Thursday, August 9, 2007

Reading 62: Features of Debt Securities

a. explain the purposes of a bond’s indenture, and describe affirmative and negative

Bond indenture is a contract that specifies all the rights and obligations of the issuer and the owners.

Contract provisions are called covenants
  • negative covenants (prohibits on the borrower)
    • restriction of asset sales
    • negative pledge colleterals
    • restriction on additional borrowings
  • affirmative covenants ( actions that the borrower promises to perform)
    • maintanance of certain financial ratios
    • timely payment of principal and interests

b. describe the basic features of a bond, the various coupon rate structures, and the structure of floating-rate securities;


Embedded options: they are integrated part of the contract and not a seperate security

Security owner options
  • Conversion option
    • owner has the right to convert the bond into fixed number of common shares of the issiuer
  • Put provisions
    • owners has the right to sell the bond to the issuer at a specified price before maturiy
  • Floors
    • set a min. on the coupon rate for the floating rate bonds
Security issuer options
  • Call provision
    • bond issuer has the right to redeem (pay off) the issuer prior to maturiy
  • Prepayment options
    • e.g. mortgages, and car loans
  • Accelerated sinking fund provisions
    • Allow issuer to retire a larger proportion of the issue than is required by the sinking fund provision up to a specified limit
  • Caps
    • set a maximum rate for floating rate bond
Coupon rate structures
  • Zero coupon bonds
    • no periodic coupon interest payments. They are and par value is paid at maturity
  • Accural bonds
    • similar to zero coupon bonds but coupon interest rate is compounded
  • Setup notes
    • coupon rates increase at sepecified rate
  • Deferred-coupon bonds
    • interest coupon payments are defered for some time
Floating Reate Securities
  • Coupon rates vary based on specified reference interest rate or index. Coupons are reset periodically (e.g. every 3, 6, or 12 months) and then adds/substracts a margin rate from the referance rate. e.g. refer. rate is U.S. Treasury Secs. or LIBOR
  • Quoted Margin can also vary by time. Schedule is refered to as coupon formula.
    • new coupon rate = reference rate +/- quoted margin
  • Caps and floors
    • caps set upper limit
    • floors set lower limit
    • collars set upper and lower limits

c. define accrued interest, full price, and clean price;


test

d. explain the provisions for redemption and retirement of bonds;


test


e. identify the common options embedded in a bond issue, explain the importance of embedded options, and state whether such options benefit the issuer or the bondholder;


test


f. describe methods used by institutional investors in the bond market to finance
the purchase of a security (i.e., margin buying and repurchase agreements).


test

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