CFA Level 1 - Fixed Income - Module 2- 3 FIXED-INCOME CONTINGENCY PROVISIONS - Sandeep Kanao

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.

CFA Level 1 - Fixed Income - Module 2-2 Fixed-Income Cash Flows and Types - Sandeep Kanao

 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 an entity (like a corporation or government) in exchange for a return on their investment. The cash flow structures of these instruments describe how and when the investor gets paid back.

The most common structure is the bullet bond. In this case, the investor lends a certain amount of money, known as the principal, to the entity. The entity agrees to pay a fixed amount of interest on this loan periodically (usually every six months or annually). At the end of the loan term, the entity pays back the principal in full. This is like lending $100 to a friend who agrees to pay you $5 every year and then gives you back your $100 after five years.

Some fixed-income instruments have different structures. For example, in an amortizing loan, the entity pays back a portion of the principal along with the interest periodically. This is like lending $100 to a friend who agrees to pay you back $20 every year for five years. Each $20 payment includes a part of your original $100 and some interest.

Zero-coupon bonds are another type of fixed-income instrument. These are sold at a discount and do not pay any interest during their life. Instead, the investor gets paid the full principal at maturity. This is like buying a $100 bond for $80 and getting paid $100 after five years.

Cash flow contingency provisions are special conditions that can change the cash flow structure of the bond. These provisions can benefit either the issuer or the investor. For example, a call provision allows the issuer to pay back the bond before its maturity date. This benefits the issuer if interest rates fall because they can pay back the bond and issue a new one at a lower interest rate. On the other hand, a put provision allows the investor to sell the bond back to the issuer before its maturity date. This benefits the investor if interest rates rise because they can sell the bond and invest in a new one that pays a higher interest rate.

In summary, the cash flow structure of a fixed-income instrument describes how the investor gets paid back, and cash flow contingency provisions can change this structure to benefit either the issuer or the investor.

Describe how legal, regulatory, and tax considerations affect the issuance and trading of fixed-income securities . 

Legal, regulatory, and tax considerations play a significant role in the issuance and trading of fixed-income securities, such as bonds. 

1. Legal Considerations: These refer to the laws and regulations that govern the issuance and trading of bonds. For example, the issuer must comply with securities laws, which may require them to disclose certain information about their financial condition and the risks associated with the bond. This is to ensure transparency and protect investors. For instance, if a company wants to issue bonds in the U.S., it must comply with the Securities Act of 1933, which requires the company to register the bonds with the Securities and Exchange Commission (SEC) and provide detailed information about the offering.

2. Regulatory Considerations: These are rules set by regulatory bodies that oversee the financial markets. For example, bonds must be issued in accordance with rules set by bodies like the SEC in the U.S. or the Financial Conduct Authority in the U.K. These rules can affect various aspects of the bond, such as its structure, the information that must be disclosed to investors, and how it can be traded.

3. Tax Considerations: These refer to the impact of taxes on the returns from bonds. The interest earned from a bond is usually taxed as ordinary income. However, some bonds offer tax advantages. For example, in the U.S., the interest earned from municipal bonds is often exempt from federal income tax and sometimes from state and local taxes as well. This can make municipal bonds more attractive to investors in high tax brackets.

In summary, legal, regulatory, and tax considerations can affect the structure, pricing, and attractiveness of bonds to investors. Issuers and investors must understand these considerations when issuing or investing in bonds.

Describe A. bullet bond, B. partially amortizing bond, C. fully amortizing bond

A. A bullet bond is a type of bond where the entire principal amount is paid at once upon the bond's maturity. For example, if you buy a bullet bond with a face value of $1000 that matures in 10 years, you will receive the full $1000 only at the end of the 10 years, along with the final interest payment. 

B. A partially amortizing bond is a bond that pays back a portion of the principal along with the interest payments during the life of the bond, with the remaining principal paid at maturity. For instance, if you buy a partially amortizing bond with a face value of $1000 that matures in 10 years, you might receive $100 back each year along with the interest payment, and then the remaining $100 at the end of the 10 years.

C. A fully amortizing bond is a bond that pays back the entire principal over the life of the bond along with the interest payments. If you buy a fully amortizing bond with a face value of $1000 that matures in 10 years, you might receive $100 back each year along with the interest payment, so that by the end of the 10 years, you have received the full $1000 back.

Describe difference between . bullet bond and Fully amortizing bond..

A bullet bond and a fully amortizing bond are two types of fixed-income securities that differ in how and when the principal amount is repaid to the investor.

A bullet bond, also known as a standard fixed-coupon bond, is a type of bond where the issuer pays periodic interest payments, also known as coupons, and repays the entire principal amount only at the bond's maturity. For example, if a company issues a 5-year bullet bond with a face value of $1000 and an annual interest rate of 5%, the investor will receive $50 (5% of $1000) every year for five years, and at the end of the fifth year, the investor will receive the final interest payment and the $1000 principal.

On the other hand, a fully amortizing bond is a type of bond where the issuer makes periodic payments that include both interest and a portion of the principal. This means that by the time the bond reaches its maturity date, the entire principal amount has been paid off along with the interest. For example, if a company issues a 5-year fully amortizing bond with a face value of $1000 and an annual interest rate of 5%, the investor will receive payments that include both interest and a portion of the $1000 principal every year for five years. By the end of the fifth year, the investor would have received the total principal amount along with the interest.

In summary, the main difference between a bullet bond and a fully amortizing bond lies in the repayment of the principal amount. In a bullet bond, the principal is repaid in a lump sum at maturity, while in a fully amortizing bond, the principal is repaid in installments over the life of the bond.

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 an entity (like a government or corporation), which promises to pay back the loan with interest. The way these payments are structured can vary, but the most common structure is a "bullet bond". 

In a bullet bond, the issuer (the one borrowing the money) receives the principal (the initial loan amount) upfront, makes regular interest payments, and then repays the principal at the end of the loan's term. For example, if a company issues a 5-year bullet bond for $300 million with a 3.2% semiannual interest rate, 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.

However, not all fixed-income instruments follow this structure. Some, like most loans, have principal repayments distributed over the life of the instrument. This means the borrower pays back a portion of the principal along with the interest in each payment. For example, a mortgage is a type of loan where the borrower makes regular payments that include both interest and a portion of the principal. 

There are also zero-coupon bonds, which are sold at a discount and do not have any cash flow during their life until the repayment of the principal at maturity. The difference between the discount price and the principal at maturity represents the interest payment.

Cash flow contingency provisions are special features in a bond contract that can benefit either the issuer or the investor. For example, a call provision benefits the issuer. It gives the issuer the right to pay off the bond before its maturity date, which can be beneficial if market interest rates have fallen since the bond was issued. 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 have risen since the bond was purchased 

In conclusion, the cash flow structures of fixed-income instruments can vary, and different structures and provisions can benefit either the issuer or the investor depending on the circumstances.

Describe amortizing debt, fully amortizing, loan, balloon payment, partially amortizing bond 

Amortizing debt is a type of loan where the borrower makes regular payments over a set period of time. Each payment includes both principal and interest. Over time, the principal portion of each payment increases and the interest portion decreases, so by the end of the loan term, the entire debt is paid off. For example, if you take out a car loan for $20,000 with a five-year term, you would make monthly payments that include both principal and interest until the entire $20,000 is paid off at the end of five years.

A fully amortizing loan is a specific type of amortizing debt where the entire principal amount is paid off over the term of the loan. This means that at the end of the loan term, there is no remaining balance or "balloon payment" due. For example, a 30-year fixed-rate mortgage is a fully amortizing loan. If you borrow $200,000 to buy a house and make all of your monthly payments on time, you will have paid off the entire $200,000 after 30 years.

A balloon payment is a large, lump-sum payment that is due at the end of a loan term. This typically occurs in a partially amortizing loan, where the borrower makes smaller regular payments, but the full amount of the principal is not paid off over the term of the loan. Instead, the remaining balance is due as a balloon payment at the end of the term. For example, you might take out a five-year loan for $100,000, but only $60,000 is amortized over those five years. At the end of the five years, you would owe a balloon payment of $40,000.

A partially amortizing bond is a type of bond where the issuer makes regular interest payments to the bondholder, but only a portion of the principal is repaid over the term of the bond. The remaining principal is paid as a lump sum at the end of the bond's term. For example, a company might issue a 10-year bond with a face value of $1,000, but only $600 is amortized over the 10 years. At the end of the 10 years, the company would owe a balloon payment of $400 to the bondholder.

Describe sinking funds, waterfall structures

Sinking funds and waterfall structures are financial mechanisms used in the repayment of debt.

A sinking fund is a way for companies to pay off part of their bond issue before it reaches maturity. It is a fund into which a company sets aside money over time, specifically for the purpose of retiring its debt. For example, if a company issues a $20 million bond due in 10 years, it might create a sinking fund to repay that bond. Instead of making the investors wait for 10 years to be paid, the company might repay $2 million each year. This reduces risk for investors, as it lessens the chance that the company will not have sufficient funds to pay the bond when it matures.

A waterfall structure, on the other hand, is a method of distributing the cash flows from a bond issue to different classes of investors, also known as tranches. In a waterfall structure, the cash flows are distributed sequentially, starting with the most senior tranche, then moving to the next senior tranche once the previous one is fully paid off. For example, consider a company that issues three tranches of bonds: A, B, and C. Tranche A is the most senior, followed by B and C. In a waterfall structure, all principal and interest payments go to Tranche A investors until their bonds are fully paid off. Only then do payments start going to Tranche B investors, and so on. This structure prioritizes the repayment of the most senior tranches, reducing risk for those investors.

Describe market reference rate (MRR), credit spread, floating-rate loan assets, floating-rate notes (FRN)

Market Reference Rate (MRR): The MRR is a benchmark interest rate that floating-rate notes (FRNs) or loans are tied to. It is usually a short-term money market rate. For example, the London Interbank Offered Rate (LIBOR) is a common MRR. It is the rate at which banks lend to each other in the London interbank market.

Credit Spread: The credit spread is the difference between the yield of a corporate bond and the yield of a government bond with the same maturity. It reflects the additional risk of the corporate bond compared to the risk-free government bond. For example, if a corporate bond yields 6% and a government bond yields 4%, the credit spread is 2%.

Floating-Rate Loan Assets: These are loans where the interest rate changes periodically based on changes in a reference interest rate. For example, a bank might issue a mortgage with an interest rate that adjusts every year based on changes in the U.S. Prime Rate.

Floating-Rate Notes (FRN): An FRN is a bond that has a variable coupon, equal to a money market reference rate, like LIBOR or federal funds rate, plus a quoted spread. The spread is a rate that remains constant. For instance, if the LIBOR rate is 3% and the quoted spread is 2%, then the interest rate for the FRN would be 5%.

For example, Antelas AG, a German technology company, issued a four-year FRN with a principal amount of EUR250 million. The interest rate is set as MRR plus 250 basis points per annum, which means the interest rate will adjust based on the MRR, with an additional 2.5% added on top. The MRR is reset quarterly, and interest is paid quarterly

Reference:

Describe payment-in-kind (PIK), green bonds, leveraged loans, credit-linked notes, step-up bonds 

Payment-in-kind (PIK) is a type of financing where the interest or principal is not paid in cash but rather by increasing the principal amount of the loan or bond. For example, if a company has a PIK loan of $100 with an annual interest rate of 5%, instead of paying $5 in cash at the end of the year, the loan principal would increase to $105. This is often used by companies with high debt levels or cash flow problems, as it allows them to defer cash payments

Green bonds are a type of fixed-income instrument used to finance projects with environmental benefits. For example, a company might issue a green bond to raise money for a new renewable energy project. Investors who buy these bonds are essentially lending money to the issuer for this green project, and in return, they receive periodic interest payments and the return of the principal amount at the end of the bond's term 

Leveraged loans are loans provided to companies or individuals that already have considerable amounts of debt. Borrowers might use leveraged loans to finance mergers and acquisitions, recapitalizations, or refinance existing debt. For example, if a company with a significant amount of debt wants to acquire another company, it might take out a leveraged loan to finance the acquisition 

Credit-linked notes are a type of security that has its cash flows linked to the credit performance of a reference entity. For instance, if a company issues a credit-linked note and the reference entity defaults on its debt, the investors in the note could lose some or all of their investment. This type of note is often used as a way for investors to gain exposure to specific credit risks

Step-up bonds are bonds that have a coupon rate that increases over time at predetermined intervals. For example, a step-up bond might have a coupon rate of 2% for the first two years, 3% for the next two years, and 4% for the final two years. This type of bond can be attractive to investors who believe that interest rates will rise in the future .

Describe Index-linked , inflation-linked bonds, Treasury Inflation-Protected Securities(TIPS), capital-indexed bond, interest-indexed bonds. 

Index-linked or inflation-linked bonds are a type of bond where the principal amount or the interest payments are adjusted according to the rate of inflation. This means that the value of the bond increases with inflation, protecting the investor's purchasing power. 

For example, let's say you buy a $1,000 inflation-linked bond with a 2% annual interest rate. If inflation is 3% over the year, the principal value of your bond would increase to $1,030. Your interest payment for the year would then be 2% of $1,030, or $20.60, instead of $20. This way, your investment keeps pace with inflation.

A well-known example of inflation-linked bonds are Treasury Inflation-Protected Securities (TIPS) issued by the U.S. government. The principal of a TIPS increases with inflation as measured by the Consumer Price Index. When a TIPS matures, you are paid the adjusted principal or original principal, whichever is greater.

Capital-indexed bonds are similar to inflation-linked bonds, but the principal is adjusted according to a specific index, such as a stock market index. This means the value of the bond can go up or down depending on the performance of the index.

Interest-indexed bonds, on the other hand, have a fixed principal value, but the interest payments are adjusted according to a specific index. This could be an inflation index, a stock market index, or an interest rate index. For example, if the index goes up by 2%, the interest payment would increase by 2%.

These types of bonds can be a good investment if you expect inflation or the specific index to rise. However, they can also be riskier than traditional bonds because the value can go down if the index falls.

Describe Zero-Coupon Structures, Deferred Coupon Structures, with example

Zero-Coupon Structures are a type of bond that does not make any interest payments until the bond matures. Instead, they are sold at a discount to their face value. For example, you might buy a zero-coupon bond for $900 that will be worth $1,000 in a year's time. The $100 difference between the purchase price and the face value is the interest you earn. These types of bonds are often used by governments and are particularly common when interest rates are very low or even negative.

Deferred Coupon Structures, on the other hand, are bonds that do not pay any interest for a certain period after they are issued. After this period, they start paying a higher rate of interest. For instance, a company might issue a deferred coupon bond that pays no interest for the first three years, but then pays a higher rate of interest for the remaining years until it matures. This can be useful for companies that are undertaking large projects that will not generate income until they are completed.

Both of these types of bonds have different risk and return profiles and can be useful in different situations. For example, zero-coupon bonds can be useful for investors who do not need regular income and are looking for a guaranteed return at a specific point in the future. Deferred coupon bonds can be useful for companies that need to raise money but do not have the cash flow to make regular interest payments immediately.

CFA Level 1 - Fixed Income - Module 2- 1 - Fixed-Income Instrument Features - Sandeep Kanao

 Describe WHICH LIABILITIES ARE FIXED-INCOME INSTRUMENTS?. 

Fixed-income instruments are essentially loans made by an investor to a borrower. These instruments are called "fixed-income" because the borrower is required to make fixed payment on a specified schedule. 

For example, when a company issues a bond, it is borrowing money from the investor who purchases the bond. In return, the company promises to pay the investor a fixed amount of interest at regular intervals (usually every six months or annually) and to return the principal amount of the loan at a specified future date, known as the maturity date. 

Similarly, when a government issues a Treasury bond, it is borrowing money from the investor and promises to make fixed interest payments and return the principal at maturity. 

In both cases, the interest payments and return of principal are obligations or liabilities of the issuer, whether it's a company or a government. So, these obligations or liabilities are fixed-income instruments from the perspective of the investor, who is effectively acting as a lender.

Describe Contingency Provisions in bonds and relationship with embedded options. 

Contingency provisions in bonds are essentially conditions or scenarios that can change the cash flow of a bond. They are called "contingent" because they depend on certain events or conditions occurring. 

One of the most common types of contingency provisions are embedded options. These are rights given to either the bond issuer (the company or government that is borrowing money) or the bondholder (the investor who is lending money) that can change the cash flow of the bond.

For example, a call option is a type of embedded option that benefits the issuer. It allows the issuer to "call" or buy back the bond before its maturity date, usually when interest rates have fallen. This is beneficial to the issuer because they can pay off their debt early and possibly reissue new bonds at a lower interest rate, reducing their cost of borrowing.

On the other hand, a put option is a type of embedded option that benefits the bondholder. It allows the bondholder to "put" or sell the bond back to the issuer before its maturity date, usually when interest rates have risen. This is beneficial to the bondholder because they can get their money back early and possibly reinvest in new bonds that offer a higher interest rate.

To illustrate, let's say a company issues a bond with a call option. If interest rates fall, the company can exercise the call option, pay off the bond early, and then issue new bonds at the lower interest rate. This would save the company money in interest payments. On the other hand, if a bondholder has a bond with a put option and interest rates rise, they can exercise the put option, get their money back, and then invest in new bonds that offer a higher interest rate. This would earn the bondholder more money in interest payments.

In summary, contingency provisions like embedded options can significantly impact the cash flow and value of a bond, depending on changes in interest rates and the actions of the issuer and bondholder.

Describe bond Yield Measures, with example

Bond yield measures are used to calculate the return an investor would get if they were to buy a bond. There are several types of yield measures, including simple yield, street convention yield, and yield-to-worst.

1. Simple Yield: This is a basic calculation that involves adding up the bond's coupon payments (the interest payments made to the bondholder) and the straight-line amortized share of the gain or loss (the difference between the purchase price and the face value of the bond, divided by the number of years to maturity), and then dividing this sum by the flat price (the price of the bond without considering accrued interest). 

For example, if you buy a bond with a face value of $1000, a coupon rate of 5%, and a price of $950, the simple yield would be (50 + (1000-950)/10) / 950 = 5.79%.

2. Street Convention Yield: This yield measure assumes that all cash flows (coupon payments and the repayment of the principal) are paid on their scheduled dates, without taking into account weekends and bank holidays. This simplifies the calculation but may not accurately reflect the actual timing of cash flows.

3. Yield-to-Worst: This is the lowest yield that an investor can expect from a bond, considering all possible call dates (dates when the issuer can choose to repay the bond early) and the bond's maturity date. The yield-to-worst is calculated by comparing the yields-to-call and the yield-to-maturity, and choosing the lowest one. This gives the investor a conservative estimate of the bond's return.

For example, if a bond has a yield-to-first call of 2%, a yield-to-second call of 3%, a yield-to-third call of 4%, and a yield-to-maturity of 5%, the yield-to-worst would be 2%.

These yield measures can help investors compare different bonds and make informed investment decisions 

CFA Level 1 - Fixed Income - Module 1- 3 - BOND INDENTURES AND COVENANTS - Sandeep Kanao

 Describe the contents of a bond indenture and contrast affirmative and negative covenants. 

A bond indenture is essentially a legal contract between the issuer of the bond (the borrower) and the bondholders (the lenders). This contract outlines the terms and conditions of the bond, including the interest rate (coupon rate), the maturity date (when the principal amount is to be repaid), and any other obligations or restrictions on the borrower. 

For example, let's say a company named ABC Corp. wants to raise money for a new project. They decide to issue bonds. The bond indenture would specify that ABC Corp. will pay the bondholders a certain percentage in interest every year, and will repay the principal amount on a specific date in the future. 

Now, within this bond indenture, there are certain promises or covenants made by the borrower. These can be either affirmative or negative. 

Affirmative covenants are actions that the borrower promises to perform. For ABC Corp., an affirmative covenant might be that they promise to maintain their physical assets (like buildings or equipment) in good condition, or that they will make regular financial disclosures to their bondholders.

Negative covenants, on the other hand, are things that the borrower is prohibited from doing. For ABC Corp., a negative covenant might be that they are not allowed to take on additional debt beyond a certain limit, or they can't sell certain assets without the approval of the bondholders.

These covenants are designed to protect the interests of the bondholders, by ensuring that the borrower maintains their ability to repay the bond. 

For example, by limiting the amount of additional debt ABC Corp. can take on (a negative covenant), the bondholders can be more confident that ABC Corp. won't become over-leveraged and unable to repay their bond. Similarly, by requiring ABC Corp. to maintain their physical assets (an affirmative covenant), the bondholders can be assured that the company won't fall into disrepair and lose value.

In summary, a bond indenture is a detailed contract that outlines the terms of a bond and includes both affirmative and negative covenants designed to protect the bondholders. 

Explain Sovereign Bond and Corporate Bond Sources of Repayment

Sovereign bonds and corporate bonds are types of debt securities, which means they are a way for entities to borrow money from investors. The entity that issues the bond promises to pay back the borrowed amount, plus interest, to the investor at a specified future date.

A sovereign bond is a debt security issued by a national government. The government promises to pay back the borrowed amount, plus interest, to the investor at a specified future date. The source of repayment for these bonds is typically the government's revenue, which comes from taxes and other fees. For example, if the U.S. government issues a sovereign bond, it would repay the bond using the money it collects from income taxes, sales taxes, and other sources of revenue.

A corporate bond, on the other hand, is a debt security issued by a corporation. The corporation promises to pay back the borrowed amount, plus interest, to the investor at a specified future date. The source of repayment for these bonds is typically the corporation's profits. For example, if Apple Inc. issues a corporate bond, it would repay the bond using the profits it makes from selling iPhones, iPads, and other products.

In both cases, the investor is taking on a risk. With a sovereign bond, the risk is that the government will not have enough revenue to repay the bond. With a corporate bond, the risk is that the corporation will not make enough profit to repay the bond. However, both types of bonds are generally considered to be relatively safe investments, especially if they are issued by stable governments or profitable corporations.

Describe Tranches

Tranches are portions of debt or securities that are structured to divide risk or group characteristics among the different portions. These portions or "tranches" are usually seen in mortgage-backed securities (MBS) or collateralized debt obligations (CDO). 

For example, imagine a bank has issued 1000 home loans and wants to package these loans into an investment product. The bank might create a mortgage-backed security (MBS) and divide it into three tranches: A, B, and C. 

Tranche A might contain the 300 most reliable loans (those most likely to be repaid). Because these loans are the safest, Tranche A will pay a lower interest rate to its investors. 

Tranche B might contain the next 300 most reliable loans. These loans are riskier than those in Tranche A, so Tranche B will pay a higher interest rate. 

Tranche C contains the riskiest 400 loans. These loans are the most likely to default, so Tranche C pays the highest interest rate of all. 

In this way, the bank can sell the same 1000 loans to different investors, depending on how much risk those investors are willing to take on. 

Describe Asset-Backed Security Sources of Repayment

Asset-Backed Securities (ABS) are financial instruments that are backed by a pool of assets, often loans. These assets can include home equity loans, auto loans, credit card receivables, student loans, and more. The income from these underlying assets is used to make payments to the investors who hold the ABS.

Let's take an example to understand this better. Suppose a bank has issued a large number of auto loans. The bank can pool these loans together and issue an ABS. Investors who buy this ABS will receive payments from the bank. These payments are funded by the car loan repayments made by the borrowers. So, if you have a car loan and you make your monthly payment to the bank, a portion of that payment is used to pay the investors who hold the ABS.

The primary sources of repayment for ABS are the principal and interest payments made by the borrowers of the underlying loans. If a borrower defaults on their loan, the loss is absorbed by the investors. However, ABS often have credit enhancements, such as overcollateralization or subordination, to protect investors from losses.

Overcollateralization means that the total value of the underlying assets is greater than the value of the ABS. This provides a cushion to absorb losses if some borrowers default. Subordination involves dividing the ABS into different tranches, or levels, each with a different level of risk and return. The highest-risk tranche absorbs losses first, protecting the lower-risk tranches.

In summary, the sources of repayment for ABS are the cash flows from the underlying assets. These cash flows are used to make payments to the investors, and any losses from defaults are absorbed by the investors and mitigated by credit enhancements.

Describe Bond Covenants, with example

Bond covenants are legally binding terms of an agreement between a bond issuer and a bondholder. They are designed to protect the interests of both parties. 

For example, let's say a company (let's call it ABC Corp.) wants to raise money for a new project. They decide to issue bonds to investors. When an investor buys a bond, they are essentially lending money to ABC Corp. In return, ABC Corp. promises to pay the investor a fixed amount of interest over a certain period and to return the principal amount at the end of that period. 

However, the investor wants some assurance that ABC Corp. will be able to fulfill its promises. This is where bond covenants come in. These are conditions that ABC Corp. agrees to meet during the term of the bond. 

For instance, a bond covenant might require ABC Corp. to maintain a certain level of cash reserves or limit the amount of additional debt it can take on. If ABC Corp. fails to meet these conditions, it would be considered a breach of the bond covenant, which could lead to consequences such as early repayment of the bond or legal action by the bondholders.

Bond covenants are described as "legally enforceable terms agreed to at the time of issuance. These may either require the bond issuer to take an action or prohibit the issuer from performing some action" 

Describe pari passu clause and cross-default clause

A pari passu clause is a provision in a bond contract that ensures all creditors are treated equally in terms of repayment, regardless of when the debt was issued. For example, if a company issues two sets of bonds, one in 2020 and another in 2022, both sets of bondholders would have equal rights to repayment. This means that if the company goes bankrupt, the assets would be distributed equally among all bondholders, regardless of when they purchased their bonds.

A cross-default clause, on the other hand, is a provision that states if a borrower defaults on one financial obligation, it is considered to be in default on all its other obligations. For example, if a company has multiple loans and fails to make a payment on one of them, the cross-default clause would trigger a default on all the other loans. This protects lenders by allowing them to take action if the borrower defaults on any of its debts.

These clauses are important features of bond contracts as they protect the rights and interests of bondholders.

Describe senior secured callable bonds

Senior secured callable bonds are a type of bond that has two main features: they are "senior" and "secured", and they are "callable". 

Being "senior" means that in the event of the issuer's bankruptcy, these bondholders are among the first to be repaid, before other creditors and shareholders. This makes these bonds less risky and therefore they usually have a lower yield compared to other types of bonds.

Being "secured" means that the bonds are backed by specific assets of the issuer. If the issuer defaults on the bond payments, the bondholders have a claim on those assets. This further reduces the risk for the bondholders.

The "callable" feature means that the issuer has the right to buy back the bonds before their maturity date, at a predetermined price. This is usually done when interest rates fall, allowing the issuer to refinance its debt at a lower cost. However, this feature is a disadvantage for bondholders, as it limits their potential gains.

For example, let's say a company issues senior secured callable bonds to finance a new project. The bonds are backed by the company's property and have a 10-year maturity. However, after 5 years, interest rates fall significantly. The company decides to call the bonds, meaning it buys them back from the bondholders and reissues new bonds at a lower interest rate. The bondholders get their investment back, but they miss out on the higher interest payments they would have received if the bonds had not been called.

Explain the difference in the sources of repayment for a secured and an unsecured corporate bond.

The repayment of a secured corporate bond and an unsecured corporate bond differs based on the assets backing the bond. 

For a secured corporate bond, the company issuing the bond provides specific assets as collateral. This means that if the company is unable to repay the bond from its operating cash flows, the bondholders have a claim on these specific assets. For example, a car manufacturing company might issue a secured bond backed by its factory equipment. If the company fails to make the bond payments, the bondholders could potentially take possession of the factory equipment to recover their investment.

On the other hand, an unsecured corporate bond does not have any specific assets backing it. The bondholders are relying solely on the company's ability to generate enough cash from its operations to repay the bond. If the company fails to make the bond payments, the bondholders do not have a claim on any specific assets and may not be able to recover their investment. For example, a technology company might issue an unsecured bond based on its expected future cash flows from software sales. If the company's software sales do not meet expectations, it might not have enough cash to repay the bond, and the bondholders could lose their investment.

In summary, a secured corporate bond has a secondary source of repayment in the form of specific assets, while an unsecured corporate bond relies solely on the company's operating cash flows for repayment .

Describe the source of repayment for asset-backed securities.

Asset-backed securities (ABS) are financial instruments that are backed by a pool of assets, such as loans, leases, credit card debt, royalties, or receivables. The source of repayment for these securities comes from the cash flows generated by these underlying assets. 

For example, let's consider an ABS that is backed by auto loans. When a finance company issues auto loans to customers, it receives monthly payments from these customers, which include both principal and interest. These payments form the cash flows that are used to repay the ABS investors. 

If the customers default on their loans, the finance company may repossess and sell the vehicles to recover some of its losses. This provides an additional layer of protection for the ABS investors. However, if the defaults are widespread and the recovery from the sale of repossessed vehicles is not sufficient, the ABS investors may suffer losses.

In summary, the source of repayment for asset-backed securities comes from the cash flows generated by the underlying assets, and in some cases, from the recovery of losses through the sale of collateral.

CFA Level 1 - Fixed Income - Module 1-2 - FEATURES OF FIXED-INCOME SECURITIES - Sandeep Kanao

 Describe the features of a fixed-income security.

A fixed-income security, often referred to as a bond, is essentially a loan that an investor makes to a borrower, such as a corporation or government. This security has several features:

1. Issuer: This is the entity that borrows the money and issues the bond. It could be a corporation, a government, or a non-profit organization.

2. Maturity Date: This is the date when the borrower has to pay back the money they borrowed. It could be in a few months, a few years, or even several decades.

3. Par Value: This is the amount of money that the borrower has to pay back when the bond reaches its maturity date. It's also known as the principal.

4. Coupon Rate and Frequency: The coupon rate is the interest rate that the borrower agrees to pay the investor. This interest is usually paid semi-annually (twice a year), but it can also be paid annually, quarterly, or monthly.

5. Currency: This is the currency in which the payments will be made. It's usually in the currency of the country where the bond is issued.

For example, if a company issues a bond with a par value of $1,000, a coupon rate of 5%, and a maturity date in 10 years, it means that the company is borrowing $1,000 from the investor. The company agrees to pay the investor $50 (5% of $1,000) every year for the next 10 years. At the end of the 10 years, the company will also pay back the $1,000 it borrowed.

Describe WHICH LIABILITIES ARE FIXED-INCOME INSTRUMENTS?

Fixed-income instruments are essentially loans made by an investor to a borrower. These instruments are called "fixed-income" because the borrower is required to make fixed payments on a set schedule. Examples of fixed-income instruments include bonds, treasury bills, and certificates of deposit. 

Fixed-income instruments are described as debt instruments, such as loans and bonds, that represent a contractual agreement under which an issuer borrows money from investors in exchange for interest and future repayment of principal. 

For example, when a company issues a bond, it is essentially borrowing money from the investors who purchase the bond. In return, the company promises to pay these investors a fixed amount of interest at regular intervals and to return the principal amount of the loan at a specified future date. 

Similarly, when a government issues a treasury bill, it is borrowing money from investors. The government promises to repay the principal amount of the loan at a specified future date, and in the meantime, it pays the investors a fixed amount of interest.

These fixed payments of interest and principal are the "liabilities" of the borrower, and they are what make these instruments "fixed-income" instruments 

Explain Key bond features

Key bond features are important characteristics that define a bond's structure and terms. 

1. Issuer: The issuer is the entity that is borrowing money and issuing the bond. This could be a government, a corporation, or a municipality. For example, if Apple Inc. wants to raise money, it might issue bonds. In this case, Apple Inc. is the issuer.

2. Time to Maturity: This is the date when the bond will mature, and the issuer will repay the principal amount to the bondholders. For example, if a bond is issued on 01/01/2020 and has a 10-year maturity, it will mature on 01/01/2030.

3. Principal Amount: This is the face value of the bond, or the amount that will be repaid to the bondholder at maturity. For example, if a bond has a face value of $1,000, the bondholder will receive $1,000 when the bond matures.

4. Coupon Rate and Frequency: The coupon rate is the interest rate that the issuer will pay to the bondholder. The frequency refers to how often these interest payments will be made. For example, a bond might have a 5% annual coupon rate, paid semi-annually. This means that the bondholder will receive 2.5% of the principal amount twice a year.

5. Seniority: This refers to the priority of a bond in case of bankruptcy. Senior bonds are paid first, followed by subordinated bonds. For example, if a company goes bankrupt and has to liquidate its assets, the proceeds will first go to senior bondholders before any remaining funds are distributed to subordinated bondholders.

6. Contingency Provisions: These are special features or conditions of a bond. For example, a bond might have a call provision, which allows the issuer to repay the bond before its maturity date.

Explain Contingency provisions 

Contingency provisions in bonds are special features that can alter the cash flows of the bond. They are designed to protect either the issuer or the investor from certain risks. 

For example, a call provision is a contingency that benefits the issuer. It allows the issuer to buy back the bond before its maturity date, usually when interest rates have fallen. This means the issuer can reissue new bonds at a lower interest rate, reducing their cost of borrowing. 

On the other hand, a put provision is a contingency that benefits the investor. It allows the investor to sell the bond back to the issuer before its maturity date, usually when interest rates have risen. This means the investor can reinvest the money in new bonds that offer a higher interest rate.

Another example is a conversion feature, which allows the bondholder to convert the bond into a specified number of shares of the issuer's common stock. This can be beneficial to the investor if the issuer's stock price increases significantly.

In summary, contingency provisions in bonds can significantly impact the cash flows and risks associated with the bond, and they can provide benefits to either the issuer or the investor depending on the specific provision. 

Explain Yield Measures with example

Yield measures are used to calculate the return on investment for bonds. They take into account the annual interest payments, the bond's current market price, and the amount of time until the bond matures. 

For example, the current yield is a simple measure that equals a bond’s annual coupon (the interest payment) divided by the flat price (the market price without considering accrued interest). If a bond with a face value of $100 and an annual coupon of 3.2% is trading at a price of $98.7, its current yield would be 3.2%/0.987 = 3.242%. This means that for every $100 invested in the bond, the investor will receive $3.242 in interest payments per year.

However, the current yield is a crude measure of return because it focuses solely on interest income, ignoring the frequency of coupon payments, interest on interest (time value of money), and accrued interest. It also doesn't take into account any gain if the bond is purchased at a discount and is redeemed at par value, or any loss if the bond is purchased at a premium and is redeemed at par value.

Another yield measure is the yield-to-maturity (YTM), which is the total return anticipated on a bond if it is held until it matures. YTM is expressed as an annual percentage rate (APR). For example, if a bond with a face value of $1000 is purchased at a price of $900 and has a YTM of 5%, the investor will earn $50 per year in interest payments, plus an additional $100 when the bond matures and the face value is returned.

Yield spread measures, on the other hand, are used to compare the yields of different bonds. For instance, the government equivalent yield is used to compare the yield of a corporate bond to that of a government bond. This is calculated by restating the corporate bond yield from the 30/360 day count basis to the actual/actual day count basis, which is used for government bonds.

In conclusion, yield measures and yield spread measures are important tools for investors to compare the potential returns of different bonds and make informed investment decisions.

Explain Yield Curves with example

Yield curves are graphical representations of the interest rates on debt for a range of maturities. They show the relationship between the interest rate (or cost of borrowing) and the time to maturity of the debt for a given borrower in a given currency. 

For example, the U.S. Treasury Department issues debt with maturities ranging from a few days to 30 years. The yield on these bonds (i.e., the return an investor receives for lending the government money) is closely watched by market participants, and the resulting yield curve is seen as an important benchmark of the cost of borrowing in the U.S. economy.

Typically, the yield curve is upward sloping, meaning that bonds with longer maturities have higher yields. This is because investors demand a higher return for locking up their money for a longer period of time. However, sometimes the yield curve can become inverted, meaning that short-term yields are higher than long-term yields. This is often seen as a sign of economic trouble ahead, as it suggests that investors expect interest rates to fall in the future.

For example, if you look at the yield curve for U.S. Treasury bonds on December 31, 2020, you would see that the yield on a 1-month Treasury bill was about 0.08%, while the yield on a 30-year Treasury bond was about 1.65%. This means that if you were to lend the U.S. government money for 30 years, you would expect to earn an annual return of 1.65%, compared to just 0.08% for lending money for 1 month.

In conclusion, yield curves provide a snapshot of how yields vary across different maturities, and they can provide valuable insights into investor expectations about future economic conditions.

CFA Level 1 - Fixed Income - Module 1- 1 - Fixed-Income Instrument Features- Sandeep Kanao

 

Describe the features of a fixed-income security.

A fixed-income security is a type of investment that pays regular interest payments to the investor and returns the principal amount (the original amount invested) at a specified maturity date. Here are some of its features:

1. Credit Risk: This is the risk that the issuer (the entity that borrowed the money) will not be able to make full and timely payments of interest or repay the principal amount. The higher the credit risk, the higher the interest rate the investor would expect.

2. Credit Quality: This refers to the likelihood that the issuer will be able to repay the debt. It is determined by factors such as the issuer's financial health, the source of repayment, and the legal terms of the bond.

3. Indenture: This is a legal contract that outlines the terms and conditions of the bond, including the interest rate, the schedule of interest payments, and the maturity date.

4. Covenants: These are legally enforceable terms that the issuer agrees to at the time of issuance. They can either require the issuer to take certain actions or prohibit the issuer from doing certain things.

5. Coupon Rate: This is the interest rate that the issuer agrees to pay the investor. It can be fixed or variable. In a fixed-rate bond, the interest rate remains the same throughout the life of the bond. In a variable-rate bond, the interest rate can change based on market conditions.

6. Maturity: This is the date when the issuer has to repay the principal amount to the investor. The time remaining until the maturity date is called the tenor.

7. Principal: This is the original amount of money that the investor lends to the issuer. It is also the amount that the issuer agrees to repay the investor at the maturity date.

For example, if you buy a bond with a principal of $1000, a coupon rate of 5%, and a maturity of 10 years, you will receive $50 (5% of $1000) every year for 10 years. At the end of the 10 years, you will get your $1000 back.

Describe the contents of a bond indenture and contrast affirmative

A bond indenture is a legal contract between the issuer of a bond (the borrower) and the bondholder (the lender). It outlines the characteristics of the bond, such as its maturity date, interest rate, and principal amount. It also specifies the obligations of the issuer and the rights of the bondholder.

In the bond indenture, there are two types of covenants or promises made by the issuer: affirmative and negative covenants.

Affirmative covenants are things that the issuer promises to do. For example, the issuer may promise to maintain certain financial ratios, such as a specific debt-to-equity ratio, or to provide regular financial statements to the bondholders.

Negative covenants, on the other hand, are things that the issuer promises not to do. These could include not taking on additional debt beyond a certain level, not selling certain assets without the bondholders' approval, or not merging with another company without meeting certain conditions.

These covenants are designed to protect the bondholders' interests by ensuring that the issuer maintains a certain level of financial health and does not engage in activities that could jeopardize its ability to repay the bond.

For example, consider a company that issues a bond to raise money for a new project. An affirmative covenant in the bond indenture might require the company to maintain a certain level of cash reserves. A negative covenant might prohibit the company from taking on additional debt that could make it harder for the company to repay the bond.

In summary, the bond indenture serves as a legal contract that outlines the terms of the bond and includes covenants that protect the bondholders by governing the issuer's actions.

Describe how annual coupon amount for a fixed-rate bond is calculated.

The annual coupon amount for a fixed-rate bond is calculated based on the bond's face value and its coupon rate. The face value is the amount the bondholder will receive when the bond matures, and the coupon rate is the interest rate that the bond issuer promises to pay the bondholder annually. 

For example, if a bond has a face value of $1,000 and a coupon rate of 5%, the annual coupon payment would be $50 ($1,000 * 5%). This means that every year, the bondholder will receive $50 from the bond issuer until the bond matures, at which point the bondholder will also receive the bond's face value of $1,000.

In simple terms, if you buy a bond, you are lending money to the issuer of the bond. In return, the issuer promises to pay you a certain amount of interest every year (the annual coupon payment) and to return the money you lent (the face value) when the bond matures 

Question

A. Fixed-coupon bond - II. Usually involves uniform payments that occur at monthly, quarterly, semi-annual, or annual intervals. This means that the bond pays a fixed interest rate to the bondholder at regular intervals (monthly, quarterly, etc.).

B. Floating-rate note - III. Involves interest payments that reset periodically based on market factors. This means that the interest rate on the bond can change over time, based on changes in the market interest rate.

C. Zero-coupon bond - I. The difference between its issuance price and par value at maturity represents a cumulative interest payment at maturity. This means that the bond does not pay regular interest payments, but is sold at a discount to its face value and pays the full face value at maturity.

Which of the following is the appropriate order of claims in liquidation, by

type of bond, in order of highest to lowest?

The appropriate order of claims in liquidation, by type of bond, from highest to lowest is: Senior secured, senior unsecured, junior . This means that in the event of a company's bankruptcy, the first to be paid are the senior secured bondholders, followed by senior unsecured bondholders, and lastly, junior bondholders. 

Senior secured bondholders have the highest priority because their bonds are backed by specific assets of the company. If the company goes bankrupt, these bondholders have a claim to these specific assets. 

Senior unsecured bondholders are next in line. Their bonds are not backed by specific assets, but they still have a higher claim than junior bondholders. 

Junior bondholders are last in line. They are the most at risk of losing their investment if the company goes bankrupt, as they are only paid after all other bondholders have been paid. 

This order is important as it affects the risk and potential return of the bond. The higher the risk (i.e., the lower the priority in case of bankruptcy), the higher the potential return needs to be to attract investors 

Explain in simple English., with an example,  the purpose of a pari passu clause in a bond indenture.

A pari passu clause in a bond indenture is a provision that ensures all debts are treated equally, without any preference or priority for one over another. This means that if a company goes bankrupt, all of its debt holders will be paid back at the same rate, without any one debt holder getting paid before another. 

For example, let's say a company has two types of bonds outstanding: Bond A and Bond B. If the company goes bankrupt and has to liquidate its assets to pay back its debts, a pari passu clause would ensure that the holders of Bond A and Bond B are paid back at the same rate. Neither group of bondholders would get preferential treatment over the other.

This clause is important because it provides a level of protection for bondholders, ensuring that they will be treated fairly in the event of a company's bankruptcy.