Last updated November 20264 sectionsabout 6 min read
Key takeaways
Every bond is defined by five basic features: its issuer, maturity, par value, coupon rate and frequency, and currency denomination.
A fixed-rate bond pays a constant coupon, a floating-rate note resets its coupon against a reference rate plus a fixed spread, and a zero-coupon bond is issued at a discount and redeemed at par.
The indenture is the legal contract setting out the bond's terms: affirmative covenants say what the issuer must do, negative covenants what it must not do.
Call, put, conversion and sinking fund provisions change a bond's cash flows before its scheduled maturity.
Fixed income securities were introduced generally in Introduction to Finance and Investments and, as a comparison point for equity, in Equity Investments Analysis; this paper develops them into their own full discipline, starting with the basic contractual features every bond shares.
Basic features of a bond
Issuer
The entity borrowing the funds: a government, agency, supranational or corporation (see the next chapter, on market participants), each carrying different credit risk.
Maturity
The date the issuer must repay the principal (par/face value), defining the bond's term.
Par value (face value)
The amount the issuer promises to repay at maturity, and the amount coupon payments are typically calculated against.
Coupon rate and frequency
The stated annual interest rate paid to bondholders, and how often it is paid (annually, semi-annually), determining the size and timing of periodic cash flows.
Currency denomination
The currency the bond's cash flows are paid in, introducing currency risk (see Introduction to Finance and Investments, on asset classes) for an investor whose base currency differs.
Types of bond
Fixed-rate bonds
Pay a constant coupon throughout the bond's life.
Floating-rate notes (FRNs)
Pay a coupon that resets periodically against a reference rate (see the next chapter) plus a fixed spread, so the coupon amount varies with market rates.
Zero-coupon bonds
Pay no periodic coupon at all, issued at a discount to par and redeemed at par, the entire return coming from that price appreciation.
Amortising bonds
Repay principal gradually over the bond's life alongside interest, rather than a single lump sum at maturity (the loan amortisation logic of Introduction to Finance and Investments, applied to a tradable bond).
Inflation-linked bonds
Index their principal or coupon to an inflation measure, protecting the investor's real (inflation-adjusted) return.
The indenture and its covenants
Bond indenture
The legal contract between issuer and bondholders setting out the bond's terms, covenants, and the trustee's role in enforcing them on bondholders' collective behalf.
Affirmative covenants
Actions the issuer promises to take, maintaining specified financial ratios, using proceeds as stated, providing regular financial reporting.
Negative covenants
Actions the issuer promises not to take, incurring additional debt beyond a specified limit, disposing of key assets, paying dividends beyond a specified threshold, protecting bondholders against value being transferred away to shareholders (echoing the shareholder-bondholder version of the agency conflict in Professional Ethics and Governance).
Legal, regulatory and tax effects
Three sets of rules bear on a bond:
Securities law (see Regulation of Financial Markets) governs disclosure and registration requirements for issuance.
Tax treatment of interest income (see Public Finance and Taxation) affects investor demand and pricing.
Regulatory capital rules affect which institutions can hold which bond types.
Bonds with embedded options
Bonds carrying a right, held by the issuer or the bondholder, to alter the bond's cash flows before scheduled maturity, developed fully in the chapter on bonds with embedded options.
Cash flow structures and contingencies
Call provision
Gives the issuer the right to redeem the bond early, typically exercised when interest rates fall and refinancing at a lower rate becomes attractive (see the chapter on bonds with embedded options).
Put provision
Gives the bondholder the right to sell the bond back to the issuer early, typically exercised when interest rates rise and the bond's fixed coupon becomes unattractive (see the chapter on bonds with embedded options).
Conversion provision
Gives the bondholder the right to convert the bond into a specified number of the issuer's common shares (see Convertible bonds, in the chapter on embedded options), linking the bond's value to the issuer's equity performance.
Sinking fund provision
Requires the issuer to retire a portion of the bond issue periodically before final maturity, reducing the credit risk of a single large repayment at maturity.
Exam tip
Affirmative covenants (what an issuer must do) and negative covenants (what an issuer must not do) are easy to reverse under exam pressure, anchor each to a concrete example, reporting requirements are affirmative, a debt-incurrence limit is negative.
Self-check
(a) State the five basic features of a fixed income security. (5 marks)
(b) Distinguish a zero-coupon bond from an amortising bond. (3 marks)
(c) Distinguish an affirmative covenant from a negative covenant, with an example of each. (4 marks)
(d) Distinguish a call provision from a put provision, and state the interest rate movement under which each is typically exercised. (4 marks)
Show worked answer
(a) Issuer; maturity; par (face) value; coupon rate and frequency; currency denomination.
(b) A zero-coupon bond pays no periodic coupon, is issued at a discount to par and redeemed at par, its whole return being that price appreciation. An amortising bond repays principal gradually over its life alongside interest rather than in a single lump sum at maturity.
(c) An affirmative covenant is an action the issuer promises to take, e.g. providing regular financial reporting or maintaining specified ratios. A negative covenant is an action the issuer promises not to take, e.g. incurring debt beyond a specified limit or disposing of key assets.
(d) A call provision gives the issuer the right to redeem early, typically exercised when rates fall and refinancing at a lower rate becomes attractive. A put provision gives the bondholder the right to sell back early, typically exercised when rates rise and the fixed coupon becomes unattractive.