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The Fixed-Income Marketplace

Fixed-income securities represent the debt of the issuing entity. Terms include repaying the principal (maturity value) on the maturity date and paying interest at stated intervals or at maturity. Varieties include bonds, debentures, money market instruments, mortgages, and preferred shares. Issuers modify terms to suit their needs and investor demands.

The Rationale for Issuing Fixed-Income Securities

Corporations and governments issue fixed-income securities to finance operations and growth, or to take advantage of financial leverage.

Examples:

• A company issues bonds for general corporate purposes to meet increasing product demand.

• A corporation issues bonds to purchase another company, paying borrowing costs from its revenue stream.

• A company issues bonds to open a new plant, expecting increased profits to exceed borrowing costs.

Financial leverage occurs when the expected return from investing borrowed funds is greater than the cost of borrowing.

Basic Features and Terminology

Bonds

Bonds are long-term debt securities secured by physical assets. They impose fixed financial obligations, including regular interest payments and principal repayment at maturity. Details are in a trust deed and bond contract. Default allows bondholders to seize assets.

Debentures

Debentures are unsecured bonds backed by the issuer's general creditworthiness rather than specific assets. They promise regular interest payments and principal repayment at maturity.

Bond Terminology

Bond Features

Interest on Bonds

Coupon indicates income, also called interest income or coupon income. Most bonds pay a fixed coupon rate, but some have variable rates (floating-rate securities). Interest payments can change over time (step-up bonds, savings bonds), be compounded and paid at maturity (zero-coupon bonds), or be linked to an equity index (index-linked notes). In North America, most bonds pay interest semi-annually.

Denominations

Bonds are purchased in specific denominations, commonly 1,000 and 10,000 for retail markets, and larger denominations (millions of dollars) for institutional investors.

Bond Pricing

• A bond trading at a quoted price of 100 is trading at par (face value).

• Trading below par (e.g., 98) is at a discount.

• Trading above par (e.g., 104) is at a premium.

Market interest rates, relative to the coupon, determine the bond price. Changes in market interest rates affect bond values. If the bond's coupon is lower than prevailing market interest rates, it will trade at a discount. If the bond's coupon is higher than prevailing market interest rates, it will trade at a premium.

Bond Yields

Bond yield represents the amount of return on the bond. Types of yields include yield to maturity, interest income divided by face value, and current yield (coupon income divided by current market price). While coupon income remains constant, yield and price fluctuate.

Term to Maturity

• Short-term bonds: More than one year but less than five years.

• Medium-term bonds: Five to 10 years.

• Long-term bonds: Greater than 10 years.

• Money market securities: Term to maturity of up to one year.

Liquidity, Negotiability, and Marketability

Liquidity, negotiability, and marketability relate to the ease of trading bonds.

• Liquid bonds trade in significant volumes.

• Negotiable bonds can be transferred.

• Marketable bonds have a ready market.

Strip Bonds

A strip bond (zero coupon bond) is created by separating individual interest coupons from the underlying bond and selling each coupon and the residue separately at a discount. Holders receive no interest payments but purchase at a discount, receiving par at maturity. Income is interest, taxed annually even if not received until maturity and should be held in tax-deferred plans.

Example:

An investment dealer buys 10 million face value of a five-year, semi-annual pay Government of Canada bond with a coupon of 5.50%, stripping the bond for sale. They create 10 strip coupons, each with a face value of 275,000 (10 million * 0.055 * 0.5). Each coupon has its own maturity date. The principal repayment is sold as a residual with a face value of 10 million. Strip coupons are sold at a discount. A coupon payable in three years sells for 233,690. Buying this strip bond the investor receives 275,000 in three years without other income.

Callable Bonds

Issuers can pay off the bond before maturity, a call or redemption feature. Bonds bearing this clause are callable or redeemable. Notice is typically 10 to 30 days. Most corporate and provincial bond issues are callable; Government of Canada bonds and municipal debentures are usually non-callable.

Standard Call Features

Allow the issuer to call bonds at a specified price on specific dates or intervals, usually higher than par value, providing a premium payment to the holder as compensation. The premium decreases as the bond approaches maturity.

Extendible and Retractable Bonds

Extendible Bonds

Issued with a short maturity term (typically five years), with an option to extend the investment. The investor exchanges the debt for an identical amount of longer-term debt (typically 10 years) at the same or slightly higher interest rate. The maturity date can be extended, changing the bond from a short-term to a long-term bond.

Example:

GHI International Inc. 7% Extendible Junior Bonds, Series B2.1, due July 26, 2020, are extendible to July 26, 2030 from July 26, 2020 at a rate of 7.125%.

Retractable Bonds

Issued with a long maturity term, but with the option to redeem early. The maturity date is usually at least 10 years, but investors have the right to redeem the bonds at par by a retraction date (typically five years earlier than the maturity date).

Example:

JKL Inc. 4% bonds are due on June 30, 2025 and are retractable at par on June 30, 2020.

Election Period: The decision to exercise the maturity option must be made during a specific time. If the holder takes no action, the bond automatically matures on the earlier date (extendible) or remains a longer-term issue (retractable).

Convertible Bonds and Debentures

Combine bond advantages with the option to exchange the bond for common shares (conversion privilege). Allows investors to lock in a specific price (conversion price) for common shares.

Characteristics:

• Fixed interest rate and a definite date on which the principal must be repaid.

• Possibility of capital appreciation through the right to convert the bonds into common shares at the holder’s option, at stated prices over stated periods.

• Conversion price may increase over time to encourage early conversion.

• Some issues stipulate "no adjustment for interest or dividends".

• Protection against dilution clause.

• Normally callable, usually at a small premium and after reasonable notice.

Forced Conversion

Built into some convertible debt issues, giving the issuing company more control in calling in the debt for redemption. Once the market price of the common stock rises above a specified level for a specific number of days, the issuing company can call the bonds for redemption at a stipulated price. Relieves the issuer of interest payments and can free up room for new debt financing.

Market Behavior of Convertibles

Market price is influenced by investment value as a fixed-income security and the price of the common shares. When the stock price is below the conversion price, the convertible behaves like a straight fixed-income security. When the stock price rises above the conversion price, the bond price rises accordingly. However, even if interest rates rise sharply, the bond price will not drop below the conversion value.

Sinking Funds and Purchase Funds

Issuers repay portions of their bonds for redemption before maturity.

Sinking Funds

Sums of money set aside out of earnings each year to provide for the repayment of all or part of a debt issue by maturity. Provisions are as binding as any mortgage provision. Some corporate bonds have a mandatory call feature for sinking fund purposes. The issuer attempts to buy the debt in the secondary market when the price is at or below a specified price. If it is unable to purchase the required amount, it will resort to calling the debt to meet its obligations.

Purchase Funds

A fund set up to retire a specified amount of the outstanding bonds or debentures through purchases in the market. Purchases must be available at or below a stipulated price. Provisions are less binding than sinking funds.

Protective Provisions of Corporate Bonds

General covenants that secure the bond, guarding against any weakening in the security holder’s position.

Common protective covenants:

• Security

• Negative Pledge

• Limitation on Sale and Leaseback Transactions

• Sale of Assets or Merger

• Dividend Test

• Debt Test

• Additional Bond Provisions

• Sinking or Purchase Fund and Call Provisions

Government of Canada Securities

Issued to finance deficits, fund programs, and finance infrastructure projects.

Bonds

Marketable bonds with a specific maturity date and interest rate, transferable and non-callable. Crown corporations can issue debt with a direct call on the Government of Canada. Foreign investors compare the quality of Canadian issues to other governments.

Treasury Bills

Short-term obligations offered in denominations from 1,000 up to 1 million. Sold at a discount and mature at 100. The difference is taxable as income. Every two weeks, bills are sold at auction with terms of three months, six months, and one year.

Canada Savings Bonds and Canada Premium Bonds

Secure savings products fully guaranteed by the Government of Canada. The government discontinued the sale of CSBs and CPBs in November 2017 due to declining sales. Any existing CSBs and CPBs are still guaranteed and will be honored by the government until investors redeem their bonds or the bonds mature, whichever comes first. CSBs and CPBs are not transferrable and therefore have no secondary market.

Real Return Bonds

Pay interest and repay the original principal amount upon maturity, adjusted for inflation to provide a fixed real coupon rate. The real coupon rate is applied to a principal balance that has been adjusted for the cumulative level of inflation since the date the bond was issued.

Provincial and Municipal Government Securities

Provincial Bonds

Debentures representing promises to pay. Their value depends upon the province’s ability to pay interest and repay principal. They are second in quality only to Government of Canada direct and guaranteed bonds because most provinces have taxation powers second only to the federal government.

Guaranteed Bonds

Many provinces guarantee the bond issues of provincially appointed authorities and commissions. Provincial guarantees may also extend guarantees to cover municipal loans and school board costs.

Example:

The Ontario Electricity Financial Corporation’s 8.5% notes, due May 26, 2025, are “Irrevocably and Unconditionally Guaranteed by the Province of Ontario.”

Unlike the federal government, provinces borrow extensively in international markets to take advantage of lower borrowing costs.

Provincial Securities

Some provinces offer their own savings bonds. There are certain characteristics that distinguish these instruments from other provincial bonds and make them suitable as savings vehicles:

• They can be purchased only by residents of the province.

• They can be purchased only at a certain time of the year.

• They are redeemable every six months (or, in Quebec, at any time).

Some provinces issue different types of savings bonds. For example, there are three types of Ontario Savings Bonds: a variable-rate bond, a fixed-rate bond, and a step-up bond (in which interest paid increases over time).

Municipal Securities

Most municipalities use the instalment debenture (serial bond) to raise capital. Are usually non-callable. A municipality’s credit rating depends upon its taxation resources.

Example:

A debenture of 1 million may be issued so that 100,000 becomes due each year over a 10-year period.

Types of Corporate Bonds

Corporations can sell ownership of the company by selling stocks to investors or they can borrow money from investors by selling fixed-income securities.

Mortgage Bonds

A legal document containing an agreement to pledge land, buildings, or equipment as security for a loan. Entitles the lender to take over ownership of these properties if the borrower fails to pay interest or repay the principal when it is due. First mortgage bonds are the senior securities of a company.

A phrase called the after-acquired clause means that all assets can be used to secure the loan, even those acquired after the bonds were issued.

Floating-Rate Securities

Automatically adjust to changing interest rates. Offer an advantage to investors during periods of rising interest rates. A minimum rate on the bonds can provide some protection, although the minimum rate is normally relatively low.

Domestic, Foreign, and Eurobonds

Classified by where and how they are issued.

• Domestic bonds: Issued in the currency and country of the issuer.

• Foreign bonds: Issued outside of the issuer’s country and denominated in the currency of the country in which they are issued.

Example:

When a Canadian company issues bonds in U.S. dollars in the United States, these bonds are considered foreign bonds in the U.S. market; they are also called Yankee bonds. When a British company issues yen-denominated bonds in Japan, the bonds are called Samurais and are considered foreign bonds in the Japanese market.

• Foreign pay bonds: Offer the investor a choice of interest payments in either of two currencies; other bonds pay interest in one currency and the principal in another.

• Eurobonds: International bonds issued in a currency other than the currency of the country where the bond is issued.

Example:

Assume that the Canadian government has decided to issue a new bond denominated in U.S dollars in the Euromarket. If a Canadian corporation or government issues Eurobonds denominated in Canadian dollars, the bonds are called EuroCanadian bonds. Eurobonds denominated in U.S. dollars are called Eurodollar bonds.

Other Types of Corporate Debt

• Collateral trust bonds Secured by a pledge of securities, or collateral. Commonly issued by holding companies.

• Equipment trust certificates Pledges equipment as security. Usually issued in serial form.

• Subordinated debentures Junior to other securities issued by the company.

• Corporate notes Short-term unsecured promise to pay interest and repay the funds borrowed.

• High yield-bonds Lower-credit quality bonds with a higher risk of default.

Other Fixed-Income Securities

Bankers’ Acceptances

A commercial draft drawn by a borrower for payment on a specified date, guaranteed at maturity by the borrower’s bank. Sold at a discount and mature at their face value. Trade in multiples of 1,000, with a minimum investment of 25,000. Generally have a term to maturity of 30 to 90 days, although some may have a maturity of up to 365 days.

Commercial Paper

Unsecured promissory note issued by a corporation or an asset-backed security. Issue terms range from less than three months to one year. Sold at a discount and matures at face value.

Term Deposits

Offer a guaranteed rate for a short-term deposit (usually up to one year). A penalty normally applies for withdrawing funds before a certain period.

Guaranteed Investment Certificates (GIC)

Offer fixed rates of interest for a specific term. Both principal and interest payments are guaranteed. Can be redeemable or non-redeemable. Banks can also customize their GICs to provide investors with more choice.

Fixed-Income Mutual Funds and Exchange-Traded Funds

Provide investors with easy access to a diversified portfolio of debt securities in domestic and global markets. Attractive for investors with limited funds or those who find investing in individual bonds too complex.

How to Read Bond Quotes and Ratings

A typical bond quote includes the issuer, coupon rate, maturity date, bid and ask prices, and yield to maturity. In Canada, DBRS, Moody’s, and S&P provide independent rating services for fixed-income securities. Ratings help investors assess debt quality and can impact security prices.

Example:

Moody's Long-Term Rating Scale

The following table outlines Moody's long-term rating scale and their descriptions:

Numerical modifiers (1, 2, 3) indicate ranking within the generic category.

Chapter 7 Overview

In this chapter, the calculation methods for the price and yield of fixed-income securities are discussed. The factors that determine the term structure of interest rates are also examined. The way that bond prices react to changes in interest, yield, coupon and yield are also discussed. The way that bond indexes work, their construction, and their usefulness for performance measurements are analyzed.

Learning Objectives

The Learning Objectives for this chapter are as follows:

1. Perform calculations related to bond pricing and yield.

2. Describe the factors that determine the term structure of interest rates and the shape of the yield curve.

3. Explain how bond prices react to changes in interest rates, maturity, coupon, and yield.

4. Describe how bond trading is conducted.

5. Define bond indexes and how they are used in the securities industry.

Introduction

Before recommending fixed-income securities, understand their potential risks and rewards, including how bond yields and prices are determined and the relationship between prices and interest rates. This chapter focuses on methods used to determine the fair price for fixed-income securities and the impact of various events on the markets.

Calculating Price and Yield of a Bond

The most effective method to determine the value of a bond is to calculate the present value (PV). The PV is the amount an investor should pay today to invest in a security that guarantees a sum of money on a specific date in the future.

Example

Suppose you had the opportunity to invest money today to receive 1,000 dollars one year from today, and the current interest rate is 5%. Since you could invest money today and earn 5 percent interest over the course of a year, the present value must be less than the future value of 1,000 dollars. How much must you invest today at 5% to achieve that future value of 1,000 dollars? This can be determined through the simplified calculation given by:

PV = { \frac{FV}{1 + i}}

PV = \frac{1000}{(1+0.05)} = 952.38

After this calculation, we see that 952.38 invested today for one year at a 5% rate of interest will grow to a future value of $1,000.

The PV of a bond with coupon payments can be calculated in 4 steps:

1. Choose the appropriate discount rate.

2. Calculate the present value of the income stream for the bond's coupon payments.

3. Calculate the present value of the bond's principal to be received at maturity.

4. Add these present values together to determine the bond's worth today.

The general formula used for calculating present value is given by:

PV = \frac{C}{(1 + r)^1} + \frac{C}{(1 + r)^2} + … + \frac{C}{(1 + r)^n} + \frac{FV}{(1 + r)^n}

Where:

(
PV = Present value of the bond
)

(
C = Coupon Payment
)

(
r = ) discount rate per period

(
n =) number of compounding periods

(
FV = ) principal received at maturity.

Discount Rate

The discount rate is the rate at which you would discount a future value to determine the present value. The appropriate discount rate is chosen based on the risk of the particular bond, such as liquidity and credit risks.

Calculating the Fair Price of a Bond

The fair price of a bond is the present value of the bond's principal and the present value of all coupon payments to be received over the life of the bond.

If we wanted to calculate the PV of a 4 year, semi-annual 9 percent bond, the formula would be:

PV = \frac{4.5}{(1 + 0.05)^1} + \frac{4.5}{(1 + 0.05)^2} + … + \frac{4.5}{(1 + 0.05)^8} + \frac{100}{(1 + 0.05)^8}

Present Value of a Bond

Present Vale of the Income Stream

The income stream of a bonds PV is calculated by identifying the coupon payment values. In the example calculation, there are semi-annual coupon payments of 4.50. Using a calculator, we can calculate these payments:

1. Type 8, then press N.

2. Type 5, then press I/Y.

3. Type 4.50, then press PMT.

4. Type 0, then press FV (to tell the calculator you are not interested in the principal).

5. Press COMP, then press PV. Answer: –29.0845

Present Value of the Principal

Since the bonds principal represents a single cash flow to be received in the future, we can calculate the PV principal of our bond:

1. Type 8, then press N.

2. Type 5, then press I/Y.

3. Type 0, then press PMT (to tell the calculator you are not interested in the coupons).

4. Type 100, then press FV.

5. Press COMP, then press PV. Answer: –67.6839

The PV of the principal is approximately 67.68. This tells us that if you were to invest 67.68 at a semi-annual rate of 5% today, you would receive 100 in four years. You can verify this on your calculator by entering 67.6839 + 5% + 5% + 5% + 5% + 5% + 5% + 5% + 5%.

Present Value of the Bond

The fair price for a bond is the sum of its two sources of value: the present value of its coupons and the present value of its principal. In the example above, the coupons are worth 29.08 and the principal is worth 67.68. Therefore, at a discount rate of 10%, this bond has a present value of 96.77 (calculated as 29.0844 + 67.6839) today. We can also carry out the calculation for the present value of the bond in one easy step using a financial calculator:

1. Type 8, then press N.

2. Type 5, then press I/Y.

3. Type 4.50, then press PMT.

4. Type 100, then press FV.

5. Press COMP, then press PV. Answer: –96.7684

Calculating the Yield on a Treasury Bill

Treasury Bills (T-bills) is a very short-term security that trades at a discount and matures at par. No interest is paid in the interim. The return is generated from the difference between the purchase price and the sale price. A formula for calculating this yield is given by:

Yield = [\frac{100 - Price}{Price}] * [\frac{365}{Term}] * 100

An 89 day T-bill, with a price of 99.5 can be calculated to have a yield of 2.061%:

[[\frac{100 - 99.5}{99.5}] * [\frac{365}{89}]] * 100 = 2.061

Calculating the Current Yield on a Bond

Current Yield only focuses on the cash flows and current market price of an investment, not the amount that was originally invested. In order to calculate this, the equation is given by:

CurrentYield = \frac{AnnualCashFlow}{Price}

Using the formula and the 4 year, semi-annual 9 percent bond data from the previous calculation, the Current Yield is 9.30%:

\frac{9.00}{96.77} = 9.30

Calculating the Yield to Maturity on a Bond

The Yield to Maturity is the most popular measure of yield in the bond market. It shows the total return you would expect to earn over the life of a bond starting today, assuming you are able to reinvest each coupon payment you receive at the same YTM that existed at the time you purchased the bond.

Given bonds that costs 103 and matures in four years, and with a 7% coupon rate, you will end up with a 3 percent capital loss. Over the course of four years, the payments from the issuer would be given by: $3.50 + $3.50 + $3.50 + $3.50 + $3.50 + $3.50 + $3.50 + $3.50 + $100 = $128. Keep in mind that each instance you receive payment, you have an opportunity to invest that money and earn a potential return from it.

An approximate YTM calculation is given by:

AYTM = [{\frac{Interest Income + [\frac{Par Value - Purchase Price}{Compounding Periods}]}{\frac{Purchase Price + Par Value}{2}}}] * 100

On the four-year, semi-annual, 9% bond, trading at a price of 96.77 that matures at 100, the semi-annual interest or coupon income is 4.50. The semi-annual approximate YTM on this bond is 4.9684:

An XYZ corporation trading at the following levels, will have a yield to maturity (YTM) of 12.5 %.

• Issue Coupon 7%

• Maturity 5 Years

• Bid 79.75

• Ask 80.25

• Last Price 80.00

The formula to calculate YTM is given by: N10, –80 PV, 3.5 PMT, 100 FV, COMP I/Y × 2.

Also, keep in mind that in most cases, the current yield, approximate YTM, and the YTM will differ because they apply different formulas based on different assumptions. When the bond trades at par, the current yield, approximate YTM, and the YTM will be the same.

Reinvestment Risk

Because interest Rates fluctuate, the interest rate prevailing at the time of purchase is unlikely to be the same as the interest rate prevailing at the time the investor reinvests cash flows from each coupon payment. The longer the term to maturity, the less likely it is that interest rates will remain constant over the term. Reinvestment risk refers to the risk that the coupons will earn a return at a lower rate than the rate that prevailed at the time the bond was purchased.

Term Structure of Interest Rates

The Market forces of supply and demand can affect the trading prices of bonds, and therefore their YTM. An important factor in driving a bond's price is Market interest rates. It is important that you understand the factors that determine the general level of interest rates at any particular time, and the level of interest rates at different terms to maturity.

In a general sense, interest rates are simply the result of the interaction between those who want to borrow funds and those who want to lend funds. Interest rates are the result of the interaction between the inflation rate, the normal interest Rate, and the real interest rate.

The Real Rate of Return

The rate of return that a bond offers is made up of two components:

1. The real rate of return

2. The inflation rate.

Because inflation reduces the value of a dollar, the return that is received, called the nominal rate, must be reduced by the inflation rate to arrive at the real rate of return.

The nominal rate for loans is made up of the real rate, as established by supply and demand, plus the expected inflation rate: Nominal Rate = Real