While many people are intrigued by the exciting stories sometimes found with equities—who has not heard of someone who invested in the common stock of a small company and earned enough to retire at a young age?—we will find in our study of fixed income securities that the multitude of possible structures opens a fascinating field of study. While frequently overshadowed by the media prominence of the equity market, fixed income securities play a critical role in the portfolios of individual and institutional investors.

In its simplest form, a fixed income security is a financial obligation of an entity that promises to pay a specified sum of money at specified future dates. The entity that promises to make the payment is called the issuer of the security. Some examples of issuers are central governments such as the U.S. government and the French government, government-related agencies of a central government such as Fannie Mae and Freddie Mac in the United States, a municipal government such as the state of New York in the United States and the city of Rio de Janeiro in Brazil, a corporation such as Coca-Cola in the United States and Yorkshire Water in the United Kingdom, and supranational governments such as the World Bank.

Fixed income securities fall into two general categories: debt obligations and preferred stock. In the case of a debt obligation, the issuer is called the borrower. The investor who purchases such a fixed income security is said to be the lender or creditor. The promised payments that the issuer agrees to make at the specified dates consist of two components: interest and principal (principal represents repayment of funds borrowed) payments. Fixed income securities that are debt obligations include bonds, mortgage-backed securities, asset-backed securities, and bank loans.

In contrast to a fixed income security that represents a debt obligation, preferred stock represents an ownership interest in a corporation. Dividend payments are made to the preferred stockholder and represent a distribution of the corporation’s profit. Unlike investors who own a corporation’s common stock, investors who own the preferred stock can only realize a contractually fixed dividend payment. Moreover, the payments that must be made to preferred stockholders have priority over the payments that a corporation pays to common stockholders. In the case of the bankruptcy of a corporation, preferred stockholders are given preference over common stockholders. Consequently, preferred stock is a form of equity that has characteristics similar to bonds.

Prior to the 1980s, fixed income securities were simple investment products. Holding aside default by the issuer, the investor knew how long interest would be received and when the amount borrowed would be repaid. Moreover, most investors purchased these securities with the intent of holding them to their maturity date. Beginning in the 1980s, the fixed income world changed. First, fixed income securities became more complex. There are features in many fixed income securities that make it difficult to determine when the amount borrowed will be repaid and for how long interest will be received. For some securities it is difficult to determine the amount of interest that will be received. Second, the hold-to-maturity investor has been replaced by institutional investors who actively trades fixed income securities.

We will frequently use the terms “fixed income securities” and “bonds” interchangeably. In addition, we will use the term bonds generically at times to refer collectively to mortgage-backed securities, asset-backed securities, and bank loans.

In this chapter we will look at the various features of fixed income securities and in the next chapter we explain how those features affect the risks associated with investing in fixed income securities. The majority of our illustrations throughout this book use fixed income securities issued in the United States. While the U.S. fixed income market is the largest fixed income market in the world with a diversity of issuers and features, in recent years there has been significant growth in the fixed income markets of other countries as borrowers have shifted from funding via bank loans to the issuance of fixed income securities. This is a trend that is expected to continue.

As part of the indenture, there are affirmative covenants and negative covenants. Affirmative covenants set forth activities that the borrower promises to do. The most common affirmative covenants are (1) to pay interest and principal on a timely basis, (2) to pay all taxes and other claims when due, (3) to maintain all properties used and useful in the borrower’s business in good condition and working order, and (4) to submit periodic reports to a trustee stating that the borrower is in compliance with the loan agreement. Negative covenants set forth certain limitations and restrictions on the borrower’s activities. The more common restrictive covenants are those that impose limitations on the borrower’s ability to incur additional debt unless certain tests are satisfied.

The practice in the bond market is to refer to the “term to maturity” of a bond as simply its “maturity” or “term.” As we explain below, there may be provisions in the indenture that allow either the issuer or bondholder to alter a bond’s term to maturity.

Some market participants view bonds with a maturity between 1 and 5 years as “short-term.” Bonds with a maturity between 5 and 12 years are viewed as “intermediate-term,” and “long-term” bonds are those with a maturity of more than 12 years.

There are bonds of every maturity. Typically, the longest maturity is 30 years. However, Walt Disney Co. issued bonds in July 1993 with a maturity date of 7/15/2093, making them 100-year bonds at the time of issuance. In December 1993, the Tennessee Valley Authority issued bonds that mature on 12/15/2043, making them 50-year bonds at the time of issuance.

There are three reasons why the term to maturity of a bond is important:

Because bonds can have a different par value, the practice is to quote the price of a bond as a percentage of its par value. A value of “100” means 100% of par value. So, for example, if a bond has a par value of $1,000 and the issue is selling for $900, this bond would be said to be selling at 90. If a bond with a par value of $5,000 is selling for $5,500, the bond is said to be selling for 110.

When computing the dollar price of a bond in the United States, the bond must first be converted into a price per US$1 of par value. Then the price per $1 of par value is multiplied by the par value to get the dollar price. Here are examples of what the dollar price of a bond is, given the price quoted for the bond in the market, and the par amount involved in the transaction:¹

Notice that a bond may trade below or above its par value. When a bond trades below its par value, it said to be trading at a discount. When a bond trades above its par value, it said to be trading at a premium. The reason why a bond sells above or below its par value will be explained in Chapter 2.

When describing a bond of an issuer, the coupon rate is indicated along with the maturity date. For example, the expression “6s of 12/1/2020” means a bond with a 6% coupon rate maturing on 12/1/2020. The “s” after the coupon rate indicates “coupon series.” In our example, it means the “6% coupon series.”

In the United States, the usual practice is for the issuer to pay the coupon in two semiannual installments. Mortgage-backed securities and asset-backed securities typically pay interest monthly. For bonds issued in some markets outside the United States, coupon payments are made only once per year.

The coupon rate also affects the bond’s price sensitivity to changes in market interest rates. As illustrated in Chapter 2, all other factors constant, the higher the coupon rate, the less the price will change in response to a change in market interest rates.

An example of an actual multiple step-up note is a 5-year issue of the Student Loan Marketing Association (Sallie Mae) issued in May 1994. The coupon schedule is as follows:

The quoted margin is the additional amount that the issuer agrees to pay above the reference rate. For example, suppose that the reference rate is the 1-month London interbank offered rate (LIBOR).² Suppose that the quoted margin is 100 basis points.³ Then the coupon formula is:

The quoted margin need not be a positive value. The quoted margin could be subtracted from the reference rate. For example, the reference rate could be the yield on a 5-year Treasury security and the coupon rate could reset every six months based on the following coupon formula:

It is important to understand the mechanics for the payment and the setting of the coupon rate. Suppose that a floater pays interest semiannually and further assume that the coupon reset date is today. Then, the coupon rate is determined via the coupon formula and this is the interest rate that the issuer agrees to pay at the next interest payment date six months from now.

A floater may have a restriction on the maximum coupon rate that will be paid at any reset date. The maximum coupon rate is called a cap. For example, suppose for a floater whose coupon formula is the 3-month Treasury bill rate plus 50 basis points, there is a cap of 9%. If the 3-month Treasury bill rate is 9% at a coupon reset date, then the coupon formula would give a coupon rate of 9.5%. However, the cap restricts the coupon rate to 9%. Thus, for our hypothetical floater, once the 3-month Treasury bill rate exceeds 8.5%, the coupon rate is capped at 9%. Because a cap restricts the coupon rate from increasing, a cap is an unattractive feature for the investor. In contrast, there could be a minimum coupon rate specified for a floater. The minimum coupon rate is called a floor. If the coupon formula produces a coupon rate that is below the floor, the floor rate is paid instead. Thus, a floor is an attractive feature for the investor. As we explain in Section X, caps and floors are effectively embedded options.

While the reference rate for most floaters is an interest rate or an interest rate index, a wide variety of reference rates appear in coupon formulas. The coupon for a floater could be indexed to movements in foreign exchange rates, the price of a commodity (e.g., crude oil), the return on an equity index (e.g., the S&P 500), or movements in a bond index. In fact, through financial engineering, issuers have been able to structure floaters with almost any reference rate. In several countries, there are government bonds whose coupon formula is tied to an inflation index.

The U.S. Department of the Treasury in January 1997 began issuing inflation-adjusted securities. These issues are referred to as Treasury Inflation Protection Securities (TIPS). The reference rate for the coupon formula is the rate of inflation as measured by the Consumer Price Index for All Urban Consumers (i.e., CPI-U). (The mechanics of the payment of the coupon will be explained in Chapter 3 where these securities are discussed.) Corporations and agencies in the United States issue inflation-linked (or inflation-indexed) bonds. For example, in February 1997, J. P. Morgan & Company issued a 15-year bond that pays the CPI plus 400 basis points. In the same month, the Federal Home Loan Bank issued a 5-year bond with a coupon rate equal to the CPI plus 315 basis points and a 10-year bond with a coupon rate equal to the CPI plus 337 basis points.

Typically, the coupon formula for a floater is such that the coupon rate increases when the reference rate increases, and decreases when the reference rate decreases. There are issues whose coupon rate moves in the opposite direction from the change in the reference rate. Such issues are called inverse floaters or reverse floaters.⁴ It is not too difficult to understand why an investor would be interested in an inverse floater. It gives an investor who believes interest rates will decline the opportunity to obtain a higher coupon interest rate. The issuer isn’t necessarily taking the opposite view because it can hedge the risk that interest rates will decline.⁵

The coupon formula for an inverse floater is: where K and L are values specified in the prospectus for the issue.

For example, suppose that for a particular inverse floater, K is 20% and L is 2. Then the coupon reset formula would be:

Notice that if the 3-month Treasury bill rate exceeds 10%, then the coupon formula would produce a negative coupon rate. To prevent this, there is a floor imposed on the coupon rate. There is also a cap on the inverse floater. This occurs if the 3-month Treasury bill rate is zero. In that unlikely event, the maximum coupon rate is 20% for our hypothetical inverse floater.

There is a wide range of coupon formulas that we will encounter in our study of fixed income securities.⁶ These are discussed below. The reason why issuers have been able to create floating-rate securities with offbeat coupon formulas is due to derivative instruments. It is too early in our study of fixed income analysis and portfolio management to appreciate why some of these offbeat coupon formulas exist in the bond market. Suffice it to say that some of these offbeat coupon formulas allow the investor to take a view on either the movement of some interest rate (i.e., for speculating on an interest rate movement) or to reduce exposure to the risk of some interest rate movement (i.e., for interest rate risk management). The advantage to the issuer is that it can lower its cost of borrowing by creating offbeat coupon formulas for investors.⁷ While it may seem that the issuer is taking the opposite position to the investor, this is not the case. What in fact happens is that the issuer can hedge its risk exposure by using derivative instruments so as to obtain the type of financing it seeks (i.e., fixed rate borrowing or floating rate borrowing). These offbeat coupon formulas are typically found in “structured notes,” a form of medium-term note that will be discussed in Chapter 3.

In the United States and in many countries, the bond buyer must pay the bond seller the accrued interest. The amount that the buyer pays the seller is the agreed upon price for the bond plus accrued interest. This amount is called the full price. (Some market participants refer to this as the dirty price.) The agreed upon bond price without accrued interest is simply referred to as the price. (Some refer to it as the clean price.)

A bond in which the buyer must pay the seller accrued interest is said to be trading cum-coupon (“with coupon”). If the buyer forgoes the next coupon payment, the bond is said to be trading ex-coupon (“without coupon”). In the United States, bonds are always traded cum-coupon. There are bond markets outside the United States where bonds are traded ex-coupon for a certain period before the coupon payment date.

There are exceptions to the rule that the bond buyer must pay the bond seller accrued interest. The most important exception is when the issuer has not fulfilled its promise to make the periodic interest payments. In this case, the issuer is said to be in default. In such instances, the bond is sold without accrued interest and is said to be traded flat.

Fixed income securities backed by pools of loans (mortgage-backed securities and asset-backed securities) often have a schedule of partial principal payments. Such fixed income securities are said to be amortizing securities. For many loans, the payments are structured so that when the last loan payment is made, the entire amount owed is fully paid.

Another example of an amortizing feature is a bond that has a sinking fund provision. This provision for repayment of a bond may be designed to pay all of an issue by the maturity date, or it may be arranged to repay only a part of the total by the maturity date. We discuss this provision later in this section.

An issue may have a call provision granting the issuer an option to retire all or part of the issue prior to the stated maturity date. Some issues specify that the issuer must retire a predetermined amount of the issue periodically. Various types of call provisions are discussed in the following pages.

The right of the issuer to retire the issue prior to the stated maturity date is referred to as a call provision. If an issuer exercises this right, the issuer is said to “call the bond.” The price which the issuer must pay to retire the issue is referred to as the call price or redemption price.

When a bond is issued, typically the issuer may not call the bond for a number of years. That is, the issue is said to have a deferred call. The date at which the bond may first be called is referred to as the first call date. The first call date for the Walt Disney 7.55s due 7/15/2093 (the 100-year bonds) is 7/15/2023. For the 50-year Tennessee Valley Authority 6 s due 12/15/2043, the first call date is 12/15/2003.

Bonds can be called in whole (the entire issue) or in part (only a portion). When less than the entire issue is called, the certificates to be called are either selected randomly or on a pro rata basis. When bonds are selected randomly, a computer program is used to select the serial number of the bond certificates called. The serial numbers are then published in The Wall Street Journal and major metropolitan dailies. Pro rata redemption means that all bondholders of the issue will have the same percentage of their holdings redeemed (subject to the restrictions imposed on minimum denominations). Pro rata redemption is rare for publicly issued debt but is common for debt issues directly or privately placed with borrowers.

A bond issue that permits the issuer to call an issue prior to the stated maturity date is referred to as a callable bond. At one time, the callable bond structure was common for corporate bonds issued in the United States. However, since the mid-1990s, there has been significantly less issuance of callable bonds by corporate issuers of high credit quality. Instead, as noted above, the most popular structure is the bullet bond. In contrast, corporate issuers of low credit quality continue to issue callable bonds.⁸ In Europe, historically the callable bond structure has not been as popular as in the United States.

Many investors are confused by the terms noncallable and nonrefundable. Call protection is much more robust than refunding protection. While there may be certain exceptions to absolute or complete call protection in some cases (such as sinking funds and the redemption of debt under certain mandatory provisions discussed later), call protection still provides greater assurance against premature and unwanted redemption than refunding protection. Refunding protection merely prevents redemption from certain sources, namely the proceeds of other debt issues sold at a lower cost of money. The holder is protected only if interest rates decline and the borrower can obtain lower-cost money to pay off the debt.

For example, Anheuser-Busch Companies issued on 6/23/88 10% coupon bonds due 7/1/2018. The issue was immediately callable. However, the prospectus specified in the call schedule that

A concern of an investor is that an issuer will use all means possible to maneuver a call so that the special redemption price applies. This is referred to as the par call problem. There have been ample examples, and subsequent litigation, where corporations have used the special redemption price and bondholders have challenged the use by the issuer.

Basically, the prepayment option is the same as a call option. However, unlike a call option, there is not a call price that depends on when the borrower pays off the issue. Typically, the price at which a loan is prepaid is par value. Prepayments will be discussed when mortgage-backed and asset-backed securities are discussed.

An example of an issue with a sinking fund requirement that pays the entire principal by the maturity date is the $150 million Ingersoll Rand 7.20s issue due 6/1/2025. This bond, issued on 6/5/1995, has a sinking fund schedule that begins on 6/1/2006. Each year the issuer must retire $7.5 million.

Generally, the issuer may satisfy the sinking fund requirement by either (1) making a cash payment to the trustee equal to the par value of the bonds to be retired; the trustee then calls the bonds for redemption using a lottery, or (2) delivering to the trustee bonds purchased in the open market that have a total par value equal to the amount to be retired. If the bonds are retired using the first method, interest payments stop at the redemption date.

Usually, the periodic payments required for a sinking fund requirement are the same for each period. Selected issues may permit variable periodic payments, where payments change according to certain prescribed conditions set forth in the indenture. Many bond issue indentures include a provision that grants the issuer the option to retire more than the sinking fund requirement. This is referred to as an accelerated sinking fund provision. For example, the Anheuser-Busch 8 s due 12/1/2016, whose call schedule was presented earlier, has a sinking fund requirement of $7.5 million each year beginning on 12/01/1997. The issuer is permitted to retire up to $15 million each year.

Usually the sinking fund call price is the par value if the bonds were originally sold at par. When issued at a premium, the call price generally starts at the issuance price and scales down to par as the issue approaches maturity.

The advantage of a put provision to the bondholder is that if, after the issuance date, market rates rise above the issue’s coupon rate, the bondholder can force the issuer to redeem the bond at the put price and then reinvest the put bond proceeds at the prevailing higher rate.

An issue in which payments to bondholders are in U.S. dollars is called a dollar-denominated issue. A nondollar-denominated issue is one in which payments are not denominated in U.S. dollars. There are some issues whose coupon payments are in one currency and whose principal payment is in another currency. An issue with this characteristic is called a dual-currency issue.

The accelerated sinking fund provision is an embedded option because the issuer can call more than is necessary to meet the sinking fund requirement. An issuer usually takes this action when interest rates decline below the issue’s coupon rate even if there are other restrictions in the issue that prevent the issue from being called.

The cap of a floater can be thought of as an option requiring no action by the issuer to take advantage of a rise in interest rates. Effectively, the bondholder has granted to the issuer the right not to pay more than the cap.

Notice that whether or not the first three options are exercised by the issuer or borrower depends on the level of interest rates prevailing in the market relative to the issue’s coupon rate or the borrowing rate of the underlying loans (in the case of mortgage-backed and asset-backed securities). These options become more valuable when interest rates fall. The cap of a floater also depends on the prevailing level of rates. But here the option becomes more valuable when interest rates rise.

The value of the conversion privilege depends on the market price of the stock relative to the embedded purchase price held by the bondholder when exercising the conversion option. The put privilege benefits the bondholder if interest rates rise above the issue’s coupon rate. While a cap on a floater benefits the issuer if interest rates rise, a floor benefits the bondholder if interest rates fall since it fixes a minimum coupon rate payable.

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

For example, consider a callable bond issued by a corporation. Projecting the cash flow requires (1) modeling interest rates (over the life of the security) at which the issuer can refund an issue and (2) developing a rule for determining the economic conditions necessary for the issuer to benefit from calling the issue. In the case of mortgage-backed or asset-backed securities, again it is necessary to model how interest rates will influence borrowers to refinance their loan over the life of the security. Models for valuing bonds with embedded options will be covered in Chapter 9.

It cannot be overemphasized that embedded options affect not only the value of a bond but also the total return of a bond. In the next chapter, the risks associated with the presence of an embedded option will be explained. What is critical to understand is that due to the presence of embedded options it is necessary to develop models of interest rate movements and rules for exercising embedded options. Any analysis of securities with embedded options exposes an investor to modeling risk. Modeling risk is the risk that the model analyzing embedded options produces the wrong value because the assumptions are not correct or the assumptions were not realized. This risk will become clearer when we describe models for valuing bonds with embedded options.

A repurchase agreement is the sale of a security with a commitment by the seller to buy the same security back from the purchaser at a specified price at a designated future date. The repurchase price is the price at which the seller and the buyer agree that the seller will repurchase the security on a specified future date called the repurchase date. The difference between the repurchase price and the sale price is the dollar interest cost of the loan; based on the dollar interest cost, the sales price, and the length of the repurchase agreement, an implied interest rate can be computed. This implied interest rate is called the repo rate. The advantage to the investor of using this borrowing arrangement is that the interest rate is less than the cost of bank financing. When the term of the loan is one day, it is called an overnight repo (or overnight RP); a loan for more than one day is called a term repo (or term RP). As will be explained, there is not one repo rate. The rate varies from transaction to transaction depending on a variety of factors.