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INVESTMENT MANAGEMENT 324Mr. Terblanche
Luschke Labuschagne
25100572
Notes
Chapter 1: Fixed-Income Securities: Defining element.
Why should we care to learn about fixed income securities?
• A fixed-income security is an investment that allows governments, companies and other
types of issuers to borrow money from investors.
• Any borrowing of money is debt. The promised payments on fixed-income securities are
contractual obligations of the issuer to the investor.
• Critical role in the global economy
• Companies and governments raise capital in the debt market to fund operations; buy
equipment; build factories, roads, bridges, airports and hospitals.
• Practical way how people with money can grow their money and people without can
obtain money.
• The debt capital market facilitates economic growth by channeling savings from
investors to issuers into productive investments.
• Fixed income securities form the base rate for almost all valuations of financial
instruments.
What is a fixed income security?
• Contractual agreement between the issuer (borrower) and the bondholder/investor
(lender) that specifies the issuer’s obligation to pay: (not like equity where the issuer
can choose if they pay dividends)
- Capital (par value)
- Interest/ coupon (coupon rate x par value)
- Payment dates
,Overview of a fixed income security
• A bond is a contractual agreement between the issuer and the bondholders. There are
three important elements that an investor needs to know about when investing in a bond:
o The bond’s features, including the issuer, maturity, par value, coupon rate and
frequency, and currency denomination. These features determine the bond’s
scheduled cash flows and, therefore, are key determinants of the investor’s
expected and actual returns.
o The legal, regulatory, and tax considerations that apply to the contractual
agreements between the issuer and the bondholders.
o Any options that may affect the bond’s scheduled cash flows.
• Issuer
o Entity that borrows money
o Supernational organization
o Sovereign governments
o Non-sovereign government (municipalities)
o Quasi-government (SOE)
o Banks
o Corporates
o Companies
o Special legal entities.
▪ Bond markets are classified into sectors based on the issuer’s
creditworthiness as judged by credit-rating agencies. The promised
payments of investment-grade bonds are perceived as less risky than
non-investment grade bonds because of probability and liquidity
consideration.
• Par value
o Principal value that is equal to the amount initially borrowed.
o The principal amount, principal value or the principal of a bond is the amount that
the issuer agrees to repay the bondholders on the maturity date.
o This amount is also referred to as the par value, par, face value, nominal value,
redemption value, or maturity value.
o If the bond’s price is below its par value, then the bond is trading at a discount.
o If the bond’s price is above its par value, the bond is trading at a premium.
• Maturity date
o Date when the issuer is obligated to redeem/repay all outstanding principal.
o The maturity date of a bond refers to the date when the issuer is obligated to
redeem the bond by paying the outstanding principal amount.
• Tenor
o The remaining time until the bond’s maturity date (term to maturity)
• Coupon rate and Frequency
o Interest the issuer agrees to pay each year.
o Coupon=coupon rate x par value
o Frequency of coupon payments (annual, semi-annual, quarterly, monthly)
o The coupon rate or the nominal rate of the bond is the interest rate that the issuer
agrees to pay each year until the maturity date. The annual amount of interest
payments made is called the coupon.
, o A bond’s coupon is determined by multiplying its coupon rate by its par value.
o A plain vanilla bond or conventional bond pays a fixed rate of interest.
o Floating-rate notes or floaters pay a floating rate of interest. The coupon rate
includes two components: reference rate + a spread.
▪ The spread, also called a margin, is typically constant and expressed in
basis points. A basis point is equal to 0.01% (there are 100 basis points in
1%)
▪ The higher the issuer’s credit quality the lower the spread. As the
reference rate changes, the coupon rate and coupon payments change
accordingly.
o All bonds, whether they pay a fixed or floating rate of interest, make periodic
coupon payments except for zero-coupon bonds.
o Zero-coupon bonds do not pay interest and are issued at a discount to par and
redeem at par.
• Company ABC has a three-year, 7% bond that pays coupons semi-annually. Show the
cashflow profile of Company ABC’s bond.
1. Issuers
• Supernational organization
• Sovereign governments
• Non-sovereign government (municipalities)
• Quasi-government (SOE)
• Banks
• Corporates
2. Currency
• If the currency that the bond is issued in is not liquid or freely traded, or if the currency is
very volatile relative to major currencies, investments in that currency will not appeal to
many investors.
• For this reason, borrowers in developing countries often elect to issue in bonds other
than their local currency because doing so makes it easier to place the bond with
international investors.
• Issuers may also choose to issue in a foreign currency if they are expecting cash flows
in the foreign currency because the interest payments and the principal repayments can
act as a natural hedge, reducing currency risk.
• Dual-currency bonds make coupons in one currency and pay the par value at maturity in
another currency.
, • Currency option bonds can be viewed as a combination of a single-currency bond + a
foreign currency option. They give bondholders the right to choose the currency in which
they want to receive interest payments and principal repayments.
• Local currency
• Foreign currency
o Euro bond: is an international bond that is demonstrated in a currency not native
to the country where it is issued. They are also called external bonds and do not
refer to the euro currency. They are usually categorized according to the
currency in which they are issued: eurodollar, euroyen.
• Dual currency: pays coupon in one currency and principal in another.
• Currency option bonds: bondholders the right to choose the currency in which they want
to receive coupon and principal payments.
3. Term
• Term ˂ 1 year: Money market
o Fixed-income securities with an original maturity of one year or less. E.g.,
commercial paper and certificates of deposit.
• Term ˃ 1 year: Capital markets
o Fixed-income securities with an original maturity of more than one year.
• Perpetual bonds: (rare, although popular as a preference share) – do not have a
maturity date.
4. Coupon type
• Fixed rate bonds
• Index linked bonds: An index-linked bond has its coupon payments and/or principal
repayment linked to a specified index.
o Inflation linked bonds: protect investors from inflation by linking it to an index like
CPI.
• Floating rate notes: (FRN) reference rate (JIBAR, LIBOR, EURIBOR) plus a spread
quoted in basis points (bps): 100 bps= 0.01%
o Floating-rate notes do not have a fixed coupon; instead, their coupon rate is
linked to an external reference rate, such as Euribor.
• A deferred coupon bond, sometimes called a split coupon bond, pays no coupons for its
first few years but then pays a higher coupon than it otherwise normally would for the
remainder of its life.
5. Credit rating
• Distinction between investment grade debt and non-investment grade debt is the credit
quality.
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