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 in 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.
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)
- 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).
Bonds are also broken up into two types of categories based on credit risk: investment-grade and non-investment-grade (high-yield or speculative bonds). Investment-grade bonds are those rated above BBB- or Baa and have relatively low risk of default. Non-investment-grade bonds are considered low quality to reflect a relatively higher probability of default.
Maturity is the date when the issuer is obligated to redeem the bonds, while tenor refers to the amount of time left to maturity. Tenor is important as it indicates the length of time over 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, e.g., 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 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 a premium.
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 they can be floating and the frequency of the payment 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 bond’s price.
- Yield to maturity is the internal rate of return (IRR) that equates the present value (PV) of a bond’s expected cash flows with its price.
Zero-coupon bonds do not pay interest but are issued at a discount to par value and then redeemed at par.
Bonds can be issued in any currency. An international bond issued that is denominated in a currency not native to the country where 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.
What type of issuer would fall under the sovereign government category?
A. New York City
B. The State of California
The correct answer is C.
Sovereign governments are countries like Brazil or China while New York City and the State of California would fall into the non-sovereign government category.
Reading 42 LOS 42a:
Describe basic features of a fixed-income security