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Basic Features of a Fixed-income Security

Basic Features of a Fixed-income Security

A fixed-income security is a financial obligation that pays a fixed amount of interest—in the form of coupon payments—to investors at specified points in the future. The payments are anchored on contractual guidelines and must be made. This is, in fact, the main distinguishing feature between fixed income securities and stocks because payment of dividends is at the discretion of directors. Shareholders have no right to compel directors to pay dividends.

In the field of finance, the terms “fixed-income securities,” “debt securities,” and “bonds” are often used interchangeably.

Basic Features

Issuer

Bonds can be issued by a host of institutions, including:

  • supranational organizations (i.e., European Union, World Trade Organization, etc.);
  • sovereign governments (Countries);
  • non-sovereign governments (States, Provinces, and Municipalities);
  • quasi-government entities, (i.e.: government-sponsored enterprises, agency-related non-profit organizations);
  • companies (i.e., Apple); or
  • special legal entities.

The bond market is generally broken up into three sectors:

  • government bonds;
  • corporate bonds; and
  • structured finance (a sector of finance that was created to help transfer risk using complex legal and corporate entities).

Credit Risk

Bonds are also broken into two categories based on credit risk: investment-grade and non-investment-grade (high-yield or speculative bonds). Investment-grade bonds are those that are rated above BBB- or Baa3 and have a relatively low risk of default. Conversely, non-investment-grade bonds are considered low quality to reflect a relatively higher probability of default.

Maturity

Maturity refers to the date when the issuer is obligated to redeem the bonds, while tenor is the amount of time left before maturity. Tenor is important as it indicates the time within which the investor expects to receive payments and the amount of time left before the bond is redeemed. Almost all bonds have a maturity of 30 years or less. Those with a maturity of less than a year are called money market instruments. They include treasury bills, commercial paper, and bankers’ acceptances. Bonds with a maturity of more than a year are called capital market instruments, e.g., debentures.

Par Value

Par value is the amount that will be repaid at maturity. It is also called the principal or principal value. In this regard, it is important to note the following:

  • if the market price is greater than the par value, the bond is trading at a premium;
  • if the market price is less than the par value, the bond is trading at a discount; and
  • if the market price is equal to the par value, the bond is trading at par.

Coupon Rate and Frequency

The coupon rate is the interest rate that the bondholder will receive. Interest rates can either be fixed over the life of the bond or floating, and the payment frequency can differ depending on the issuer. Annual, semi-annual, and monthly payments are common.

Plain vanilla bonds pay a fixed coupon rate, while floating-rate bonds pay a floating rate of interest. The floating rate is tied to a reference rate such as LIBOR (London Interbank Offered Rate).

The yield is different from the coupon rate and can be measured in two ways: current yield or yield to maturity.

  • Current yield is simply the annual coupon payment divided by the price of the bond.
  • Yield to maturity is the internal rate of return (IRR) that equates the present value (PV) of a bond’s expected cash flows to its price.

Zero-coupon bonds do not pay interest but are issued at a discount to par value and then redeemed at par.

Currency Denomination

Bonds can be issued in any currency. An international bond denominated in a currency that does not belong to the country to which it is issued is called a Eurobond. However, it is important to note that Eurobonds are not always issued in Euros.

Dual currency bonds pay interest in one currency, say, the US dollar, and principal in another currency, say, the Euro.

Question

What type of issuer would fall under the sovereign government category?

  1. Ireland.
  2. New York City.
  3. The State of California.

Solution

The correct answer is A.

Sovereign governments are countries such as Brazil or China. New York City and the State of California fall under the non-sovereign government category.

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