Fixed-Income Markets: An Introduction

Fixed-income securities are debt instruments that promise a fixed stream of payments to investors. These markets are
crucial for funding businesses and governments, playing a vital role in economic growth. Understanding the
intricacies of these markets is essential for navigating the world of finance.

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 Bond Indenture and Covenants
The bond indenture is the legal agreement between the issuer and the bondholders. It outlines the terms and conditions
of the bond issue, including the payment schedule, interest rate, and maturity date.

Affirmative Negative
These covenants require the issuer to take certain actions, such as These covenants restrict the issuer from taking certain actions,
Covenants
Covenants
maintaining a minimum level of working capital or providing such as incurring additional debt or selling assets without the
financial statements to bondholders. consent of bondholders.
•barring the issuer from taking on additional debt;
•imposing a maximum acceptable debt ratio (such as
•outlining what the issuer can do with the proceeds from the
leverage or gearing ratios) or a minimum acceptable
bond issue;
interest coverage ratio;
•obligating the issuer to promise to return the principal of a loan
•restricting asset disposals, distributions to shareholders,
at maturity; or
or engagement in (risky) investments; or
•obligating the issuer to comply with laws and regulations, insure
•explicitly ruling out mergers and acquisitions of any form
assets adequately, or deliver timely audit reports.
unless certain conditions are met
 Bond Features and Coupon
Bonds typically have a par value, which is the principal amount repaid at maturity. The
Structures
coupon rate is the annual interest rate paid on the par value.

1 Fixed-Rate 2 Floating-Rate 3 Zero-Coupon

These bonds have a fixed coupon The coupon rate on these bonds is linked
Bonds These
Bondsbonds do not pay periodic
Bonds
rate that remains constant to a benchmark interest rate, such as interest payments but are issued at

throughout the life of the bond. LIBOR, and adjusts periodically. a discount to par value.
All the 21 Types of
Bonds | General
Features and
Valuation | eFM
(efinancemanageme
nt.com)
Accrued Interest, Full Price, and Clean Price
Accrued interest is the interest earned on a bond from the last coupon payment date to the settlement date.

Full Price The price an investor pays for a bond,

including accrued interest.

Clean Price The price an investor pays for a bond,

excluding accrued interest.
Bond Redemption and Retirement Provisions
Bond redemption provisions allow the issuer to repurchase outstanding bonds before maturity, usually at a premium to par value.

1
Sinking Fund
A sinking fund is a fund that the issuer sets up to retire bonds over time.

2
Call Provision
A call provision gives the issuer the right to redeem the bonds at a specified price before maturity.

3
Put Provision
A put provision gives the bondholder the right to sell the bonds back to the issuer at a specified price
before maturity.
 Key characteristics of a sinking fund: Sinking Fund
•Purpose-driven: Created for a specific financial goal.
•Regular contributions: Typically involves consistent deposits over time.
•Investment: Funds are often invested to generate returns.
•Maturity date: A predetermined time when the funds are to be used.

Common uses of sinking funds:

•Debt repayment: To pay off bonds or loans at maturity.
•Capital replacement: To replace aging equipment or infrastructure.
•Insurance premiums: To cover large insurance premiums.
•Tax liabilities: To prepare for significant tax payments.

Benefits of a sinking fund:

•Financial stability: Provides a cushion against unexpected expenses.
•Reduced risk: Helps avoid borrowing money in times of financial stress.
•Improved creditworthiness: Can enhance an entity's credit rating.
•Long-term planning: Encourages disciplined financial management.

Example:
A company might establish a sinking fund to replace a piece of machinery that is expected to wear out in five years.
The company would make regular contributions to the fund, investing the money to earn interest. When the
machinery reaches the end of its useful life, the accumulated funds in the sinking fund can be used to purchase a
replacement.
 Call Provision: A Bondholder's Risk
A call provision is a clause in a bond contract that gives the issuer the right to redeem the bond before its maturity date. In
simpler terms, it allows the company to buy back the bond from the bondholder at a predetermined price.
Why would a company want to call its bonds?
•Lower interest rates: If interest rates have declined since the bond was issued, the company can refinance its debt at a lower
cost by calling the old bonds and issuing new ones.
•Early repayment: The company might have excess cash and want to reduce its debt burden.
•Project funding: The company might need to raise funds for a new project and can do so by calling its bonds.
What are the implications for bondholders?
•Premature redemption: Bondholders may lose the opportunity to earn interest until the bond's maturity date.
•Potential for lower returns: If the bond is called, the bondholder may have to reinvest the proceeds in a new bond with a lower
interest rate.
•Call premium: In some cases, the issuer may have to pay a premium to bondholders when they call the bonds. This is to
compensate them for the early redemption.
Example:
Imagine a company issues a 10-year bond at a coupon rate of 5%. A few years later, interest rates have dropped to 3%. The
company can call the bond, refinance it at the lower rate, and save money on interest payments. However, this means the
bondholders will receive their principal back earlier than expected and may have to reinvest it at a lower interest rate.
In essence, a call provision introduces an element of risk for bondholders. While it can benefit the issuer, it can lead to lower
returns for investors if the bond is called. Investors should carefully consider the call provision when purchasing bonds,
especially those with a higher likelihood of being called, such as callable bonds or bonds issued by companies with a strong
financial position.
Embedded Bond Options and Their
Benefits
Embedded bond options can provide both benefits and risks to investors, depending on market
conditions and the specific features of the option.

Call Option Put Option Conversion

A call option allows the issuer A put option allows the Option
A conversion option allows the
to redeem the bonds before bondholder to sell the bonds bondholder to convert the bond
maturity, potentially at a lower back to the issuer at a specified into shares of common stock.
interest rate. price, providing downside
protection.
 Margin Buying and Repurchase Agreements
Margin buying allows investors to purchase bonds with borrowed funds, leveraging their investment and increasing potential returns.

Margin Buying
Investors borrow funds from a broker to purchase bonds, paying interest on the loan.

Repurchase Agreements
These agreements involve the sale of a security with a simultaneous agreement to repurchase it at a later date.

Reverse Repurchase Agreements

These agreements involve the purchase of a security with a simultaneous agreement to resell it at a later date.
Conclusion and Key
Takeaways
Fixed-income markets are essential for the functioning of the global economy. By understanding the intricacies of these
markets, investors can make informed decisions and manage risk effectively.

Maturity Yield Credit Risk Interest Rate

The date when the principal The annual return an The risk that the issuer of a Risk
The risk that the value of a
amount of a bond is due to investor receives on a bond will default on its bond will decline due to
be repaid. bond investment. obligations. rising interest rates.
• Introduction to Debt Securities
• Credit Risk Characteristics and Government Securities
• Stripped Treasury Securities
• Collateralized Debt Obligations
• Corporate Bonds, Structured Notes, and Commercial Paper
• Asset-Backed Securities and Credit Enhancements
• Primary and Secondary Bond Markets
• Bond Pricing, Options, and Repurchase Agreements
Introduction to Debt Securities
Debt securities represent a loan from an investor to a borrower, promising repayment of principal and
interest. They are an integral part of the financial markets, enabling governments and corporations to raise
capital.

Credit Risk Characteristics and Government Securities

Credit Risk
Credit risk refers to the possibility that a borrower may default on their debt obligations. Government securities
are typically considered low-risk due to their backing by the sovereign entity.

Distribution of Government Securities

Government securities are distributed through various channels, including auctions, primary dealers, and
secondary markets, ensuring liquidity and efficient pricing.
Stripped Treasury Securities
Principal and Interest Separation
Stripped Treasury securities separate the principal and interest components of a bond into distinct securities.

Zero-Coupon Bonds
The principal component is a zero-coupon bond, paying no interest until maturity.

Interest-Only Securities
The interest component pays periodic interest payments but no principal at maturity.

Collateralized Debt Obligations

Asset Pool
Collateralized debt obligations (CDOs) are structured securities backed by a pool of underlying assets, such as mortgages or corporate bonds.

Tranches
The pool is divided into tranches with varying levels of risk and return, offering investors a range of investment choices.

Credit Enhancement
Credit enhancements, such as overcollateralization, can be used to reduce the credit risk associated with CDOs.
Corporate Bonds, Structured Notes, and Commercial Paper

Corporate Bonds Structured Notes Commercial Paper

Issued by corporations Structured with embedded options Short-term unsecured debt

Maturities typically under 270

Varying maturities Customized to specific investor needs
days

Asset-Backed Securities and Credit Enhancements

Asset Pool
Asset-backed securities (ABSs) are backed by a pool of assets, such as mortgages, auto loans, or credit card receivables.

Issuance
Issuance is driven by the need to diversify funding sources and potentially reduce financing costs.

Credit Enhancements
Credit enhancements, like letters of credit or guarantees, can mitigate credit risk and attract investors.
Primary and Secondary Bond Markets
Primary Market
New bond issues are sold to investors for the first time in the primary market.

Secondary Market
Existing bonds are traded between investors in the secondary market, providing liquidity and price discovery.

Accrued Interest
When a bond is sold between trading dates, the seller is entitled to accrued interest since the last coupon payment.

Full Price and Clean Price

The full price includes accrued interest, while the clean price excludes it.
Bond Pricing, Options, and Repurchase Agreements

Bond Pricing
Bond prices are determined by factors such as interest rates, credit risk, and maturity.

Options
Some bonds have embedded options, such as call provisions or put provisions, which give the issuer or investor
the right to buy or sell the bond before maturity.

Repurchase Agreements
Repurchase agreements (repos) involve the sale of a security with an agreement to repurchase it at a later date.

Margin Buying
Margin buying involves purchasing a bond with borrowed funds, amplifying potential returns but increasing risk.