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P1.T3. Financial Markets & Products

Fabozzi, The Handbook of Fixed Income Securities

Bionic Turtle FRM Study Notes

By David Harper, CFA FRM CIPM

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Fabozzi, Chapter 12: Corporate Bonds

DESCRIBE A BOND INDENTURE AND EXPLAIN THE ROLE OF THE CORPORATE TRUSTEE ............. 3
EXPLAIN A BOND’S MATURITY DATE AND HOW IT IMPACTS BOND RETIREMENTS ........................ 4
DESCRIBE THE MAIN TYPES OF INTEREST PAYMENT CLASSIFICATIONS .................................... 4
DESCRIBE ZERO-COUPON BONDS AND EXPLAIN THE RELATIONSHIP BETWEEN ORIGINAL-ISSUE
DISCOUNT AND REINVESTMENT RISK. .................................................................................... 4
DESCRIBE THE VARIOUS SECURITY TYPES RELEVANT FOR CORPORATE BONDS: ...................... 5
DESCRIBE THE MECHANISMS BY WHICH CORPORATE BONDS CAN BE RETIRED BEFORE
MATURITY. .......................................................................................................................... 7
DESCRIBE, AND DIFFERENTIATE BETWEEN CREDIT DEFAULT RISK AND CREDIT-SPREAD RISK .... 8
DESCRIBE EVENT RISK AND WHAT MAY CAUSE IT IN CORPORATE BONDS ................................. 9
DEFINE HIGH-YIELD BONDS, AND DESCRIBE TYPES OF HIGH-YIELD BOND ISSUERS AND SOME OF
THE PAYMENT FEATURES UNIQUE TO HIGH YIELD BONDS. ....................................................... 9
DEFINE AND DIFFERENTIATE BETWEEN AN ISSUER DEFAULT RATE AND A DOLLAR DEFAULT RATE
........................................................................................................................................ 10
DEFINE RECOVERY RATES AND DESCRIBE THE RELATIONSHIP BETWEEN RECOVERY RATES AND
SENIORITY ........................................................................................................................ 10
CHAPTER SUMMARY ......................................................................................................... 11
QUESTIONS & ANSWERS: .................................................................................................. 12

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Fabozzi, Chapter 12: Corporate Bonds

Describe a bond indenture and explain the role of the corporate trustee in a bond
indenture.

Explain a bond’s maturity date and how it impacts bond retirements.

Describe the main types of interest payment classifications.

Describe zero-coupon bonds and explain the relationship between original-issue

discount and reinvestment risk.

Describe the various security types relevant for corporate bonds, including:
 Mortgage bonds
 Collateral trust bonds
 Equipment trust certificates
 Debenture bonds (including subordinated and convertible debentures)
 Guaranteed bonds

Describe the mechanisms by which corporate bonds can be retired before maturity.

Describe, and differentiate between credit default risk and credit-spread risk.

Describe event risk and what may cause it in corporate bonds.

Define high‐yield bonds and describe types of high‐yield bond issuers and some of
the payment features unique to high yield bonds.

Define and differentiate between an issuer default rate and a dollar default rate.

Define recovery rates and describe the relationship between recovery rates and
seniority.

Describe a bond indenture and explain the role of the corporate

trustee
Bond indenture
The contract that contains corporate bond issuer promises and investors’ rights. The
indenture is made out to corporate trustee, who represents bondholders’ interests.
Corporate trustee
The corporate trustee is a third party to the contract. The trustee acts in a fiduciary (legal)
capacity on behalf of the investors. Typically, the trustee is a bank or trust company with a
corporate trust department and officers who are experts in performing trustee functions.

The corporate trustee’s responsibilities include authenticating the bonds issued. Moreover,
acting on behalf of the bondholders, the trustee must ensure that the bond issuer is in
compliance with the covenants of the indenture at all times. These covenants are often many
and technical, and they must be watched during the entire period that a bond issue is
outstanding.

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Corporate Bonds
The five broad categories of corporate bonds sold in the United States based on the type of
issuer are:
1. Public utilities,
2. Transportations,
3. Industrials,
4. Banks and finance companies; and
5. International or Yankee issues.

Explain a bond’s maturity date and how it impacts bond retirements

Bond’s maturity: date on which the issuer’s obligation to satisfy the terms of the indenture is
fulfilled. Principal is repaid with any premium and accrued interest that may be due.
However, many issues can be retired prior to maturity.

Describe the main types of interest payment classifications

The 3 main interest payment classifications of domestically (US) issued corporate bonds are:

1. Straight-coupon bonds (sometimes also referred to as plain-vanilla bonds),

2. Zero-coupon bonds, and
3. Floating-rate, or variable-rate, bonds.

Describe zero-coupon bonds and explain the relationship between

original-issue discount and reinvestment risk.
Zero-coupon bonds
Zero-coupon bonds are bonds without coupons or interest rate payments. Zero-coupon
bonds pay only the principal portion at some future date.

Zero-coupon bonds are issued at discounts to par; the difference is the return to the
bondholder. Furthermore, zero-coupon rates play an important role in the construction of a
discount curve: it informs the rate of return for the date at which it matures since there is no
re-investment risk.
Original-issue-discount
The difference between the face amount and the offering price when first issued is called the
original-issue discount (OID). The rate of return depends on the amount of the discount and
the period over which it accrues.

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Zero reinvestment risk in a zero

A zero-coupon bond eliminates reinvestment risk (shifting all of the risk to interest rate risk;
e.g., duration) because there is no coupon to reinvest.
 A zero is considered beneficial in declining-interest-rate markets: the zero is
discounted less heavily AND we do not worry about having to reinvest any coupon
payments at a low rate of interest.
 When interest rates are rising, the opposite is true, we discount the zero more
heavily, but we do not receive any coupons that we can reinvest at the higher rate,
thus we are stuck with a low-rate bond.
Recall Tuckman: a bond investor faces a tradeoff between reinvestment risk (the
reinvestment of coupons) and interest rate risk. Consequently, investors tend to find zeros
less attractive in lower-interest-rate markets. Moreover, the lower the rates are, the more
likely it is that they will rise again, making a zero-coupon investment worth less in the eyes of
potential holders.
Treatment of zeroes in bankruptcy
In bankruptcy, zero-coupon bond creditor claim original offering price plus accrued and
unpaid interest, but not the principal amount of $1,000.

Zero-coupon bonds are sold at (deep) discounts: liability of the issuer at maturity may be
substantial and there are no sinking funds on most of these issues. The potentially large
balloon repayment creates a cause for concern among investors. Thus it is most important to
invest in higher-quality issues so as to reduce the risk of a potential problem1.

Describe the various security types relevant for corporate bonds:

Mortgage bonds
A mortgage bond grants bondholders a first-mortgage lien on substantially all its properties.

The issuer is thus able to borrow at a lower interest rate than would be the case with
unsecured debt. A lien is a legal right to sell mortgaged property to satisfy unpaid obligations
to bondholders. Foreclosure and sale of mortgaged property are not typical. In default, there
is typically a financial reorganization and provisions are made for settlement of the debt to
bondholders. However, mortgage lien gives bondholders a very strong bargaining position
relative to other creditors in determining the terms of reorganization.
Collateral trust bonds
When companies cannot pledge fixed assets or other real property, they pledge securities of
other companies or Treasury’s instead. To satisfy the desire of bondholders for security, they
pledge stocks, notes, bonds, or whatever other kinds of obligations they own. If they are
holding companies, the other companies may be their subsidiaries. These assets are termed
collateral (or personal property), and bonds secured by such assets are collateral trust
bonds.

1This is not entirely true, as one would readily expect to be compensated for the higher risk in terms
of higher returns on the bond issue (a deeper discount at the time of issuance).

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Equipment trust certificates

Although railroads have issued the largest amount of equipment trust certificates, airlines
have also used this form of financing. The legal arrangement is one that vests legal title to
railway equipment in a trustee, which is better from the standpoint of investors than a first-
mortgage lien on property. A railway company orders some cars and locomotives from a
manufacturer. When the job is finished, the manufacturer transfers the legal title of the
equipment to a trustee. The trustee leases it to the railroad that ordered it and at the same
time sells equipment trust certificates (ETCs) in an amount equal to a large percentage of
the purchase price, normally 80%. Money from sale of certificates is paid to the
manufacturer.
Debenture bonds (including subordinated and convertible debentures)
Unsecured bonds are called debentures. With the exception of the utilities and structured
products, nearly all other corporate bonds issued are unsecured. Debenture bondholders do
have the claim of general creditors on all assets of the issuer not pledged specifically to
secure other debt. Subordinated debenture bonds: issue ranks after secured debt, after
debenture bonds, and often after some general creditors in its claim on assets and earnings.
Owners of this bond “stand last in line”. Because subordinated debentures are weaker in
their claim on assets, issuers must offer a higher rate of interest, unless they also offer some
special inducement to buy the bonds. The inducement may be in the form of an option to
convert bonds into stock of the issuer at the discretion of bondholders, subject to certain
restrictions.

This conversion privilege also may be included in the provisions of debentures that are not
subordinated. The bonds may be convertible into the common stock of a corporation other
than that of the issuer. Such issues are called exchangeable bonds. There are also issues
indexed to a commodity’s price or its cash equivalent at the time of maturity or redemption.
Guaranteed bonds
Guaranteed bonds: a corporation may guarantee the bonds of another corporation.
The guarantee, however, does not mean that these obligations are free of default risk. The
safety of a guaranteed bond depends on the financial capability of the guarantor to satisfy
the terms of the guarantee, as well as the financial capability of the issuer. The terms of the
guarantee may call for the guarantor to guarantee the payment of interest and/or principal
repayment

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Describe the mechanisms by which corporate bonds can be retired

before maturity.
Retiring bonds before maturity
Frequently, bonds are retired early, before maturity. There are several mechanisms by which
a corporation may go about retiring their debt. Included below are some of the most
important and commonly used retirement mechanisms. The mechanisms with a star (*) are
particularly important.
 Call and refunding provisions*
 Fixed-price call provision
 Make-whole call provision
 Sinking-fund provision*
 Maintenance and replacement funds*
 Redemption through sale of assets
 Tender offers*
Call provision
Corporate bonds with a call provision given contain an embedded option that gives the
issuer the right to buy the bonds back at a fixed price prior to maturity, either in whole or in
part. The ability to retire debt before its scheduled maturity date is a valuable option for
which bondholders will demand compensation ex-ante.

Ceteris paribus, bondholders will pay a lower price for a callable bond than an otherwise
identical option-free (i.e., straight) bond. The difference between the price of an option-
free bond and the callable bond is the value of the embedded call option.
Fixed price
Bond issuer has the option to buy back some or all of the bond issue prior to maturity at a
fixed price (“call price”).

Call prices generally start at a substantial premium over par and decline toward par over
time; in the final years of a bond’s life, the call price is usually par.
Make-whole
Call price is calculated as the present value of the bond’s remaining cash flows subject to a
floor price equal to par value. The discount rate used to determine the present value is the
yield on a comparable maturity.

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Sinking‐fund provisions
Money applied periodically to redemption of bonds before maturity.

Two advantages from the bondholder’s perspective:

 Default risk is reduced
 If bond prices decline as a result of an increase in interest rates, the issuer or its
fiscal agent may provide price support because it must enter the market on the buy
side in order to satisfy the sinking-fund requirement.

Disadvantage is the bonds may be called at the special sinking-fund call price at a time
when interest rates are lower than rates prevailing at time of issuance.
Maintenance and replacement funds
Maintenance and replacement fund (M&R) provisions first appeared in bond indentures of
electric utilities subject to regulation by the Securities and Exchange Commission (SEC)
under the Public Holding Company Act of 1940. It remained in the indentures even when
most of the utilities were no longer subject to regulation under the act. The original
motivation for their inclusion is straightforward. Property is subject to economic depreciation,
and the replacement fund ostensibly helps to maintain the integrity of the property securing
the bonds. An M&R differs from a sinking fund in that the M&R only helps to maintain the
value of the security backing the debt, whereas a sinking fund is designed to improve the
security backing the debt. Although it is more complex, it is similar in spirit to a provision in a
home mortgage requiring the homeowner to maintain the home in good repair.
Tender offers
At any time a firm may execute a tender offer and announce its desire to buy back specified
debt issues. Firms employ tender offers to eliminate restrictive covenants or to refund debt.
Usually the tender offer is for “any and all” of the targeted issue, but it also can be for a fixed
dollar amount that is less than the outstanding face value. An offering circular is sent to the
bondholders of record stating the price the firm is willing to pay and the window of time
during which bondholders can sell their bonds back to the firm.

Describe, and differentiate between credit default risk and credit-

spread risk
Credit default risk
Any bond investment carries with it the uncertainty as to whether the issuer will make timely
payments of interest and principal as prescribed by the bond’s indenture.
Credit default risk is the risk that a bond issuer will be unable to meet its financial obligations.
Credit-spread risk
The credit spread is the difference between a corporate bond’s yield and the yield on a
comparable-maturity benchmark Treasury security.

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What explains the difference?

The difference in yields is due primarily to the corporate bond’s exposure to credit risk, but
not exclusively. The risk profile of corporate bonds differs from Treasuries on other
dimensions; corporate bonds are less liquid and may have embedded options. Credit-spread
risk is the risk of financial loss resulting from changes in the level of credit spreads used in
the marking-to-market of a fixed income product. Credit spreads driven by: Macroeconomic
forces include such things as the level and slope of the Treasury yield curve, the business
cycle, and consumer confidence. Issue-specific factors include the corporation’s financial
position and the future prospects of the firm and its industry.

Describe event risk and what may cause it in corporate bonds

Event risk is the risk that a transaction (or corporate event) will devalue bondholder’s
position. Restructurings, recapitalizations, mergers, acquisition, leveraged buyouts, and
share repurchase often cause substantial changes in a corporation’s capital structure,
greatly increased leverage and decreased equity. Event risk has caused some companies
to include other special debt- retirement features in their indentures. An example is the
maintenance of net worth clause included in the indentures of some lower-rated bond
issues.

Define high-yield bonds, and describe types of high-yield bond

issuers and some of the payment features unique to high yield
bonds.
High-yield bonds are those rated below investment grade by the ratings agencies, these
issues are also known as junk bonds.
Types of high-yield bond issuers
 Original Issuers
 Fallen Angels
 Restructurings and Leverage Buyouts
Payment features peculiar to high-yield bonds (deferred-coupon structures)
 Deferred-interest bonds,
 Step-up bonds, and
 Payment-in-kind bonds.

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Define and differentiate between an issuer default rate and a dollar

default rate
Issuer default rate
Number of issuers that default divided by total number of issuers. Gives no recognition to
amount defaulted nor amount of issuance.
Dollar default rate
Par value of all defaulted bonds divided by total par value of bonds outstanding during the
year (Altman uses this method).

Average annual default rate

Cumulative $ value of all defaulted bonds ÷ Cumulative $ value of all issuance by
weighted average number of years outstanding

Cumulate default rate

Cumulative $ value of all defaulted bonds ÷ Cumulative $ value of all issuance

Define recovery rates and describe the relationship between

recovery rates and seniority
Measuring the amount recovered is non-trivial. The final distribution to claimants may consist
of cash and securities. However, it can often be difficult to track what was received and then
additionally, determine the present value of any noncash payments received. Moody’s use
the trading price at the time of default as a proxy for the amount recovered. The recovery
rate is thus the trading price at that time divided by the par value. Moody’s found that the
recovery rate was 38% for all bonds. While default rates are the same regardless of the level
of seniority, recovery rates differ. The study found that the higher the level of seniority, the
greater is the recovery rate.

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Chapter Summary
The bond’s indenture is the contract that contains corporate bond issuer promises and
investors’ rights.

The corporate trustee is a third party to the contract and acts in a fiduciary (legal) capacity
for, or on behalf of, investors. It is the role of the trustee to certify that the bond issuer is in
compliance with the covenants set forth in the bond’s indenture.

The maturity date of the bond is the date on which the issuer’s obligation to satisfy the terms
of the indenture are fulfilled. Moreover, the principal must be repaid along with any premium
and accrued interest.

The 3 main interest payment classifications of domestically (US) issued corporate bonds are:

1. Straight-coupon bonds (sometimes also referred to as plain-vanilla bonds),

2. Zero-coupon bonds, and
3. Floating-rate, or variable-rate, bonds.

Zero-coupon bonds are bonds without coupons or interest rate payments. They are issued at
discounts to par; the difference is the return to the bondholder. Furthermore, zero-coupon
rates play an important role in the construction of a discount curve: it informs the rate of
return for the date at which it matures since there is no re-investment risk. The difference
between the face amount and the offering price when first issued is called the original-issue
discount (OID).

The security types relevant for corporate bonds include mortgage bonds, collateral trust
bonds, equipment trust certificates, debenture bonds, including subordinated and convertible
bonds, and guaranteed bonds.

Firms often retire their bonds before maturity. The mechanisms by which they do this
includes: call and refunding provisions, fixed-price call provision, make-whole call
provision, sinking-fund provision, maintenance and replacement funds, redemption
through sale of assets and tender offers.

Credit default risk is the risk that a bond issuer will be unable to meet its financial obligations.
The credit spread is the difference between a corporate bond’s yield and the yield on a
comparable-maturity benchmark Treasury security. Credit-spread risk is the risk of financial
loss resulting from changes in the level of credit spreads used in the MTM of a fixed income
product.

The issuer default rate is the number of issuers that default divided by total number of
issuers. The dollar default rate is the par value of all defaulted bonds divided by total par
value of bonds outstanding during the year.

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Questions & Answers:

1. Each of the following is true about the corporate trustee in a corporate bond issuance
EXCEPT:
a) The trustee is paid by bondholders
b) The trustee acts in a fiduciary capacity for investors who own the bond issue
c) The trustee must, at the time of issue, authenticate the bonds issued (i.e., keep track
of all the bonds sold) and make sure that they do not exceed the principal amount
authorized by the indenture
d) If a corporate issuer fails to pay interest or principal, the trustee may declare a default
and take such action as may be necessary to protect the rights of bondholders

2. What is an advantage of a fixed-spread tender offer over a fixed-price tender offer?

a) No significant advantage
b) It is easier for bondholders to assess the value of a fixed-spread tender offer
c) Significantly less counterparty credit risk to bondholders in a fixed-spread tender offer
d) Fixed-spread tender offers eliminate the exposure to interest-rate risk for both
bondholders and the issuer during the tender offer window

3. Consider which of the following statements are true about bond reinvestment risk and
bond duration (interest rate risk):
I. Less bond reinvestment risk implies greater interest rate risk (duration), ceteris
paribus
II. Due to reinvestment risk, the yield-to-maturity on a bond is unlikely to equal the
bond’s realized return
III. Reinvestment risk is eliminated in a zero-coupon bond

a) I. Only
b) II and I.
c) II and III.
d) All three

4. Each of the following is an example of a high-yield bond issuer EXCEPT:

a) Issuer with a credit rating of “BBB-”
b) Original issuer
c) Fallen angel
d) Leveraged buyout

5. Each of the following is true about a bond indenture EXCEPT:

a) A bond indenture is a legal contract that details the obligations (promises) of the
bond issuer and the rights of investors
b) A bond indenture is a corporate bond that is unsecured by collateral
c) Bond indenture terms are a compromise between issuer (wants to pay lowest rate;
prefers fewer covenants) and bond holders (want to earn highest possible rate; prefer
more covenants)
d) The Trust Indenture Act requires a corporate trustee for all corporate bond offerings
in the amount of more than $5 million sold in interstate commerce

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Answers
1. A. “It must be emphasized that the trustee is paid by the debt issuer and can only
do what the indenture provides.”

In regard to (B), (C), and (D), each is true.

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2. D. Fixed-spread tender offers eliminate the exposure to interest-rate risk for both
bondholders and the issuer during the tender offer window

Fabozzi: “Recently, tender offers have been executed using a fixed spread as opposed to a
fixed price. In a fixed-spread tender offer, the tender offer price is equal to the present value
of the bond’s remaining cash flows either to maturity or the next call date if the bond is
callable. The present-value calculation occurs immediately after the tender offer expires. The
discount rate used in the calculation is equal to the yield-to-maturity on a comparable-
maturity Treasury or the associated CMT yield plus the specified fixed spread. Fixed-spread
tender offers eliminate the exposure to interest-rate risk for both bondholders and the firm
during the tender offer window.”

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3. D. All three

Fabozzi: “One important risk is eliminated in a zero-coupon investment—the reinvestment

risk. Because there is no coupon to rein-vest, there isn’t any reinvestment risk. Of course,
although this is beneficial in declining-interest-rate markets, the reverse is true when interest
rates are rising. The investor will not be able to reinvest an income stream at rising
reinvestment rates. Investors tend to find zeros less attractive in lower-interest-rate markets
because compounding is not as meaningful as when rates are higher. Also, the lower the
rates are, the more likely it is that they will rise again, making a zero-coupon investment
worth less in the eyes of potential holders.”

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4. A. “BBB-” is the lowest S&P Investment Grade rating; BB+ is the highest
Speculative Grade (aka, high-yield, junk)

In regard to (A), (B), and (C), each are an example, given by Fabozzi, of high-yield bond
issuers.

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5. B. A debenture (not an indenture!) is an unsecured corporate bond.

In regard to (A), (C) and (D), each is true.

Please note in particular, with regard to (C) “The terms of bond issues set forth in bond
indentures are always a compromise between the interests of the bond issuer and those of
investors who buy bonds. The issuer always wants to pay the lowest possible rate of interest
and wants its actions bound as little as possible with legal covenants. Bondholders want the
highest possible interest rate, the best security, and a variety of covenants to restrict the
issuer in one way or another. As we discuss the provisions of bond indentures, keep this
opposition of interests in mind and see how compromises are worked out in practice.”

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