Introduction to Fixed Income Securities: Basic Features | CFA Level I Fixed Income
Welcome to our CFA Level 1 Fixed Income study notes! In this article, we’ll discuss the basic features of fixed income securities, focusing on bonds. We’ll cover:
- What are fixed income securities?
- Key elements of bonds
- Bond issuers
- Maturity date and term to maturity
- Par value
- Coupon rate and frequency
- Currency denomination
- Yield measures
What are Fixed Income Securities?
Fixed income securities are financial instruments that allow a borrower to borrow money from a lender. The most common type of fixed-income security is a bond, which is a contractual agreement between the bond issuer and the bondholders. When investing in a bond, you need to know its features, legal and regulatory considerations, and contingency provisions.
Key Elements of Bonds
Some essential elements of a bond include the issuer, maturity, par value, coupon rate and frequency, and currency denomination. These features determine the bond’s scheduled cash flows and the investor’s expected and actual return.
Bond Issuers
Bonds can be issued by various entities, such as governments, corporations, and structured finance entities. Government bonds include sovereign nations, supranational entities, non-sovereign governments, and quasi-government entities. Corporate bonds are issued by financial and non-financial companies, while structured finance bonds mainly consist of asset-backed securities.
Maturity Date and Term to Maturity
The maturity date of a bond is when the principal is to be repaid. The time remaining until maturity is the term to maturity or tenor of a bond. Bonds can have maturities as short as one day or as long as 30 years or more. Bonds with original maturities of one year or less are money market securities, while those with longer maturities are capital market securities. Some bonds, called perpetual bonds, have no maturity date.
Par Value
The par value of a bond is the principal amount to be repaid at maturity. It is also called the face value, maturity value, redemption value, or principal value. Bond prices are often quoted as a percentage of par.
Coupon Rate and Frequency
The coupon rate of a bond is the annual percentage of its par value paid to bondholders. The frequency of coupon payments can vary, with semi-annual payments being the most common. Some bonds may have unusual coupon structures, such as floating-rate bonds, where the coupon rate adjusts periodically based on a reference rate.
Currency Denomination
Bonds can be issued in various currencies, sometimes even in dual-currency or with currency options to appeal to a broader range of investors. For example, a company in a country with a volatile currency might issue bonds denominated in U.S. dollars to attract international investors.
Yield Measures
Investors are interested in the yield of a bond, which may fluctuate after issuance. There are several yield measures commonly used, such as the current yield and yield to maturity (YTM). The YTM is considered the most accurate estimate of the annual return an investor will earn on a bond if purchased today and held until maturity. It is the internal rate of return on a bond’s expected cash flows and takes into account both coupon payments and any capital gain or loss at maturity. The YTM is inversely related to the bond’s price: the higher the bond’s price, the lower its yield to maturity, and vice versa.
EXAMPLE
Consider a bond with a 2-year tenor, a par value of $1,000, and an 8% coupon rate, paid semi-annually.
Half a year after initiation, the first coupon of $40 is paid out, and this continues every half a year until the maturity date. At the end of the second year, the par value of $1,000 is returned to the bondholder, plus the last coupon of $40.
Now, let’s say the bond is trading at $1,030. The current yield is the annual coupon ($80) divided by the bond’s price ($1,030), which equals 7.8%. However, the YTM takes into account that the price will revert to $1,000 at maturity, resulting in a capital loss of $30 for the investor who bought the bond at $1,030.
To find the YTM, we need to calculate the internal rate of return (IRR) on the bond’s expected cash flows. Using a financial calculator, we find that the semi-annual yield (r) is 2.44%. Multiplying this figure by 2 gives the annual yield, or YTM, of 4.88%.
Note that the YTM of 4.88% is lower than the current yield of 7.8% because it accounts for the $30 capital loss the investor will incur at maturity.
Conclusion
In this article, we’ve explored the basic features of fixed income securities, particularly bonds. We’ve covered key elements such as bond issuers, maturity date, par value, coupon rate and frequency, currency denomination, and yield measures. Understanding these fundamentals is crucial for making informed investment decisions in the fixed income market.
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