«CHAPTER 9 DEBT SECURITIES by Lee M. Dunham, PhD, CFA, and Vijay Singal, PhD, CFA LEARNING OUTCOMES After completing this chapter, you should be ...»
by Lee M. Dunham, PhD, CFA, and Vijay Singal, PhD, CFA
After completing this chapter, you should be able to do the following:
a Identify issuers of debt securities;
b Describe features of debt securities;
c Describe seniority ranking of debt securities when default occurs;
d Describe types of bonds;
e Describe bonds with embedded provisions;
Describe securitisation and asset-backed securities;
f g Define current yield;
h Describe the discounted cash flow approach to valuing debt securities;
Describe a bond’s yield to maturity;
i Explain the relationship between a bond’s price and its yield to maturity;
j Define yield curve;
k Explain risks of investing in debt securities;
l m Define a credit spread.
Features of Debt Securities 3
INTRODUCTIONThe Canadian entrepreneur in the Investment Industry: A Top-Down View chapter initially financed her company with her own money and that of family and friends. But over time, the company needed more money to continue to grow. The company could get a loan from a bank or it could turn to investors, other than family and friends, to provide additional money.
Companies and governments raise external capital to finance their operations. Both companies and governments may raise capital by borrowing funds. As the following illustration shows, in exchange for the use of the borrowed money, the borrowing company or government promises to pay interest and to repay the borrowed money in the future.
If people invest in a Invest money company and earn interest by buying bonds, they are the lenders and the Receive interest company is the borrower.
The illustration has been simplified to show a company borrowing from individuals.
In reality, the borrower may be a company or a government, and the investors may be individuals, companies, or governments. Companies may also raise capital by issuing (selling) equity securities, as discussed in the Equity Securities chapter.
As discussed in the Quantitative Concepts chapter, from the borrower’s perspective, paying interest is the cost of having access to money that the borrower would not otherwise have. For the lender, receiving interest is compensation for opportunity cost and risk. The lender’s opportunity cost is the cost of not having the loaned cash to invest, spend, or hold—that is, the cost of giving up other opportunities to use the cash. The various risks associated with lending affect the interest rates demanded by lenders.
FEATURES OF DEBT SECURITIESWhen a large company or government borrows money, it usually does so through financial markets. The company or government issues securities that are generically called debt securities, or bonds. Debt securities represent a contractual obligation of the issuer to the holder of the debt security. Companies and governments may have more than one issue of debt securities (bonds). Each of these bond issues has different features attached to it, which affect the bond’s expected return, risk, and value.
Copyright © 2014 CFA Institute 4 Chapter 9 ■ Debt Securities A bond is governed by a legal contract between the bond issuer and the bondholders.
The legal contract is sometimes referred to as the bond indenture or offering circular.
In the event that the issuer does not meet the contractual obligations and make the promised payments, the bondholders typically have legal recourse. The legal contract describes the key features of the bond.
A typical bond includes the following three features: par value (also called principal value or face value), coupon rate, and maturity date. These features define the promised cash flows of the bond and the timing of these flows.
Par value. The par (principal) value is the amount that will be paid by the issuer to the bondholders at maturity to retire the bonds.
Coupon rate. The coupon rate is the promised interest rate on the bond.
Coupon payments are linked to the bond’s par value and the bond’s coupon rate. The annual interest owed to bondholders is calculated by multiplying the bond’s coupon rate by its par value. For example, if a bond’s coupon rate is 6% and its par value is £100, the coupon payment will be £6. Many bonds, such as government bonds issued by the US or UK governments, make coupon payments on a semiannual basis.
Therefore, the amount of annual interest is halved and paid as two coupon payments, payable every six months. Taking the previous example, bondholders would receive two coupon payments of £3. Coupon payments may also be paid annually, quarterly, or monthly. The bond contract will specify the frequency and timing of payments.
Maturity date. Debt securities are issued over a wide range of maturities, from as short as one day to as long as 100 years or more. In fact, some bonds are perpetual, with no pre-specified maturity date at all. But it is rare for new bond issues to have a maturity of longer than 30 years. The life of the bond ends on its maturity date, assuming that all promised payments have been made.
Example 1 describes the interaction of the three main features of a bond and shows the payments that the bond issuer will make to a bondholder over the life of the bond.
A bond has a par value of £100, a coupon rate of 6% (paid annually), and a maturity date of three years. These characteristics mean the investor receives a coupon payment of £6 for each of the three years it is held. At the end of the three years, the investor receives back the £100 par value of the bond.
Other features. Other features may be included in the bond contract to make it more attractive to bondholders. For instance, to protect bondholders’ interests, it is common for the bond contract to contain covenants, which are legal agreements that describe actions the issuer must perform or is prohibited from performing. A bond may also give the bondholder the right, but not the obligation, to take certain actions.
The bond contract gives bondholders the right to take legal action if the issuer fails to make the promised payments or fails to satisfy other terms specified in the contract. If the bond issuer fails to make the promised payments, which is referred to as default, the debtholders typically have legal recourse to recover the promised payments. In the event that the company is liquidated, assets are distributed following a priority of claims, or seniority ranking. This priority of claims can affect the amount that an investor receives upon liquidation.
The par value (principal) of a bond plus missed interest payments represents the maximum amount a bondholder is entitled to receive upon liquidation of a company, assuming there are sufficient assets to cover the claim. Because debt represents a contractual liability of the company, debtholders have a higher claim on a company’s
assets than equity holders. But not all debtholders have the same priority of claim:
borrowers often issue debt securities that differ with respect to seniority ranking. In general, bonds may be issued in the form of secured or unsecured debt securities.
Secured. When a borrower issues secured debt securities, it pledges certain specific assets as collateral to the bondholders. Collateral is generally a tangible asset, such as property, plant, or equipment, that the borrower pledges to the bondholders to secure the loan. In the event of default, the bondholders are legally entitled to take possession of the pledged assets. In essence, the collateral reduces the risk that bondholders will lose money in the event of default because the pledged assets can be sold to recover some or all of the bondholders’ claim (missed coupon payments and par value).
Unsecured. Unsecured debt securities are not backed by collateral. Consequently, bondholders will typically demand a higher coupon rate on unsecured debt securities than on secured debt securities. A bond contract may also specify that an unsecured bond has a lower priority in the event of default than other unsecured bonds. A lower priority unsecured bond is called subordinated debt. Subordinated debtholders receive payment only after higher-priority debt claims are paid in full. Subordinated debt may also be ranked according to priority, from senior to junior.
TYPES OF BONDSBonds, in general, can be classified by issuer type, by type of market they trade in, and by type of coupon rate.
Although the term “bond” may be used to describe any debt security, irrespective of its maturity, debt securities can also be referred to by different names based on time to maturity at issuance. Debt securities with maturities of one year or less may be referred to as bills. Debt securities with maturities from 1 to 10 years may be referred to as notes. Debt securities with maturities longer than 10 years are referred to as bonds.
Issuer. Bonds issued by companies are referred to as corporate bonds and bonds issued by central governments are sovereign or government bonds. Local and regional government bodies may also issue bonds.
In some cases, bonds issued by certain central governments carry particular names in the market. For example, bonds issued by the US government are referred to as Treasury securities or Treasuries, by the New Zealand government as Kiwi Bonds, by the UK government as gilts, by the German government as Bunds, and by the French government as OATs (obligations assimilables du Trésor).
8 Chapter 9 ■ Debt SecuritiesMarket. At issuance, investors buy bonds directly from an issuer in the primary market. The primary market is the market in which new securities are issued and sold to investors. The bondholders may later sell their bonds to other investors in the secondary market. In the secondary market, investors trade with other investors. When investors buy bonds in the secondary market, they are entitled to receive the bonds’ remaining promised payments, including coupon payments until maturity and principal at maturity.
Coupon rates. Bonds are often categorised by their coupon rates: fixed-rate bonds, floating-rate bonds, and zero-coupon bonds. These categories of bonds are described further in the following sections.
4.1 Fixed-Rate Bonds Fixed-rate bonds are the main type of debt securities issued by companies and governments. Because debt securities were historically issued with fixed coupon rates and paid fixed coupon payments, they may be referred to as fixed-income securities. A fixed-rate bond has a finite life that ends on the bond’s maturity date, offers a coupon rate that does not change over the life of the bond, and has a par value that does not change. If interest rates in the market change or the issuer’s creditworthiness changes over the life of the bond, the coupon the issuer is required to pay does not change.
Fixed-rate bonds pay fixed periodic coupon payments during the life of the bond and a final par value payment at maturity.
Example 2 describes how Walt Disney Corporation raised capital in August 2011 by using three different fixed-rate bond issues. Notice how the bond issues with longer times to maturity have higher coupon rates.
On 16 August 2011, the Walt Disney Corporation, a US company, raised $1.85 billion in capital with three debt issues. It issued $750 million in 5-year fixed-rate bonds offering a coupon rate of 1.35%, $750 million in 10-year fixed-rate bonds offering a coupon rate of 2.75%, and $350 million in 30-year fixed-rate bonds offering a coupon rate of 4.375%. Coupon payments are due semiannually (twice per year) on 16 February and 16 August. The following table summarises features of these issues. On the maturity date, each bondholder will receive $1,000 per bond plus the final semiannual coupon payment.
4.2 Floating-Rate Bonds Floating-rate bonds, sometimes referred to as variable-rate bonds or floaters, are essentially identical to fixed-rate bonds except that the coupon rate on floating-rate bonds changes over time. The coupon rate of a floating-rate bond is usually linked to a reference rate. The London Interbank Offered Rate (Libor) is a widely used reference rate.
The calculation of the floating rate reflects the reference rate and the riskiness (or creditworthiness) of the issuer at the time of issue. The floating rate is equal to the reference rate plus a percentage that depends on the borrower’s (issuer’s) creditworthiness and the bond’s features. The percentage paid above the reference rate is called the spread and usually remains constant over the life of the bond. In other words, for an existing issue, the spread used to calculate the coupon payment does not change to reflect any change in creditworthiness that occurs after issue. But the reference rate does change over time with changes in the level of interest rates in the economy.
Floating rate = Reference rate + Spread In bond markets, the practice is to refer to percentages in terms of basis points. One hundred basis points (or bps, pronounced bips) equal 1.0%, and one basis point is equal to 0.01%, or 0.0001. Therefore, rather than stating a floating rate as Libor plus 0.75%, the floating rate would be stated as Libor plus 75 bps. A floating-rate bond’s coupon rate will change, or reset, at each payment date, typically every quarter. Floating-rate coupon payments are paid in arrears—that is, at the end of the period on the basis of the level of the reference rate set at the beginning of the period. On a payment date, the coupon rate is set for the next period to reflect the current level of the reference rate plus the stated spread. This new coupon rate will determine the amount of the payment at the next payment date. Example 3 is a hypothetical example illustrating the effect of changes in a reference rate on coupon rates and coupon payments.
EXAMPLE 3. FLOATING-RATE BOND