Schweser Study Notes - Level 1 Book 5 [antikvár]

The following is a review of the Analysis of Fixed Income Investments principles designed to address the learning outcome statements set forth by CFA Institute. This topic is also covered in: Features of Debt Securities Exam Fixed income securities, historically, were promises to pay a stream of semiannual payments for a given number of years and then repay the loan amount at the maturity date. The contract between the borrower and the lender (the indenture) can really be designed to have any payment stream or pattern that the parties agree to. Types of contracts that are used frequently have specific names, and there is no shortage of those (for you to learn) here. Study Session 15 Focus You should pay special attention to how the periodic payments are determined (fixed, floating, and variants of these) and to how/when the principal is repaid (calls, puts, sinking funds, amortization, and prepayments). These features all affect the value of the securities and will come up again when you learn how to value these securities and compare their risks, both at Level 1 and Level 2. -LOS 65.a: Explain the purposes of a bond's indenture, and describe affirmative and negative covenants. / The contract that specifies all the rights and obligations of the issuer and the owners of a fixed income security is called the bond indentureThe indenture defines the obligations of and restrictions on the borrower and forms the basis for all future transactions between the bondholder and the issuer. These contract provisions are known as covenants and include both negative covenants (prohibitions on the borrower) and affirmative covenants (actions that the borrower promises to perform) sections. Negative covenants include restrictions on asset sales (the company can't sell assets that have been pledged as collateral), negative pledge of collateral (the company can't claim that the same assets back several debt issues simultaneously), and restrictions on additional borrowings (the company can't borrow additional money unless certain financial conditions are met). Affirmative covenants include the maintenance of certain financial ratios and the timely payment of principal and interest. For example, the borrower might promise to maintain the company's current ratio at a value of two or higher. If this value of the current ratio is not maintained, then the bonds could be considered to be in (technical) default. LOS 65.b: Describe the basic features of a bond (e.g., maturity, par value, coupon rate), the various coupon rate structures (e.g., zero-coupon bonds, step-up notes, deferred coupon bonds, floating-rate securities), the structure of floating-rate securities (i.e., the coupon formula, caps and floors), and interest payment and price definitions (e.g., accrued interest, full price, and clean price). A "straight" (option-free) bond is the simplest case. Consider a Treasury bond that has a 6% coupon and matures five years from today in the amount of $1,000. This bond is a promise by the issuer (the U.S. Treasury) to pay 6% of the $1,000 par value (i.e., $60) each year for five years and to repay the $1,000 five years from today. With Treasury bonds and almost all U.S. corporate bonds, the annual interest is paid in two semiannual installments. Therefore, this bond will make nine coupon payments (one every six months) of $30 and a final payment of $1,030 (the par value plus the final coupon payment) at the end of five years. This stream of payments is fixed when the bonds are issued and does not change over the life of the bond. ©2007 Schweser Page 11