Fixed Income | CFA® Level 1 Study Guide

Features of Fixed-Income Securities

Learning Outcome Statement:

describe the features of a fixed-income security

Summary:

Fixed-income securities are debt instruments that include features such as issuer type, maturity, principal amount, coupon rate and frequency, seniority, and contingency provisions. These features determine the credit quality, risk, and expected yield of the security. The issuer can be a government, corporation, or special purpose entity, and the maturity can range from short-term money market instruments to long-term capital market securities or even perpetual bonds. The coupon can be fixed, variable, or zero, and the seniority determines the priority in case of liquidation. Contingency provisions may include options like call, put, or conversion to equity.

Key Concepts:

Issuer

The issuer of a bond can be a government, corporation, or special purpose entity responsible for making interest and principal payments. Government bonds are generally considered lower risk due to government backing.

Maturity

Maturity refers to the final payment date of the bond when the principal is due to be repaid. Bonds can be short-term or long-term, and some, like perpetual bonds, have no maturity date.

Principal (Par or Face Value)

The principal or face value of a bond is the amount that the issuer agrees to repay the bondholders at maturity. It is also the amount on which coupon payments are calculated.

Coupon Rate and Frequency

The coupon rate is the interest rate that the bond issuer pays on the bond's face value, which can be fixed or variable. The frequency of these payments can be annual, semi-annual, quarterly, or monthly.

Seniority

Seniority determines the order of repayment in the event of the issuer's bankruptcy. Senior debt is repaid first, followed by subordinated (junior) debt.

Contingency Provisions

These are clauses in the bond's indenture that allow for certain actions based on specified events, such as the issuer's option to call (repurchase) the bond or the holder's option to put (sell) the bond back to the issuer.

Yield Measures

Yield measures like current yield and yield-to-maturity (YTM) help investors assess the return on a bond based on its price and expected cash flows.

Yield Curves

A yield curve graphs the relationship between bond yields and their maturities, helping to assess the risk and return over different periods.

Formulas:

Annual Coupon Payment

Annual\ Coupon = Coupon\ Rate \times Par\ Value

This formula calculates the total annual interest payment made by the issuer based on the bond's face value and coupon rate.

Variables:

$Coupon Rate$ :: The interest rate paid on the bond's face value
$Par Value$ :: The principal amount of the bond

Units: currency units

Semiannual Coupon Payment

Semiannual\ Coupon = \frac{Annual\ Coupon}{2}

This formula calculates the interest payment made every six months by dividing the annual coupon payment by two.

Variables:

$Annual Coupon$ :: The total annual interest payment

Units: currency units

Current Yield

CY_t = \frac{Annual\ Coupon_t}{Bond\ Price_t}

Current yield is the annual income (interest) divided by the current price of the bond, expressed as a percentage.

Variables:

$Annual Coupon_t$ :: The annual coupon payment at time t
$Bond Price_t$ :: The price of the bond at time t

Units: percentage

Yield to Maturity (YTM)

101 = \frac{1.6}{(1 + r)^1} + \frac{1.6}{(1 + r)^2} + ... + \frac{101.6}{(1 + r)^{10}}

Yield to maturity (YTM) is the internal rate of return (IRR) for a bond, considering all coupon payments and the redemption at maturity, assuming all payments are reinvested at the same rate.

Variables:

$r$ :: The yield to maturity rate

Units: percentage

Bond Indentures and Covenants

Learning Outcome Statement:

describe the contents of a bond indenture and contrast affirmative and negative covenants

Summary:

Bond indentures are legal contracts that outline the features, obligations, and rights associated with a bond. They specify the issuer's sources of repayment and any commitments to bondholders. Bond covenants, which can be affirmative (requiring specific actions) or negative (prohibiting certain actions), are legally enforceable rules agreed upon at the issuance of the bond to protect bondholders' interests.

Key Concepts:

Bond Indentures

A bond indenture is a legal document that details the features of a bond, the obligations of the issuer, and the rights of the bondholders. It includes information on the sources of repayment and any additional provisions to enhance the issuer's ability to repay the debt.

Sources of Repayment

Sources of repayment for bonds vary by issuer type. Sovereign bonds may use tax revenues, local governments might use fees from infrastructure, and corporations typically use operating cash flows. Secured corporate bonds may also include specific assets as secondary sources of repayment.

Bond Covenants

Bond covenants are conditions in the bond contract that either require (affirmative covenants) or restrict (negative covenants) certain actions by the issuer. These are designed to protect bondholders by ensuring the issuer maintains the ability to meet its debt obligations.

Formulas:

Coupon Payment Calculation

C = \frac{P \times r}{n}

This formula calculates the amount of each coupon payment for a bond. The annual coupon payment is divided by the number of payments per year to find the amount of each payment.

Variables:

$C$ :: Coupon payment
$P$ :: Par value of the bond
$r$ :: Annual coupon rate
$n$ :: Number of payments per year

Units: currency units

FRN Coupon Interest Calculation

I = P \times \left(\text{MRR} + \text{Spread}\right)

This formula calculates the interest payable on a floating rate note (FRN) by applying the sum of the market reference rate and an issuer-specific spread to the principal amount.

Variables:

$I$ :: Interest payable
$P$ :: Principal amount
$MRR$ :: Market reference rate
$Spread$ :: Issuer-specific spread

Units: currency units