Course 6 - Section A

Front 1

Three Largest Bond Issuers

Back 1

1. Domestic Corporations
a. Include regulated utilities and unregulated manufacturers
b. Each firm may sell different kinds of bonds: publicly placed or sold through private placement
c. Some may be collateralized by specific assets of the firm; some may be unsecured

2. Municipal Governments
a. General Obligation (GOs) bonds are backed by full faith;
b. Revenue bonds (its security depends on success of particular entity)

3. Federal Government and its agents
a. The bond market often receives calls from its agencies

Front 2

Reason Bond’s Maturity is Critical

Back 2

1. Indicates the expected life of the instrument
a. The number of periods during which the bondholder can expect to receive the coupon interest and the number of years before the principal will be paid

2. The yield on a bond depends on its maturity
a. The yield offered on long-term bond (at any given point in time) may be greater than, less than, or equal to the yield offered on short-term bond
b. The effect of maturity on the yield depends on the shape of the yield curve

3. The volatility of bond’s price is closely related with maturity
a. Changes in market level of rates will wrest much larger changes in price from bonds of long maturity than from other similar debt of shorter life

4. There are other risks associated with the maturity of a bond (discussed in Ch. 2)

Front 3

Typical Classification of Bonds by Maturity

Back 3

1. Short-Term (1 to 5 years)

2. Intermediate-Term (5 to 12 years)

3. Long-Term (Greater than 12 years)

Front 4

Coupon and Principal

Back 4

1. In the US the coupon payments is made in semi-annual installments (except that mortgage-backed and asset-backed securities usually pay monthly cash flows); whereas European bonds typically pay coupons annually

2. Bearer bonds have coupons that must be redeemed for payment, registered bond coupon payments are sent out automatically

Front 5

Types of Bond Coupon Payments

Back 5

1. Income bonds
a. Can delay or omit interest payments if the issuer’s earnings are too low

2. Deferrable bonds (a.k.a. trust preferred)
a. A variant of the income bonds
b. Subordinated bonds that give the issuer the option to defer coupon payments up to 5 years in the event of financial distress

3. Zero-coupon bonds
a. The US Treasury does not issue zero-coupon debt with a maturity greater than one year; but such securities can be created under the Treasury’s Separate Trading of Registered Interest and Principal Securities (STRIPS) program
b. The reason for the issuance of zero-coupon securities is explained in Ch.8

4. Inflation-indexed bonds
a. The coupon payments are tied to an inflation index (e.g. CPI-U)
b. Protect bondholders from the erosion of purchasing power of fixed nominal coupon payments due to inflation
c. Treasury Inflation-Protection Securities (TIPS) – numerical example – calculate the new semiannual coupon payment

5. Step-up notes
a. Coupon rates increase over the lifetime of the bond

6. Ratchet bonds
a. Coupon rates decrease over the lifetime of the bond
b. Also contain a put option that allows bondholder to put the bond back to the issuer when coupon rate is lowered (but only putable at par)
c. Designed as substitutes for callable bonds

7. Floating-rate bonds (or floaters)
a. The coupon rate is reset at designated dates based on the value of reference rate adjusted for a spread
b. Floaters typically have coupon rates that reset more than once a year
i. Floater may have restriction on the maximum (minimum) coupon rate that will be paid at any reset date called a cap (floor)
ii. The reference rate for most floaters is an interest rate or an interest rate index (e.g. movements in an equity index or commodity price)
iii. Floater’s coupon rate normally moves the same direction as the reference rate moves
iv. Inverse floaters or reverse floaters have coupon rate that moves in the opposite direction from the reference rate – numerical example – shows how the coupon rate of an inverse floater is based on 3-month LIBOR with a floor and a cap
v. Range notes are floaters whose coupon rate is equal to the reference rate (adjusted for a spread) given that the reference rate is within a certain range at the reset date

8. Adjustable-rate or variable-rate bonds
a. Coupon rates reset not more than once a year

9. High-yield bonds (junk bonds)
a. Allow issuers to defer making cash interest payments for a period of 3 to 7 years
b. Three types of deferred-coupon structures will be discussed in Ch.11:
i. Deferred-interest bonds
ii. Step-up bonds
iii. Payment-in-kind bonds

10. Extendible reset bonds
a. Another high-yield bond structure allows the issuer to reset the coupon rate so that the bond will trade a predetermined price
b. Coupon rate may reset annually or reset only once over the life of the bond
c. The coupon rate resets based on market conditions suggested by several investment banking firms at the time of the reset date (So the new coupon rate reflects the new level of interest rates and the new spread that investors seek)