1.    Overview of Fixed Income Securities

There are three important elements of fixed income securities that the investors and analysts must look into, before investing:

a.  The features of the securities,

b.  It’s legal, tax, and regulatory matters, and

c.  Contingency provisions.

2.    Features of Fixed Income Securities

2.1.         Issuer

The issuer is the organization that issues the fixed income securities. Some of the major issuers of the fixed income securities are:

a.  Supernational organizations such as the world bank ;

b.  Government bonds, such as the sovereign bonds (i.e. those bonds that are issued by the central governments of the countries) and the non-sovereign bonds (i.e. those bonds that are issued by the state government, province, and municipal corporations)

c.  Quasi-Government bonds, i.e. those bonds that are issued by the government-owned or government sponsored enterprises, thus are backed by the government, but not issued by the government.

d.  Corporate Bonds, i.e. those bonds that are issued by the publically traded bonds.

2.2.         Maturity

There are two terms with respect to the maturity of fixed income security:

a.  The maturity date, i.e. the due date on which the issuer of the bond is obliged to repay the principal amount of the bonds.

b.  The term to maturity, which is the time starting from now up to the maturity date of the bond. If the term to maturity of a bond, at the time of its inception is greater than one year then it is a capital market bond, else it is a money market bond.

2.3.         Par Value

a.  The par value of a bond is also its future value, maturity value, face value, redemption value, nominal value, or principal value.

b.  A bond can have any par value; it might have a par value of $1 or $ 100, or even $ 69, etc.

c.  The bonds are quoted on a 100-point system. Thus, a bond may trade at 100, which means that it is trading at 100% of its par value. If a $ 1,000 bond is trading at 98, it means that it is trading at a discount of 2%, at $ 980. Any bond trading above 100 means it is trading at a premium.

2.4.         Coupon Rate & Frequency

a.  The coupon rate is the stated rate of the bond paid annually.

b.  For example, if there is a $ 1,000 6% bond, and it is paying the interest annually, it means it would pay $ 60 once every year; however if it is paying the interest semi-annually, it means that interest of $ 30 would be paid by the issuer, twice a year, and so on.

c.  Depending upon the nature of coupons, there are different types of bonds, such as:

     i.  Plain Vanilla Bonds: These are the most basic bonds that pay coupons at a fixed rate.

    ii.  FRNs – Floating Rate Notes: These are the bonds that pay interest at a floating rate, that consist of a reference rate plus the spread (or margin). The reference rate is dependent upon some other rate such as LIBOR and usually, The spread is usually fixed and is stated on a basis point. The spread depends upon the creditworthiness of the issuer, i.e. more creditworthy the issuer is lesser is the spread.

   iii.  Zero-Coupon Bond: These are the bonds that do not carry any interest payments, rather these bonds are sold at a discount to the par value. Thus at the time of redemption or sale of the bond, all the income that is earned by the bondholder is considered as the interest income and not the capital gains. All the money market securities are generally zero-coupon bonds.

2.5.         Currency

a.  Mostly the bonds are issued by the government are denominated in the home currency. But, these bonds can be issued in any other currency as well.

b.  The bonds are sometimes issued in the dual currency as well. Here, the coupon payments are made in one currency and the principal payment is made in the other currency.

c.  There exist another category of bonds called the currency option bonds. These are generally single currency bonds, but they give the option to the bondholder to receive the interest and principal payments in the other currencies as well.

2.6.         Bond Indenture:

A bond is the legally binding contractual agreement between the two parties, i.e. the issuer and the bondholder. Therefore, since it is a contractual agreement, there is a need for the formal contract in the form of a bond indenture or a trust deed, which is a legal contract that specifies certain things, i.e.:

a.  a form of the bond,

b.  the obligation of the issuer, and

c.  rights of the bondholder.

The issuer of the bond appoints a trustee, who acts in a fiduciary capacity on the behalf of the bondholder, to monitor the issuer. The trustee is guided by the trust deed in the process.

A bond indenture consists of the following:

a.  The details of the basic bond features.

b.  The legal identity of the bond issuer and its legal form, i.e. whether the issuer is the government or a corporation, if corporate then whether it is a holding company or the subsidiary of some holding, etc. This gives the information to the analyst about the credit quality and the recourse to the assets.
For example, most of the finance companies transfer the assets to the special purpose vehicles as a bankruptcy remoteness form for the bondholders.

2.7.         Source of Repayment of Proceeds

a.  Fixed income securities require funds mainly for two purposes: one, to service the cash flows, i.e. the interest payments; and two, to service the principal cash flows.

b.  The super-national organizations receive the funds for the payments of a loan from the repayment of previous loans or paid-in capital of the members.

c.  The government, both sovereign and non-sovereign, issues bonds.
The sources of repayment proceeds of the loan for the sovereign government are generally the taxes that they receive from the public and printing the money. Thus, the sovereign government enjoys full faith and credit.
The main source of repayment of credit of the non-sovereign government is the taxes, cash flows from different projects (such as toll roads), and special taxes or fees specific to funding different projects.

d.  The corporate finance their requirements for servicing the debt through only one source mainly, i.e. cash flow from operations.

e.  The securitized bonds make payments of principal and interest on the securities held as the underlying financial assets.

2.8.         Assets or Collateral Backing

a.  The details of the assets or the collateral backing the debt are generally there in the bond indenture.

b.  While looking at the assets/collateral backing of the fixed income securities, one must look at:

     i.  The seniority ranking of the debt, whether it is a secured debt (i.e. secured by the assets) or unsecured (i.e. a general pledge). The higher the ranking, in terms of more asset backing, the less is the risk.

    ii.  The collateral quality, i.e. the quality of assets backing the security or debt. There are different types of fixed income securities having different quality of collaterals backing them.
Collateral trust bonds are the bonds that are not backed by the physical assets but are backed by the financial assets, held by the trustee.
Equipment trust certificates are backed by specific equipment. For example, an airline company may finance its assets by taking them on the lease, from a trustee, who in turn issues trust certificates and buy assets for the company. Such certificates are backed by the assets themselves.
There are other types of securities as well, such as, MBS or mortgage-based securities, covered bonds (who do not have a bankruptcy-remote cover), etc.

2.9.         Credit Enhancement

a.  Credit enhancement is a process that reduces the risk of a bond.

b.  Credit enhancement is of two types, i.e. internal credit enhancement and external credit enhancement.

c.  Internal credit enhancement is done could be done through any of these three processes:

     i.  Subordination: It is a process of assigning the order of priority for the interest in the asset.
The debt is divided into different tranches, with the senior-most tranche having the first claim over the cash flow generated from the assets. Therefore, the higher the seniority of debt, the less risky it is.

    ii.  Over-collateralization: It is a process of posting more collaterals than it is needed to secure the debt finance.

   iii.  Excess Spread: It is the excess interest cash flow, then it is paid to the investors. For example, if there is an interest cash flow at the rate of 8%, of which only 4% is paid to the bondholders right now; the remaining 4% of the debt would be transferred to the reserve, and serve as a protection against losses.
The amount in the reserve account can also be used in repayment of the principal portion of the debt.

d.  The external credit enhancement comes in the form of third-party guarantees like a corporate guarantee, letter of credit, and bond insurance.
The disadvantage of this mechanism is that it is based on the credit risk of the third-party guarantor. If the third-party guarantor feels downgraded then the issue would also be subject to downgrade, even if the structure is giving an expected performance. Thus, the investor is placed on the event risk, because the downgrading of the third-party guarantor may result in a downgrading of asset-backed securities.

2.10.     Covenants

a.  A covenant can be defined as the agreed terms and conditions between a borrower and a lender. It is a contractual provision in a bond indenture that allows and limits a borrower from taking certain actions.

b.  Two types of covenants are seen in a lending agreement, affirmative covenant and negative covenants.

c.  The affirmative covenants provide for the promise of the borrower to meet certain obligations like maintaining a current line of business, paying interest, principal, taxes, etc.

d.  The negative covenants, on the other hand, provide for the restriction to the borrower from taking certain actions. These covenants are constraining and slightly costly, but should not be too constraining to affect the efficiency of the company. The limitations of the company may be:

     i.  with respect to the limitation to debt, such as maximum debt-equity ratio the company can have, or the minimum interest coverage ratio;

    ii.  negative pledges, such as company cannot issue any debt senior to that particular issue;

   iii.  restrictions on prior claims (for unsecured bonds), wherein the company cannot use the unsecured assets for future collaterals;

   iv.  restriction on distribution to the shareholders, such as dividends and share buybacks allowed only out of earnings above certain percentage;

    v.  restrictions on investments of the company, such as restricting the investments into going concern businesses only; and

   vi.  restriction to mergers and acquisitions, etc.