Friday, October 28, 2011

Bond Features

CFA Level 1 - Fixed Income Investments

Purpose of a Bond Indenture
A bond indenture is the contract between a bondholder and the issuer. It is a legal document that states what the issuer can and cannot do, and states the bondholders rights. Since there tends to be a ton of legalese involved, the contract is managed by the corporate trustee who polices the actions of the issuer to ensure the rights of the bondholder are upheld.
Within the indenture, there are affirmative and negative covenants:
Affirmative Covenants
Affirmative covenants are what the issuer promises to do for the investor. These promises include things such as paying interest and principle in a    timely manner; paying taxes and other expenses when due; maintaining the assets backing the bond and issuing reports to the trustee to ensure compliance. 

Negative Covenants
Negative convents are the restraints put on a borrower. These restraintsinclude issuing additional securities or taking on additional debt that may    harm the current bondholders. This is generally done without meeting certaintests and/or ratios or receiving permission from the current bondholders.

Basic Features of Bonds
In order to better understand more complicated topics, the CFA Institute requires CFA candidates to have the ability to describe the basic features of a bond. These features include:

2.Par Value
3.Coupon Rate
5.Currency Denomination
6.Options Granted to the Issuer or Investors 
Maturity is the time at which the bond matures and the holder receives the final payment of principal and interest. The "term to maturity" is the amount of time until the bond actually matures. 

There are 3 basic classes of maturity:

A. Short-Term Maturity - One to five years in length
B.Intermediate-Term Maturity - Five to twelve years in length
C. Long-Term Maturity - Twelve years or more in length

Maturity is important because:
  • It indicates the length of time in which an investor will receive interest as well as when he or she will receive principal payments.
  • It affects the yield on the bond; longer maturities tend to yield higher rates.
  • The price volatility of a bond is a function of its maturity. A longer maturity typically indicates higher volatility or, in Wall Street lingo, simply the "vol". 

2.Par Value
Par value is the dollar amount the holder will receive at the bond's maturity. It can be any amount but is typically $1,000 per bond. Par value is also known as principle, face, maturity or redemption value. Bond prices are quoted as a percentage of par.

Example: Premiums and Discounts
Imagine that par for ABC Corp. is $1000, which would =100. If the ABC Corp. bonds trade at 85 what would the dollar value of the bond be? What if ABC Corp. bonds at 102?


At 85, the ABC Corp. bonds would trade at a discount to par at $850. If ABC Corp. bonds at 102, the bonds would trade at a premium of $1,020.

3.Coupon Rate
A coupon rate states the interest rate the bond will pay the holders each year. To find the coupon's dollar value, simply multiply the coupon rate by the par value. The rate is for one year and payments are usually made on a semi-annual basis. Some asset-backed securities pay monthly, while many international securities pay only annually. The coupon rate also affects a bond's price. Typically, the higher the rate, the less price sensitivity for the bond price because of interest rate movements.

4.Currency Denomination
Currency denomination indicates what currency the interest and principle will be paid in. There are two main types:

  • Dollar Denominated - refers to bonds with payment in USD.
  • Nondollar-Denominated - denotes bonds in which the payments are in another currency besides USD.

Other currency denomination structures can use various types of currencies to make payments.Because the provisions for redeeming bonds and options that are granted to the issuer or investor are more complicated topics, we will discuss them later in this LOS section.

Example: Bond Table
Let's take a look at an example of a bond with the features we've discussed so far, within a bond table format you'd see in a paper.

ABC Corp 7.00% 6/1/10 at 90.

 The issuer is ABC Corp.The maturity is 2010 with a term to maturity of roughly 5 years.
Par value
 is 1,000 per bond or 100
Coupon rate
 is 7%.
Coupon Payment
is $70 per year (coupon=coupon rate* par value = .07 *$1,000 = $70
Trading Price
in dollars in $900.00 (par price * .90)ABC Corp is a U.S. company and all payments of interest ant principle are in USD.
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