Fixed Income Basics for L1
Fixed income is a MAJOR section of the CFA Level 1 exam. Altogether the material is likely to account for ~10% of total points.
This post runs through all the basics presented in the CFA curriculum (SS 15 Reading 51) up to the calculation sections. We'll cover the basic structure of a bond, a bond's components and what they all represent, the types of issuers, and highly testable material around tranches and special bond provisions.
Basic Bond Structure
Most fixed income bonds make a series of fixed payments over the life of the bond with a final payment of the principal at maturity. There are three main cash flow structures for fixed-income securities within this basic structure.
- Bullet structures - Where periodic interest rate payments are made over the life of the bond and the final payment includes both the last interest rate payment and the principal. Most bonds have this structure.
- Amortizing loans are structures where each periodic payment includes both interest and partial repayment of the principal (student loans, mortgages). A fully amortizing loan is one where the principal is fully paid off with the last periodic payment. Others may have a balloon payment at the end.
- Sinking fund provisions – Have provisions where the principal is paid off in a series of periodic payments. This reduces credit risk to bondholders as the principal is reduced over time but also increases reinvestment risk (especially if r ↓ over the life of the loan)
Bonds and Interest Rates
The most important thing to remember on the CFA Level 1 exam is that bond prices have an inverse relationship with interest rates.
- If interest rates rise, bond prices fall ( r ↑, P ↓)
- If interest rates fall, then bond prices go up ( r ↓, P ↑)
Never forget the inverse relationship between bond prices and interest rates. It is a cornerstone financial concept and will get tested and referenced in various ways throughout the CFA curriculum.
Why are Bond Prices and Interest Rates inversely related?
Because when interest rates go up the present value (PV) of all the remaining payments decreases--this is simply an application of the math in any time value of money calculation.
You can also think of this relationship in terms of supply and demand: If an investor can get higher interest rates today they will value/demand new bonds more than old issuances.
Finally, you should always remain aware that the level of interest charged to a borrower depends on their creditworthiness. The riskier a lender (i.e. the worse their credit rating), the higher the yield they need to offer to entice an investor.
Types of Fixed-income investment risk
As a bond investor you face two main types of risk—price risk and reinvestment risk
Price risk, or interest rate risk, is the decrease (or increase) in bond prices caused by a rise (fall) in interest rates. It tell us how much the value of the portfolio fluctuates. The longer the duration of a bond the greater its price volatility. In other words a change in interest rates has a greater effect on the price of a longer duration bond than a shorter one.
Reinvestment risk refers to the increase (decrease) in cash flow or investment income caused by a rise (fall) in interest rates. If interest rates go up, any new money you invest in a bond will have a higher coupon or cash payment.
Price risk and reinvestment risk are inversely related.
The Basic Components/Variables to Know in a Bond
When we look at a fixed-income security or bond, we focus on five key aspects:
- The issuer of the bond itself
- The maturity date
- The par value, which is the principal to be repaid at maturity
- Bonds trade at premium when P > par, and discount when P < par
- The coupon rate and the frequency of payment
- The currency in which a bond is denominated
- Bonds with maturities < 1 year are money market securities
- Maturities > 1 year are capital market securities
Let's go into a few of these in a bit more detail.
Maturity refers to the date on which the principal has to be repaid. Bonds with maturities of less than one year are called money market securities and bonds with maturities greater than one year are called capital market securities. Note, we will often need to calculate the yield to maturity, which is the discount rate that makes the PV of a bond’s expected future cash flows equal to its current price
Par Value is this is the principal amount that is repaid at maturity. Par value is also called face value, principal value, or redemption value. Bond prices are often quoted as a percentage of their par value.
- If a bond’s price > 100% of par it is trading at a premium
- If a bond’s price < 100% off par it is trading at a discount
- If a bond’s price is equal to the par value than it is trading at par
Coupon Payments or coupon rates are the rate ($/% of par value) that will be paid to bondholders while the coupon is the value of the payment itself. Most bonds pay the coupon semi-annually but there are different structures including:
- A plain vanilla bond, which is a fixed rate bond
- A floating bond, has a floating rate coupon that adjusts its interest rate periodically. These may have a floor or cap on the range the interest rate can adjust between
- Zero coupon bonds are bonds issued at a discount to par which do not pay interest over the life of the bond but appreciate in value until they are redeemed at par
And while we're add it, lets just define a couple of other possible bond attributes.
- Secured bonds – Backed by assets or financial guarantees
- Unsecured bonds / Debentures– Bonds with no collateral backing them
- Tranches - We can divide a bond issuance into tranches by distinguishing the seniority of each tranche on the underlying asset(s). The more junior tranches are designed to absorb losses first and will thus require a higher coupon rate.
Of these three, tranches are the most likely to be tested on the CFA Level 1 exam and are most likely to come up in the context of asset-backed securities.
Types of Bond Issuers
- Corporations – corporate bonds
- Governments – e.g. US Treasury bonds
- Nonsovereign government – Cities, States/Provinces, munipalities
- Quasi-government bonds – Entities with no direct obligation to central bank or government
- Multilateral organizations (supranational) – IMF, World Bank etc
Sources of Funds for Repayment by Issuer Type
- Sovereign bonds – Repaid from taxes collected by the government
- Corporate bonds – Repaid from the cash generated by firm operations
- Non-sovereign bonds – Repaid from cash flows of project (e.g. toll road)
- Supranational/Multilateral Orgs – Repayment of previous loans or paid-in capital from other members
Bond Indentures & Credit Enhancements
A bond indenture is the legal contract between lender and borrower. They specify things like the source of funds for repayment, collateral, credit enhancements, and covenants. Covenants can be both positive and negative.
- Negative covenants – Describe things the company is prohibited from doing such as asset sales of collateral, specific investments, and restrictions on borrowing more
- Affirmative (positive) covenants – Describe what issuers are required to do. An affirmative covenant is mostly administrative and could include things like specifying making timely interest/principal payments on time
Outside of indentures, bonds can also have certain credit enhancements.
Credit enhancements are provisions designed to reduce the credit risk of a bond issue. These can be either internal measures, which are built into the structure of the bond itself, or external measures, which refers to guarantees from a third party guarantor. The most common type of external measure is collateral.
Since they reduce risk, the more credit enhancements that are included the lower the yield is likely to be.
- Overcollateralization - pledging more in collateral than the bond is worth
- Excess spread – Positive spread between CF of assets used to secure the issue and the interest rate paid to investors
- Junior tranches – Dividing a loan into tranches with different claim seniority. The more junior tranches absorb losses first in this case
- Surety bonds – Issued by insurance companies, guaranteed to make up any shortfall
- Letter of credit – A promise to lend money to cover cash shortages
- Bank guarantees
So which of these features benefit a bond holder and which of these features benefit an issuer? Note, this is a perfect type of CFA Level 1 multiple choice question within fixed-income.
Features that benefit a bond holder
- Put option – Sets floor value
- Floors – Sets limit to how low a floating coupon can go
- Conversion privileges – Gets upside to equity
Features that benefit a bond issuer
- Call options – Allows issuer to payoff bond if rates decrease enough where issuing a new bond makes sense
- Prepayments - Same early retirement as call option
- Caps – Ceiling on rate for floating coupon
Hopefully this has been a helpful quick recap of the Level 1 curriculum reading that introduces fixed income. There is one more reading that discusses the issuance and trading of bonds before the curriculum gets a bit more technical on fixed-income valuation.