Features of Debt Securities

Key Concepts

1. The obligations, rights, and any options the issuer or owner of a bond may have are contained in the bond indenture. The specific conditions of the obligation are covenants. Affirmative covenants specify acts that the borrower must perform, and negative covenants prohibit the borrower from performing certain acts.
2. Bonds have the following features:
   • Maturity — the term of the loan agreement.
   • Par value — the principal amount of the fixed income security that the borrower promises to pay the lender on or before the bond expires at maturity.
   • Coupon — the rate that determines the periodic interest to be paid on the principal amount. Interest can be paid annually or semiannually, depending on the terms. Coupons may be fixed or variable.
3. Types of fixed-income securities:
   • Zero-coupon bonds pay no periodic interest and are sold at a discount to par value.
   • Accrual bonds pay compounded interest, but the cash payment is deferred until maturity.
   • Step-up notes have a coupon rate that increases over time according to a specified schedule.
   • Deferred coupon bonds initially make no coupon payments (they are deferred for a period of time). At the end of the deferral period, the accrued (compound) interest is paid, and the bonds then make regular coupon payments.
4. A floating (variable) rate bond has a coupon formula that is based on a reference rate (usually LIBOR) and a quoted margin. Caps are a maximum on the coupon rate that the issuer must pay, and a floor is a minimum on the coupon rate that the bondholder will receive.
5. Accrued interest is the interest earned since the last coupon payment date and is paid by a bond buyer to a bond seller. Clean price is the quoted price of the bond without accrued interest, and full price refers to the quoted price plus any accrued interest.
6. Bond payoff provisions:
   • Amortizing securities make periodic payments that include both interest and principal payments so that the entire principal is paid off with the last payment unless prepayment occurs.
   • A prepayment provision is present in some amortizing loans and allows the borrower to payoff principal at any time prior to maturity, in whole or in part.
   • Sinking fund provisions require that a part of a bond issue be retired at specified dates, usually annually.
   • Call provisions enable the borrower to buy back the bonds from the investors (redeem them) at a price(s) specified in the bond indenture.
   • Callable but nonrefundable bonds can be called, but their redemption cannot be funded by the simultaneous issuance of lower coupon bonds.
7. Regular redemption prices refer to prices specified for calls; special redemption prices (usually par value) are prices for bonds that are redeemed to satisfy sinking fund provisions or other provisions for early retirement, such as the forced sale of firm assets.
8. Embedded options that benefit the issuer reduce the bond's value to a bond purchaser; examples are call provisions and accelerated sinking fund provisions.
9. Embedded options that benefit bondholders increase the bond's value to a bond purchaser; examples are conversion options (the option of bondholders to convert their bonds into a certain number of shares of the bond issuer's common stock) and put options (the option of bondholders to return their bonds to the issuer at a preset price).
10. Institutions can finance secondary market bond purchases by margin buying (borrowing some of the purchase price, using the securities as collateral) or, most commonly, by repurchase (repo) agreements (an arrangement in which an institution sells a security with a promise to buy it back at an agreed-upon higher price at a specified later date).