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.