Describe common cash flow structures of fixed-income instruments and contrast cash flow contingency provisions that benefit issuers and investors
Fixed-income instruments are essentially loans that investors make to the issuer, such as a corporation or government. The issuer promises to pay back the loan with interest over a specified period of time. The cash flow structures of these instruments can vary, but the most common is the standard fixed-coupon bond, also known as a bullet bond.
In a bullet bond, the issuer receives the principal amount of the loan at the beginning, makes periodic interest payments, and then repays the principal at the end of the loan term. For example, if a company issues a 5-year bullet bond for $300 million with a 3.2% semiannual coupon, it would receive $300 million upfront, make interest payments of $4.8 million every six months, and then repay the $300 million principal at the end of the 5 years.
Some fixed-income instruments have different cash flow structures. For instance, some loans have principal repayments distributed over the life of the loan. This means the borrower pays back a portion of the principal along with the interest in each payment. This is common in mortgage loans.
Zero-coupon bonds are another type of fixed-income instrument. These are sold at a discount and do not make periodic interest payments. Instead, the investor receives the full principal amount at maturity. The difference between the purchase price and the principal represents the interest earned.
Cash flow contingency provisions can benefit either the issuer or the investor. For example, a call provision benefits the issuer. It gives the issuer the right to repay the bond before its maturity date, which can be beneficial if market interest rates fall. On the other hand, a put provision benefits the investor. It gives the investor the right to sell the bond back to the issuer at a predetermined price, which can be beneficial if market interest rates rise.
In summary, the cash flow structures of fixed-income instruments can vary, and different provisions can benefit either the issuer or the investor depending on market conditions.
Describe Zero-Coupon Structures, Deferred Coupon Structures, with example
Zero-Coupon Structures are a type of bond that does not pay any interest or "coupon" payments during its life. Instead, it is sold at a discount to its face value (or "par value") and then pays the full face value at maturity. This means that the investor's return comes from the difference between the discounted price they paid for the bond and the full face value they receive at maturity.
For example, let's say you buy a zero-coupon bond with a face value of $1000 for $900. You won't receive any interest payments during the life of the bond, but when it matures, you'll receive the full $1000. So, your return is the $100 difference between what you paid and what you received at maturity.
Deferred Coupon Structures are bonds that do not pay any interest for a certain period of time after they are issued. After this initial period, they start paying a higher interest rate until they mature. These are often issued by companies that need to conserve cash in the short term, perhaps because they are building a new factory or launching a new product, and expect to have more cash in the future.
For example, a company might issue a deferred coupon bond that pays no interest for the first 3 years, and then pays a 5% interest rate for the next 7 years. If you buy this bond, you won't receive any interest payments for the first 3 years, but then you'll start receiving higher interest payments for the next 7 years.
Both of these types of bonds can be useful for different types of investors, depending on their needs and expectations about future interest rates and the company's performance.
Describe callable bond, Fixed-price calls, call protection period. call period, call price, call risk, with example.
The call protection period is a period during which the issuer cannot call the bond. This is to protect the investor from having their bond called too soon. For example, a bond might have a 5-year call protection period, meaning the issuer cannot call the bond within the first 5 years.
The call period is the time after the call protection period during which the issuer can call the bond.
The call price is the price at which the issuer can call the bond. This is usually the face value of the bond plus any accrued interest.
Call risk is the risk to the investor that a bond will be called. If a bond is called, the investor will get their money back, but they might not be able to reinvest it at as high a rate.
Describe callable bond, Fixed-price calls, with example
A callable bond is a type of bond that allows the issuer, or the entity that created the bond, to buy back the bond before it matures. This is usually done when interest rates have fallen since the bond was issued. The issuer can then reissue new bonds at a lower interest rate, saving them money on interest payments.
For example, let's say a company issues a callable bond with a 10-year maturity and a 5% interest rate. If after 5 years, the interest rates in the market have fallen to 3%, the company can choose to "call" or buy back the bond from the investors. The company can then reissue new bonds at the lower 3% interest rate, reducing their interest payment costs.
Fixed-price calls are a type of callable bond where the issuer has the right to buy back the bond at a fixed price before the bond matures. This price is usually higher than the bond's face value, providing some compensation to the bondholder for the early termination of the bond.
For example, a company might issue a callable bond with a face value of $1,000, but with a fixed call price of $1,050. This means that if the company decides to call the bond, they would pay the bondholder $1,050 for each bond, even though the face value is only $1,000.
In both cases, the callable feature benefits the issuer as it provides flexibility in managing their debt costs. However, it introduces additional risk for the bondholder, as they may have their investment returned earlier than expected, potentially at a time when interest rates are lower.
Describe conversion ratio, conversion value, contingent convertible bonds (CoCos)
The conversion ratio is the number of shares of stock that a bondholder receives if they choose to convert their bond into equity. For example, if a bond has a conversion ratio of 20, this means that for each bond, the bondholder can receive 20 shares of the company's stock.
The conversion value is the value of the bond if it were converted into stock. It is calculated by multiplying the conversion ratio by the current price of the stock. For example, if the conversion ratio is 20 and the current stock price is $10, the conversion value of the bond would be $200.
Contingent convertible bonds (CoCos) are a type of bond that can be converted into equity if a specific event occurs. This event is usually related to the financial health of the company, such as the company's capital ratio falling below a certain level. For example, a bank might issue CoCos that convert into equity if the bank's capital ratio falls below 7%. This provides a safety net for the bank, as it can strengthen its capital base in times of financial stress.
