Chapter OneOVERVIEW OF THE TYPES AND FEATURES OF FIXED INCOME SECURITIES
Frank J. Fabozzi, PH.D., CFA, CPA Professor of Finance EDHEC Business School
Michael G. Ferri, Ph.D. Professor of Finance George Mason University
Steven V. Mann, Ph.D. Professor of Finance The Moore School of Business University of South Carolina
This chapter will explore some of the most important features of bonds, preferred stock, and structured products and provide the reader with a taxonomy of terms and concepts that will be useful in the reading of the specialized chapters to follow.
Type of Issuer
One important characteristic of a bond is the nature of its issuer. Although non-U.S. governments and firms raise capital in U.S. financial markets, the three largest issuers of debt are domestic corporations, municipal governments, and the federal government and its agencies. Each class of issuer, however, features additional and significant differences.
Domestic corporations, for example, include regulated utilities as well as less regulated manufacturers. Furthermore, each firm may sell different kinds of bonds: Some debt may be publicly placed, whereas other bonds may be sold directly to one or only a few buyers (referred to as a private placement); some debt is collateralized by specific assets of the company, whereas other debt may be unsecured. Municipal debt is also varied: "General obligation" bonds (GOs) are backed by the full faith, credit, and taxing power of the governmental unit issuing them; "revenue bonds," on the other hand, have a safety, or creditworthiness, that depends on the vitality and success of the particular entity (such as toll roads, hospitals, or water systems) within the municipal government issuing the bond.
The U.S. Treasury has the most voracious appetite for debt, but the bond market often receives calls from its agencies. Federal government agencies include federally related institutions and government-sponsored enterprises (GSEs).
It is important for the investor to realize that, by law or practice or both, these different borrowers have developed different ways of raising debt capital over the years. As a result, the distinctions among the various types of issuers correspond closely to differences among bonds in yield, denomination, safety of principal, maturity, tax status, and such important provisions as the call privilege, put features, and sinking fund. As we discuss the key features of fixed income securities, we will point out how the characteristics of the bonds vary with the obligor or issuing authority. A more extensive discussion is provided in later chapters in this book that explain the various instruments.
A key feature of any bond is its term-to-maturity, the number of years during which the borrower has promised to meet the conditions of the debt (which are contained in the bond's indenture). A bond's term-to-maturity is the date on which the debt will cease and the borrower will redeem the issue by paying the face value, or principal. One indication of the importance of the maturity is that the code word or name for every bond contains its maturity (and coupon). Thus the title of the Anheuser Busch Company bond due, or maturing, in 2016 is given as "Anheuser Busch 85/8s of 2016." In practice, the words maturity, term, and term-to-maturity are used interchangeably to refer to the number of years remaining in the life of a bond. Technically, however, maturity denotes the date the bond will be redeemed, and either term or term-to-maturity denotes the remaining number of years until that date.
A bond's maturity is crucial for several reasons. First, maturity indicates the expected life of the instrument, or the number of periods during which the holder of the bond can expect to receive the coupon interest and the number of years before the principal will be paid. Second, the yield on a bond depends substantially on its maturity. More specifically, at any given point in time, the yield offered on a long-term bond may be greater than, less than, or equal to the yield offered on a short-term bond. As will be explained in Chapter 8, the effect of maturity on the yield depends on the shape of the yield-curve. Third, the volatility of a bond's price is closely associated with maturity: Changes in the market level of rates will wrest much larger changes in price from bonds of long maturity than from otherwise similar debt of shorter life. Finally, as explained in Chapter 2, there are other risks associated with the maturity of a bond.
When considering a bond's maturity, the investor should be aware of any provisions that modify, or permit the issuer to modify, the maturity of a bond. Although corporate bonds (referred to as "corporates") are typically term bonds (issues that have a single maturity), they often contain arrangements by which the issuing firm either can or must retire the debt early, in full or in part. Some corporates, for example, give the issuer a call privilege, which permits the issuing firm to redeem the bond before the scheduled maturity under certain conditions (these conditions are discussed below). Municipal bonds may have the same provision. The U.S. government no longer issues bonds that have a call privilege. The last callable bond was called in November 2009. Many industrials and some utilities have sinking-fund provisions, which mandate that the firm retire a substantial portion of the debt, according to a prearranged schedule, during its life and before the stated maturity. Municipal bonds may be serial bonds or, in essence, bundles of bonds with differing maturities. (Some corporates are of this type, too.)
Usually, the maturity of a corporate bond is between 1 and 30 years. This is not to say that there are not outliers. In fact, financially sound firms have begun to issue longer-term debt in order to lock in long-term attractive financing. For example, in the late 1990s, there were approximately 90 corporate bonds issued with maturities of 100 years.
Although classifying bonds as "short term," "intermediate term," and "long term" is not universally accepted, the following classification is typically used. Bonds with a maturity of 1 to 5 years are generally considered short term; bonds with a maturity between 5 and 12 years are viewed as intermediate term (and are often called notes). Long-term bonds are those with a maturity greater than 12 years.
Coupon and Principal
A bond's coupon is the periodic interest payment made to owners during the life of the bond. The coupon is always cited, along with maturity, in any quotation of a bond's price. Thus one might hear about the "IBM 6.5 due in 2028" or the "Campbell's Soup 8.875 due in 2021" in discussions of current bond trading. In these examples, the coupon cited is in fact the coupon rate, that is, the rate of interest that, when multiplied by the principal, par value, or face value of the bond, provides the dollar value of the coupon payment. Typically, but not universally, for bonds issued in the United States, the coupon payment is made in semiannual installments. An important exception is mortgage-backed and asset-backed securities that usually deliver monthly cash-flows. In contrast, for bonds issued in some European bond markets and all bonds issued in the Eurobond market, the coupon payment is made annually. Bonds may be bearer bonds or registered bonds. With bearer bonds, investors clip coupons and send them to the obligor for payment. In the case of registered issues, bond owners receive the payment automatically at the appropriate time. All new bond issues must be registered.
Zero-coupon bonds have been issued by corporations and municipalities since the early 1980s. For example, Barclay's Bank PLC has a zero-coupon bond outstanding due in August 2036 that was issued on August 15, 2006. Although the U.S. Treasury does not issue zero-coupon debt with a maturity greater than one year, such securities are created by government securities dealers. Merrill Lynch was the first to do this with its creation of Treasury Investment Growth Receipts (TIGRs) in August 1982. The most popular zero-coupon Treasury securities today are those created by government dealer firms under the Treasury's Separate Trading of Registered Interest and Principal Securities (STRIPS) Program. Just how these securities—commonly referred to as Treasury strips—are created will be explained in Chapter 9. The investor in a zero-coupon security typically receives interest by buying the security at a price below its principal, or maturity value, and holding it to the maturity date. The reason for the issuance of zero-coupon securities is explained in Chapter 9. However, some zeros are issued at par and accrue interest during the bond's life, with the accrued interest and principal payable at maturity.
Sovereign governments and corporations issue securities with a coupon rate tied to the rate of inflation. These debt instruments, referred to as inflation-linked bonds, or simply "linkers," have been issued since 1945. The earlier issuers of linkers were the governments of Argentina, Brazil, and Israel. The modern linker is attributed to the U.K. government's index-linked gilt issued in 1981 followed by Australia, Canada, and Sweden. The United States introduced an inflation-linked security in January 1997, calling those securities Treasury Inflation Protected Securities, or TIPS. These securities, which carry the full faith and credit of the U.S. government, comprised approximately 10% of the outstanding U.S. Treasury market as of mid-2009. Shortly after the introduction of TIPS in 1997, U.S. government-related entities such as the Federal Farm Credit, Federal Home Loan Bank, Fannie Mae, and the Tennessee Valley Authority began issuing linkers.
Different designs can be employed for linkers. The reference rate that is a proxy for the inflation rate is changes in the consumer price index (CPI). In the United Kingdom, for example, the index used is the Retail Prices Index (All Items), or RPI. In France, there are two linkers with two different indexes: the French CPI (excluding tobacco) and the Eurozone's Harmonised Index of Consumer Prices (HICP) (excluding tobacco). In the United States, the Consumer Price Index—Urban, Non-Seasonally Adjusted (denoted by CPI-U), is calculated by the U.S. Bureau of Labor Statistics.
There are securities that have a coupon rate that increases over time. These securities are called step-up notes because the coupon rate "steps up" over time. For example, a six-year step-up note might have a coupon rate that is 5% for the first two years, 5.8% for the next two years, and 6% for the last two years. Consider a stairway note issued by Barclays Bank PLC in July 2009. The initial coupon was 2.8% until January 2010 and thereafter the coupon rate reset every six months to the maximum of the previous coupon rate or six-month LIBOR.
In contrast to a coupon rate that is fixed for the bond's entire life, the term floating-rate security or floater encompasses several different types of securities with one common feature: The coupon rate will vary over the instrument's life. The coupon rate is reset at designated dates based on the value of some reference rate adjusted for a spread. For example, consider a floating-rate note issued in September 2007 by Bank of America that matured in September 2011. This floater delivered cash flows quarterly and had a coupon formula equal to three-month LIBOR plus 50 points.
Typically, floaters have coupon rates that reset more than once a year (e.g., semiannually, quarterly, or monthly). Conversely, the term adjustable-rate or variable-rate security refers to those issues whose coupon rates reset not more frequently than annually.
There are several features about floaters that deserve mention. First, a floater may have a restriction on the maximum (minimum) coupon rate that will be paid at any reset date called a cap (floor). Second, while the reference rate for most floaters is a benchmark interest rate or an interest rate index, a wide variety of reference rates appear in the coupon formulas. A floater's coupon could be indexed to movements in foreign exchange-rates, the price of a commodity (e.g., crude oil), movements in an equity index (e.g., the S&P 500), or movements in a bond index (e.g., the Merrill Lynch Corporate Bond Index). Third, while a floater's coupon rate normally moves in the same direction as the reference rate, there are floaters whose coupon rate moves in the opposite direction from the reference rate. These securities are called inverse floaters or reverse floaters. Consider a hypothetical inverse floater that makes coupon payments according to the following formula:
18% - 2.5 × (three-month LIBOR)
This inverse floater had a floor of 3% and a cap of 15.5%. Finally, range notes are floaters whose coupon rate is equal to the reference rate (adjusted for a spread) as long as the reference rate is within a certain range on the reset date. If the reference rate is outside the range, the coupon rate is zero for that period. For instance, Barclay's Bank issued a range note in November 2006 (due in November 2016). This issue makes coupon payments quarterly. The investor earns three-month LIBOR + 113 basis points for every day during this quarter that three-month LIBOR is between 0% and 7.5%. Interest accrues at 0% for each day that three-month LIBOR is outside this range. As a result, this range note has a floor of 0%.
Structures in the high-yield (junk bond) sector of the corporate bond market have introduced variations in the way coupon payments are made. For example, in a leveraged buyout or recapitalization financed with high-yield bonds, the heavy interest payment burden the corporation must bear places severe cash-flow constraints on the firm. To reduce this burden, firms involved in leveraged buyouts (LBOs) and recapitalizations have issued deferred-coupon structures that permit the issuer to defer making cash interest payments for a period of three to seven years. There are three types of deferred-coupon structures: (1) deferred-interest bonds, (2) step-up bonds, and (3) payment-in-kind bonds. These structures are described in Chapter 12.
Another high-yield bond structure allows the issuer to reset the coupon rate so that the bond will trade at a predetermined price. The coupon rate may reset annually or reset only once over the life of the bond. Generally, the coupon rate will be the average of rates suggested by two investment banking firms. The new rate will then reflect the level of interest rates at the reset date and the credit-spread the market wants on the issue at the reset date. This structure is called an extendible reset bond. Notice the difference between this bond structure and the floating-rate issue described earlier. With a floating-rate issue, the coupon rate resets based on a fixed spread to some benchmark, where the spread is specified in the indenture and the amount of the spread reflects market conditions at the time the issue is first offered. In contrast, the coupon rate on an extendible reset bond is reset based on market conditions suggested by several investment banking firms at the time of the reset date. Moreover, the new coupon rate reflects the new level of interest rates and the new spread that investors seek.
One reason that debt financing is popular with corporations is that the interest payments are tax-deductible expenses. As a result, the true after-tax cost of debt to a profitable firm is usually much less than the stated coupon interest rate. The level of the coupon on any bond is typically close to the level of yields for issues of its class at the time the bond is first sold to the public. Some bonds are issued initially at a price substantially below par value (called original-issue discount bonds, or OIDs), and their coupon rate is deliberately set below the current market rate. However, firms usually try to set the coupon at a level that will make the market price close to par value. This goal can be accomplished by placing the coupon rate near the prevailing market rate.
To many investors, the coupon is simply the amount of interest they will receive each year. However, the coupon has another major impact on an investor's experience with a bond. The coupon's size influences the volatility of the bond's price: The larger the coupon, the less the price will change in response to a change in market interest rates. Thus the coupon and the maturity have opposite effects on the price volatility of a bond. This will be illustrated in Chapter 7.