Fixed-Income Instrument Features

Introduction to Fixed Income

Fixed-income securities are debt instruments that represent a loan made by an investor to a borrower. They are a fundamental part of global financial markets.

Element	Description
Main Players	Borrowers: Entities that need to raise capital, such as corporations, governments (sovereign and local), and supranational organizations (e.g., the World Bank). Investors (Lenders): Entities that provide the capital, such as central banks, pension funds, and insurance companies.
Types of Instruments	Loans: Private agreements negotiated directly between a single borrower and a single lender (or a small group of lenders). Bonds: Standardized debt instruments that are issued to the public and can be traded openly in financial markets.

Core Features of Fixed-Income Securities

Understanding the specific features of a bond is essential for analyzing its risk and return profile.

Key Bond Features

Feature	Description
Issuer	The entity borrowing the money (e.g., government, corporation). The issuer type is the primary determinant of a bond's creditworthiness.
Maturity	The date when the issuer must repay the principal amount. Money Market: Maturity of less than one year. Capital Market: Maturity of more than one year. Perpetual Bond: Has no maturity date.
Principal (Par Value)	The amount the issuer agrees to repay the bondholder at maturity.
Coupon Rate & Frequency	The interest rate the issuer agrees to pay on the principal. Fixed-Coupon Bonds: Pay a consistent interest rate. Floating-Rate Notes (FRNs): Pay a variable interest rate that resets periodically. Zero-Coupon Bonds: Pay no periodic interest; they are issued at a discount to their principal value.
Seniority	The ranking of the bond in the issuer's capital structure, which determines the order of repayment in case of bankruptcy.
Contingency Provisions	Special terms included in the bond agreement that apply if a specific event occurs, such as call options (issuer can redeem early) or put options (investor can sell back early).

Yield Measures

Yield measures are used to estimate the return an investor can expect from a bond.

Current Yield: A simple measure of return.
Current Yield Formula

Current Yield = Annual Coupon Interest / Bond Price

Where:
Annual Coupon Interest = Coupon Rate × Par Value
Bond Price = Current Market Price

Example: A bond with a $1,000 par value and a 5% coupon rate pays $50 in interest annually. If the bond's current market price is $980, its current yield is $50 / $980 = 5.1%.
Yield-to-Maturity (YTM): The most comprehensive measure of return. It is the internal rate of return (IRR) of a bond's expected cash flows (all coupon payments and the final principal repayment) given its current market price.
Important Conditions for YTM: The calculated YTM will only be the actual return an investor earns if three conditions are met:
1. The bond is held until maturity.
2. The issuer makes all payments as scheduled (no default).
3. The investor reinvests all periodic cash flows (coupons) at the same YTM rate.

Yield Curves

A yield curve is a graph that plots the YTM of bonds against their respective maturities.

Shape: Typically, the yield curve is upward sloping, meaning bonds with longer maturities have higher YTMs. This is because investors demand a higher return for the increased risk associated with lending money for a longer period.
Credit Risk Analysis: An issuer's yield curve can be compared to that of a benchmark, like U.S. Treasury bonds (which are considered risk-free). The difference in yield between the issuer's bond and a sovereign bond of the same maturity is called the credit spread. A higher spread indicates higher perceived credit risk.

Bond Indentures and Covenants

The legal framework of a bond is critical for understanding the rights and obligations of both the issuer and the bondholders.

The Bond Indenture

The bond indenture is the legal contract between the issuer and the bondholders. It outlines all the key features of the bond, the issuer's duties, the sources of repayment, and the bondholders' rights.

Sources of Repayment & Security

Bond Type	Primary Source of Repayment
Sovereign Bonds	Backed by the government's full faith and credit, including its power to tax and issue currency.
Local/Regional Bonds	Backed by taxes or fees from specific projects (e.g., tolls from a bridge).
Corporate Bonds	Backed by the company's ability to generate cash flow from its operations.
Secured vs. Unsecured Bonds	Secured bonds give creditors a legal claim on specific assets (collateral) in case of default, giving them priority in liquidation. Unsecured bonds (debentures) are repaid after secured debts.

Bond Covenants

Covenants are legally enforceable rules within the indenture that the issuer must adhere to. They are designed to protect bondholders.

Covenant Type	Description	Examples
Affirmative Covenants	Require the issuer to take specific actions.	Use bond proceeds for the stated purpose. Provide regular financial reports. Pari Passu Clause: Treat all debts with the same seniority equally. Cross-Default Clause: A default on any of the issuer's debts triggers a default on this bond.
Negative Covenants	Prohibit or limit the issuer from taking certain actions that could harm bondholders.	Restrictions on selling major assets. Limitations on issuing additional debt. Restrictions on making certain investments.

Recourse for Covenant Violations: If an issuer violates a covenant, bondholders have legal recourse and may demand remedies such as a higher interest rate or the immediate repayment of the principal (accelerated repayment).