and ask price, and make profit from spread (ask price ‐ bid price)
Securities issued by sovereign Sovereign bonds
government ‐ Backed by taxing power, and the ability to print currency
‐ High credit rating , free of default risk
‐ Might be denominated in home currency or foreign currency
‐ Might be fixed rate, floating rate or inflation‐indexed bonds
Securities issued by non‐sovereign Non‐sovereign government bonds
government ‐ Backed by tax revenue or revenue from a specific project
‐ High credit rating, but lower than sovereign bonds → higher yeild than sovereign bonds
Securities issued by agency quasi‐ Quasi‐government bonds
government ‐ Some are backed by the national government
‐ High credit rating, but lower than sovereign bonds → higher yeild than sovereign bonds
Securities issued by supranation Supranational bonds
‐ High credit rating
‐ Could be very liquid, especially those issued by large well‐known entiities
Securities issued by corporation 1. Bank debt
‐ Typically varble rate loan, LIBOR based
‐ Could be bilateral loan (Loan from 1 bank) or syndicated loan (Loan from several banks)
2. Commercial paper : issued by large creditworthy corporations
‐ Higher credit risk and lower liquidity than ST sovereign debt
‐ fund Working Cap, as a temporary source of funds
‐ ST, unsecured debt instrument
3. Corporate bonds
‐ Both fixed rate and floating rate
‐ Might be unsecured or secured with collateral
‐ Might have call, put, or conversion option
Short‐term funding alternatives 1. Customer deposit
for banks ‐ Checking account : provide transaction services and immediate availability of funds, but typically no interest
‐ Saving account and money market mutual funds : less liquidity, less transaction services, but pay periodic interest
2. Certificate of deposit : mature on a specific dates, offered in a range of ST maturities
‐ Non‐negotiable CDs : can't be sold, withdrawal of funds incurs significant penalty
‐ Negotiable CDs : can be sold, are traded in domestic bond markets and Eurobond market
3. Borrow excess reserve from other banks in the central bank funds market : for a period of 1 day up to 1 year, using the Central bank funds rate
4. Interbank funds : unsecured loan from 1 bank to another bank, for a period of 1 day up to 1 year
Repurchase agreements and Repurchase agreement (Repo) : arrangement by which a party sells a securities to a couterparty, with a commitment to buy it back at a specified date in the future, at a specified
related risks price.
Repurchasing price > selling price, accounts for the interest charged by the buyer
Repo rate : interest rate implied by the repurchase price and the selling price
Repo margin (or haircut) : % difference between market value and the amount selling amount (amount loaned) ; to protect the lender in the event that the securities decreases over
the term of the repo agreement
Factors influence repo rate and repo margin:
‐ ↑ repo term → ↑ repo rate ; ↑ repo margin
‐ ↑ credit quality of the collateral securi es → ↓ repo rate ; ↓ repo margin
‐ Collateral is delivered to the lender → ↓ repo rate
‐ ↑ interest rate for alterna ve sources of funds → ↓ repo rate
‐ ↑ credit quality of the borrower → ↓ repo margin
‐ Collateral security is in high demand or low supply → ↓ repo margin
Concepts Description
Introduction to fixed‐income valuation
Fixed income securities : Defining elements
Basic features of a fixed income 1. Issuer of bond : Corporation (Coca Cola) ; Sovereign national government (US, Vietnam) ; Nonsovereign national government (state of California) ; Quasi‐government entities
securities (Federal National Mortgage Association) or Supranational entities (World bank, IMF)
2. Maturity date of the bond : Bond with original maturities ≤ 1 year → money market securi es ; Bond with original maturi es > 1 year → capital market securi es
3. Par value
4. Coupon rate and payment frequency
5. Currency of the payment : usually denominated in EUR or USD
‐ Dual‐currency bond : Currency of interest payment is different from currency of principal payment
‐ Currency option bond : bondholders could choose which of 2 currencies they would like to receive payments in
Bond indenture (trust deed) Definition : legal contract between the bond issuer and bondholders. Bond indenture specifies :
‐ Bond's features
‐ Souce of funds for repayment
‐ Assets pledged as collateral
‐ Credit enhancements (if any)
‐ Covenants (if any)
Affirmative (positive) covenant / Covenant : provisions of bond indenture, to protect bonholders' interest
Negative covenant Affirmative covenant: actions that the issuers must perform (e.g.: comply with laws and regulations, make payment timely, etc.)
Negative covenant : restriction on issuer's actions (e.g.: prohibit the issuer from issuing additional debt, prohibit the issuer from selling assets pledged, etc.)
Legal, regulatory and tax ‐ Bond's legal and regulations are subjected to the place of issuance and trading:
considerations of fixed income + Domestic bonds : traded in the issuer's home country and currency
securities + Foreign bonds : from foreign issuers, but denominated in the currency of the country where they are traded
+ Eurobonds : issued outside the jurisdiction of any single country, denominated in a currency other than that of the countries in which they trade
‐ Issuing entities : might be government or agency; corporation, holding company, subsidiaries or special‐purpose entities
‐ Source of repayment:
+ Sovereign bonds : Tax
+ Nonsovereign bonds : Tax or project's revenue
+ Corporate bonds : funds from firm's operation
+ Securitised bonds : CF from a pool of financial assets
‐ Secured bonds : being backed by specific collateral ; Unsecurd bonds : represent an overall claim against the issuer's CF and assets
‐ Credit enhancement :
+ Overcollateralisation ‐ internal : Value of pledged collaterals > par value
+ Excess spread ‐ internal : bond yield < yield of the assets supporting the asset‐backed securities
+ tranches with different claim seniority ‐ internal :
+ Surety bonds ‐ external : issued by insurance company, promise to make up any shortfall in cash available to repay the debt
+ Bank guarantees ‐ external : issued by bank, promise to make up any shortfall in cash available to repay the debt
+ Letter of credit ‐ external: Promise to lend money o the issuer if it does not have enough cas to make the payment
‐ Taxation : Interest income is taxed at same rate as ordinary income ; gains / losses from selling bond are taxed at capital gain tax rate
**** Purely discount bond : increase in value toward par is considered interest income
Structure of cash flow ‐ fixed 1. Bullet structure : coupon interests are paid periodically, and principal is repaid at maturity
income securities 2. Bond with amortising structure : repay part of its principal at each payment date
‐ Fully amortising structure : make equal payments throughout the bond life
‐ Partially amortising structure : has balloon payment at maturity, which repay the remaining principal as a lump sum
3. Sinking fund provision : require the issuer to retire a portion of bond issue at specified time during the bond's life
Floating rate notes : coupon rate adjust based on a reference rate (e.g.: LIBOR + 2%). Floating rate notes may have a cap (upper limit of the coupon rate) and/or floor (lower limit of
the coupon rate)
4. Step‐up coupon bond : coupon rate increase over time according to a predetermined schedule
5. Credit‐linked coupon bond : coupon rate will go up if the credit rating of issuer falls, and vice versa
6. payment in kind bond : allow issuer to make coupon payment by increasing the principal amount of outstanding bonds
7. Deferred coupon bond (split coupon bond) : regular coupon payments do not begin until a period of time after issuance
8. Index‐linked bond : coupon payment and/or principal paymet is based on an index (e.g.: CPI index)
Embedded options (contingency Definition : describe an action might be taken if an event actually occurs.
provision) in bond indentures Bonds with no embedded option are Straight bond or Option‐free bond
Most common embedded option bonds are:
‐ Callable bonds
‐ Putable bonds
‐ Convertible bonds
‐ Warrants : give warrants holders the right to buy firm's common share at a given price over a given period of time
‐ Contingent convertible bonds : Bonds that would be converted to common equity automatically if special events occurs. Usually issued by banks (e.g.: if bank's equity falls below
the required level)
, Concepts Description
Fixed‐income markets : issuance, trading and funding
Classification of fixed income ‐ By type of issuers : Government and government‐related bonds / Corporate bonds (issued by financial corporation or non‐financial corporation) / Structured finance
market ‐ Credit quality : Investment grade bonds (highest bond rating ‐ AAA, AA, A, and BBB) / speclative bonds (lower credit rating bonds)
‐ Original maturities : Money market securities (original maturities ≤ 1 year) / capital market securities (original maturities > 1 year)
‐ Coupon structure : Fixed rate bonds / Floating rate bonds
‐ Currency denomination : USD / EUR / VND
‐ Geography : domestic mond markets / foreign bonds / eurobonds ; developed markets / emerging markets
‐ Indexing : bonds might be based on index (e.g.: CPI)
‐ Tax status : tax exempt bonds / taxable bonds
Use of interbank offered rates as Interbank offered rates (e.g.: LIBOR) are published daily, for several currencies, and maturities of 1 day to 1 year
reference rates in floating rate Interbank offered rates are used as reference rates for floating rate debt
debt An appropriate reference rate must match the frequency with which the coupon rate is reset (time between 2 payments)
Mechanism for issuing bonds in Bond might be issued in primary markets via : public offering or private placement
primary markets 1. Public offering :
‐ Underwritten : Investment bank (or syndicate of investment banks) purchase the entire issue and sell the bonds to the dealers
‐ Best‐effort : investment bank sells the bonds on commission
‐ Auction : commonly used to issue government debt
2. Private placement : sale of an entire issue to qualified investor (or group of investors)
Bonds secondary markets Secondary markets : trading of previously issued bonds. Bonds are traded via:
‐ exchanges : some government bonds and corporate bonds are traded on exchanges
‐ Dealers (or OTC) markets : most bonds are traded in secondary markets via dealers. Dealers post bid prices and ask price, and make profit from spread (ask price ‐ bid price)
Securities issued by sovereign Sovereign bonds
government ‐ Backed by taxing power, and the ability to print currency
‐ High credit rating , free of default risk
‐ Might be denominated in home currency or foreign currency
‐ Might be fixed rate, floating rate or inflation‐indexed bonds
Securities issued by non‐sovereign Non‐sovereign government bonds
government ‐ Backed by tax revenue or revenue from a specific project
‐ High credit rating, but lower than sovereign bonds → higher yeild than sovereign bonds
Securities issued by agency quasi‐ Quasi‐government bonds
government ‐ Some are backed by the national government
‐ High credit rating, but lower than sovereign bonds → higher yeild than sovereign bonds
Securities issued by supranation Supranational bonds
‐ High credit rating
‐ Could be very liquid, especially those issued by large well‐known entiities
Securities issued by corporation 1. Bank debt
‐ Typically varble rate loan, LIBOR based
‐ Could be bilateral loan (Loan from 1 bank) or syndicated loan (Loan from several banks)
2. Commercial paper : issued by large creditworthy corporations
‐ Higher credit risk and lower liquidity than ST sovereign debt
‐ fund Working Cap, as a temporary source of funds
‐ ST, unsecured debt instrument
3. Corporate bonds
‐ Both fixed rate and floating rate
‐ Might be unsecured or secured with collateral
‐ Might have call, put, or conversion option
Short‐term funding alternatives 1. Customer deposit
for banks ‐ Checking account : provide transaction services and immediate availability of funds, but typically no interest
‐ Saving account and money market mutual funds : less liquidity, less transaction services, but pay periodic interest
2. Certificate of deposit : mature on a specific dates, offered in a range of ST maturities
‐ Non‐negotiable CDs : can't be sold, withdrawal of funds incurs significant penalty
‐ Negotiable CDs : can be sold, are traded in domestic bond markets and Eurobond market
3. Borrow excess reserve from other banks in the central bank funds market : for a period of 1 day up to 1 year, using the Central bank funds rate
4. Interbank funds : unsecured loan from 1 bank to another bank, for a period of 1 day up to 1 year
Repurchase agreements and Repurchase agreement (Repo) : arrangement by which a party sells a securities to a couterparty, with a commitment to buy it back at a specified date in the future, at a specified
related risks price.
Repurchasing price > selling price, accounts for the interest charged by the buyer
Repo rate : interest rate implied by the repurchase price and the selling price
Repo margin (or haircut) : % difference between market value and the amount selling amount (amount loaned) ; to protect the lender in the event that the securities decreases over
the term of the repo agreement
Factors influence repo rate and repo margin:
‐ ↑ repo term → ↑ repo rate ; ↑ repo margin
‐ ↑ credit quality of the collateral securi es → ↓ repo rate ; ↓ repo margin
‐ Collateral is delivered to the lender → ↓ repo rate
‐ ↑ interest rate for alterna ve sources of funds → ↓ repo rate
‐ ↑ credit quality of the borrower → ↓ repo margin
‐ Collateral security is in high demand or low supply → ↓ repo margin
Concepts Description
Introduction to fixed‐income valuation
