In a previous article, we introduced the CFA Institute
Investment Foundation Program (Read
more here). It is a free program
designed for anyone who wants to enter or advance within the investment
management industry, including IT, operations, accounting, administration, and
marketing. Candidates who successfully
pass the online exam earn the CFA Institute Investment Foundations Certificate.
There are total of 20 Chapters in 7 modules, covering all
the essential topics in finance, economics, ethics and regulations. This series of articles will highlight the
core knowledge of each chapter.
Chapter 9 provides an overview of quantitative concepts. The
learning outcome of chapter 9 is as follows:
·
Identify issuers of debt securities;
·
Describe features of debt securities;
·
Describe seniority ranking of debt securities
when default occurs;
·
Describe types of bonds;
·
Describe bonds with embedded provisions;
·
Describe securitisation and asset-backed
securities;
·
Define current yield;
·
Describe the discounted cash flow approach to
valuing debt securities;
·
Describe a bond’s yield to maturity;
·
Explain the relationship between a bond’s price
and its yield to maturity;
·
Define yield curve;
·
Explain risks of investing in debt securities;
·
Define a credit spread.
When a large company or government borrows money, it usually
does so through financial markets. The company or government issues securities
that are generically called debt securities, or bonds. Debt securities
represent a contractual obligation of the issuer to the holder of the debt
security. Companies and governments may have more than one issue of debt
securities (bonds). Each of these bond issues has different features attached
to it, which affect the bond’s expected return, risk, and value.
A typical bond includes the following three features: par
value (also called principal value or face value), coupon rate, and maturity
date. These features define the promised cash flows of the bond and the timing
of these flows.
Par value. The par (principal) value is the amount
that will be paid by the issuer to the bondholders at maturity to retire the
bonds.
Coupon rate. The coupon rate is the promised
interest rate on the bond.
Maturity date. Debt securities are issued over
a wide range of maturities, from as short as one day to as long as 100 years or
more. In fact, some bonds are perpetual, with no pre-specified maturity date at
all. But it is rare for new bond issues to have a maturity of longer than 30
years. The life of the bond ends on its maturity date, assuming that all
promised payments have been made.
The bond contract gives bondholders the right to take legal
action if the issuer fails to make the promised payments or fails to satisfy
other terms specified in the contract. If the bond issuer fails to make the
promised payments, which is referred to as default, the debtholders typically
have legal recourse to recover the promised payments. In the event that the
company is liquidated, assets are distributed following a priority of claims,
or seniority ranking. This priority of claims can affect the amount that an
investor receives upon liquidation.
Bonds, in general, can be classified by issuer type, by type
of market they trade in, and by type of coupon rate. Although the term “bond” may be used to describe
any debt security, irrespective of its maturity, debt securities can also be
referred to by different names based on time to maturity at issuance. Debt
securities with maturities of one year or less may be referred to as bills.
Debt securities with maturities from 1 to 10 years may be referred to as notes.
Debt securities with maturities longer than 10 years are referred to as bonds.
Issuer. Bonds issued by companies are referred
to as corporate bonds and bonds issued by central governments are sovereign or
government bonds. Local and regional government bodies may also issue bonds.
Market. At issuance, investors buy bonds
directly from an issuer in the primary market. The primary market is the market
in which new securities are issued and sold to investors. The bondholders may
later sell their bonds to other investors in the secondary market. In the
secondary market, investors trade with other investors. When investors buy
bonds in the secondary market, they are entitled to receive the bonds’ remaining
promised payments, including coupon payments until maturity and principal at
maturity.
Coupon rates. Bonds are often categorised by
their coupon rates: fixed-rate bonds, floating-rate bonds, and zero-coupon
bonds. These categories of bonds are described further in the following
sections.
Bonds may pay fixed-rate, floating-rate, or zero-coupon
payments. Fixed-rate bonds are the most
common bonds. They offer fixed coupon payments based on an interest (or coupon)
rate that does not change over time. These coupon payments are typically paid
semi-annually.
Floating-rate bonds typically offer coupon payments based on
a reference rate that changes over time plus a fixed spread; the reference
interest rate is reset on each coupon payment date to reflect current market
rates.
The only cash flow offered by a zero-coupon bond is a single
payment equal to the bond’s par value to be paid on the bond’s maturity date.
Many bonds come with embedded provisions that provide the
issuer or the bondholder with particular rights, such as to call, put, or
convert the bond.
Securitisation is a process that creates new debt securities
backed by a pool of other debt securities. These new debt securities are called
asset-backed securities. Most asset-backed securities generate monthly payments
that include both interest and principal components.
Sample Question:
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