MODULE 1: Fixed-Income Instrument Features

What a Fixed-Income Security Really Is

1. A fixed-income security is a contract where the issuer borrows money from investors and promises interest plus repayment of principal.
2. What is issuer: The borrower.
3. What is principal: The amount borrowed and normally repaid.
4. What is interest: The lender's periodic compensation for lending money.

Think of it like HDFC Bank lending money to a company, except the loan is chopped into tradable pieces and sold to many investors. The investor is not buying ownership like a shareholder. The investor is lending money under a contract.

1. Do not confuse fixed-income instruments with all liabilities.
2. All fixed-income instruments are liabilities.
3. Not all liabilities are fixed-income instruments.
4. Accounts payable, deferred revenue, taxes payable, lease liabilities, and pension liabilities are obligations, but this module focuses on loans and bonds.

Example: If Reliance owes suppliers for crude oil, that is accounts payable, not a bond. If Reliance issues a 10-year note to investors, that is a fixed-income instrument.

1. Bonds are more standardized than loans.
2. Loans are usually private agreements with banks.
3. Bonds are standardized contracts that can be sold to many investors and traded more easily.

Real-world anchor: a small shop may borrow directly from State Bank of India. Apple can issue bonds to thousands of investors globally.

Core Bond Features

1. The issuer is the legal entity responsible for paying interest and principal.
2. What is legal entity: The company, government, agency, or special purpose vehicle that can legally owe money.

Issuers can be national governments, local governments, supranational organizations like the World Bank, quasi-government entities like national railways, corporations, or special purpose entities used in securitization.

1. Sovereign bonds usually have the lowest credit risk inside their own country because national governments can tax.
2. What is sovereign bond: A bond issued by a national government.
3. Why is taxation power used: Taxes create a broad repayment source that normal companies do not have.

Example: Indian government securities are usually treated as the local low-credit-risk benchmark in India. A Tata Steel bond may be strong, but Tata Steel cannot tax the whole country.

1. Maturity is the final date on which the issuer must make the final payment.
2. What is maturity: The bond's final repayment date.
3. What is tenor: The remaining time until that final repayment date.

Watch the wording: "four years from settlement date" is time to maturity at issuance. As time passes, tenor gets shorter.

Margin case students miss: settlement date is when the trade is completed and the buyer pays for the bond. Maturity date is when the issuer makes the final promised payment. Do not mix the starting line with the finish line.

1. Money market securities have one year or less at issuance. Capital market securities have more than one year at issuance.
2. What is money market security: Short-term fixed-income instrument issued with maturity of one year or less.
3. What is capital market security: Longer-term bond issued with maturity greater than one year.

Margin case students miss: the classification is based on maturity at issuance, not how much time is left today. A 5-year bond with 6 months left is still a capital market security that is now close to maturity.

1. A perpetual bond has no stated maturity, but it is still debt, not equity.
2. What is perpetual bond: A bond with no final maturity date.

Why it is still not equity: it has contractually defined cash flows, no voting rights, and higher seniority than ordinary shares. Airport Authority Hong Kong issued perpetual bonds after the COVID-19 passenger collapse to fund airport development. Investors were not buying airport ownership; they were lending money through a debt contract with no final repayment date.

1. Principal, par value, and face value usually mean the same exam thing: the amount the issuer agrees to repay.
2. What is par value: The stated amount on which coupon payments are usually calculated.

Example: A British pound (GBP) 100,000 bond with a 2.5 percent annual coupon pays GBP 2,500 per year. If it pays semiannually, each coupon is GBP 1,250.

Coupon Structures

1. A fixed-coupon bond pays a fixed coupon on scheduled dates.
2. What is fixed coupon: A coupon amount that does not change because market rates changed.

Example: If a bond pays 6 percent on United States dollar (USD) 1,000 par every year, the annual coupon is USD 60. If rates rise tomorrow, the coupon is still USD 60.

1. A floating-rate note pays a coupon that resets using a market reference rate plus an issuer-specific spread.
2. What is floating-rate note: A bond whose coupon changes when the reference rate resets.
3. What is market reference rate: The base market borrowing rate for a currency and maturity.
4. What is issuer-specific spread: The extra rate investors demand for that borrower's credit risk.

Example: A European company issues a euro (EUR) 10 million floating-rate note paying three-month market reference rate + 125 basis points. If the market reference rate is -0.50 percent, the coupon is 0.75 percent because -0.50 percent + 1.25 percent = 0.75 percent.

1. The floating-rate note spread usually stays fixed after issuance.

This is a margin case. If the issuer's credit quality worsens one year later, the bond's market price may fall, but the coupon spread written into the contract does not automatically jump. Only the market reference rate resets unless the contract says otherwise.

1. A zero-coupon bond pays no periodic coupon. It is issued below par and pays par at maturity.
2. What is zero-coupon bond: A bond where interest is built into the gap between issue price and maturity value.

Example: If a Treasury bill is issued at United States dollar (USD) 950 and pays USD 1,000 at maturity, the USD 50 difference is the investor's return.

Yield Measures and Curves

1. Current yield is annual coupon divided by the bond's current price.
2. What is current yield: Coupon income as a percentage of today's bond price.

If price falls and coupon stays fixed, current yield rises. But current yield ignores capital gains, capital losses, and reinvestment.

1. Yield-to-maturity is the internal rate of return based on the bond's price and promised cash flows until maturity.
2. What is yield-to-maturity: The discount rate that makes promised bond cash flows equal today's price.
3. Why is yield-to-maturity used: It gives one annual return number for comparing bonds.

The catch is huge. Your actual return equals yield-to-maturity only if the issuer pays everything on time, you hold to maturity, and you reinvest every coupon at that same yield. If one condition breaks, your realized return changes.

1. A yield curve lines up yields by maturity for similar bonds from the same issuer or similar issuers.
2. What is yield curve: A picture of yields across short, medium, and long maturities.

If BRWA's 5-year bond yields 3.2 percent and the 5-year U.S. Treasury yields 2.3 percent, the 90 basis point gap is credit compensation. Investors want extra yield because BRWA is riskier than the sovereign benchmark.

Seniority, Security, and Priority of Claims

1. Seniority tells you who gets paid first if the issuer fails.
2. What is seniority: The ranking of claims in bankruptcy or liquidation.
3. What is unsubordinated debt: Debt that is not pushed below another class of debt.

Example: If Jet Airways had United States dollar (USD) 100 of value left and USD 150 of claims, the first question is not "who invested earlier?" The first question is "who has the senior legal claim?"

1. Secured debt has a claim on specific collateral. Unsecured debt relies mainly on the issuer's operating cash flows.
2. What is secured debt: Debt backed by a legal claim on specific assets.
3. What is unsecured debt: Debt with no specific asset pledged.
4. What is collateral: Asset or cash flow pledged as backup repayment.

Example: If a company pledges aircraft as collateral, secured lenders may claim those aircraft if the company defaults. Unsecured lenders stand behind them and recover only from what remains.

1. Secured corporate debt is not automatically an asset-backed security.

This is a common trap. A secured corporate bond is still the company's debt, supported by operating cash flows plus collateral. An asset-backed security is issued by a special purpose entity and paid from a pool of loans or receivables.

1. Pari passu means equal footing with debt of the same seniority.
2. What is pari passu: Equal rank for similar debt claims.

Margin case: older debt does not automatically rank above newer debt. If both are secured and unsubordinated, and the indenture says pari passu, they are treated equally.

Contingency Provisions

1. A contingency provision is a contract clause that changes what can happen if a specific event occurs.
2. What is contingency provision: A built-in "if this happens, then this right appears" clause.

Common examples are call options, put options, and conversion rights.

1. A callable bond gives the issuer the right to redeem the bond early.
2. Why is call used: The issuer wants to refinance expensive debt if market rates fall.

Real-world example: If Reliance issued debt at 8 percent and later can borrow at 6 percent, it would love to call the old bond and issue cheaper debt. Good for Reliance, bad for the investor who loses a high coupon.

1. A putable bond gives the investor the right to sell the bond back to the issuer early.

2. Why is put used: The investor wants downside protection if rates rise or credit risk worsens.

3. A convertible bond gives the investor the right to convert the bond into the issuer's equity.

4. Why is conversion used: The investor accepts lower bond income in exchange for possible stock upside.

Do not overdo these here. This module introduces contingency provisions. The pricing and risk effects come later.

Bond Indenture and Sources of Repayment

1. A bond indenture is the legal contract that lists the bond's features, issuer obligations, and bondholder rights.
2. What is bond indenture: The rulebook for the bond.
3. Why is bond indenture used: It makes the promise enforceable instead of vague.

Read the indenture like a lender, not like a tourist. You are asking: who owes me money, when do they pay, what protects me, and what can they do that hurts me?

1. Sovereign repayment usually comes from taxes and fiscal power.

Example: The Government of India can tax income, goods, services, fuel, imports, and companies. That broad fiscal power is why sovereign bonds usually sit at the lowest-credit-risk point in the local market.

1. Corporate repayment usually comes from operating cash flow.

Example: Infosys bondholders are ultimately relying on Infosys collecting cash from clients and keeping enough profit and liquidity to pay interest and principal.

1. Asset-backed security repayment comes from a pool of loans or receivables owned by a special purpose issuer.
2. What is special purpose issuer: A separate legal vehicle created to hold assets and issue securities.
3. What is tranche: A slice of the deal with its own claim priority.

Example: A bank pools car loans into a vehicle. Car buyers make monthly payments. Those cash flows pay the asset-backed security investors. Senior tranches get paid before junior tranches.

Covenants

1. Bond covenants are legally enforceable promises inside the bond contract.
2. What is covenant: A rule the borrower agrees to follow.

3. Why are covenants used: Bondholders do not control management like shareholders do, so covenants give lenders protection.

4. Affirmative covenants require the issuer to do something.

5. What is affirmative covenant: A must-do promise.

Examples: - Use the money for stated purposes. - Provide timely financial reports. - Maintain equal footing with similar debt through a pari passu clause. - Treat default on another debt as default here through a cross-default clause.

Margin case: cross-default is affirmative in the source. Students often think it is negative because the word "default" sounds restrictive.

1. Negative covenants prohibit the issuer from doing something.
2. What is negative covenant: A must-not-do restriction.

Examples: - Do not issue too much additional debt. - Do not pledge assets to new lenders in a way that weakens existing bondholders. - Do not pay dividends or repurchase shares unless financial tests are met. - Do not sell assets or do sale-and-leaseback transactions beyond limits.

1. A negative pledge clause prevents the issuer from giving future lenders a better claim on assets without protecting existing lenders.
2. What is negative pledge: A promise not to pledge assets to other lenders in a way that weakens current bondholders.

Example: If a company is already shaky, existing unsecured bondholders do not want management to pledge all good assets to a new lender and leave them holding an empty shell.

1. Incurrence tests are event-based restrictions.
2. What is incurrence test: A financial test that must be passed before the issuer can do a specific action, such as issue more debt or pay dividends.

Example: A company may be allowed to issue more debt only if net debt to earnings before interest, taxes, depreciation, and amortization is not greater than 4.5 times and interest coverage is greater than 3.0 times.

1. Covenant violations give bondholders remedies.
2. What is remedy: The action bondholders can take when the issuer breaks the contract.

Remedies can include higher interest, stronger security, accelerated repayment, or termination of the debt agreement.

1. More covenants are not always better.

This is an overlooked margin case. Very strict covenants can protect lenders, but they can also push a stressed company into default when a softer approach might have allowed it to survive and repay. A lender wants protection, not a contract that accidentally destroys the borrower too early.