INTRODUCTION TO

DEBT SECURITIES

DEBT

An amount of money borrowed by one party

from another.

Many corporations/ countries use debt as a

method for making large purchases that
they could not afford under normal
circumstances.

A debt arrangement gives the borrowing

party permission to borrow money under the
condition that it is to be paid back at a later
date, usually with interest.

Examples

Bonds, loans and commercial paper.

Debt Financing Balance Sheet

DEBT INSTRUMENTS
Capital Markets Instruments

Throughbondsfirmsobtainlongtermdebtcapital.

Claimsofbondholdersaresatisfiedbeforethoseofstockholdersincases
ofbankruptcy.

Money market instruments

Shorttermdebtas:TBills,CommercialPaper,etcsecuritiesissued
bycorporations,financialinstitutions,andgovernments.
Generallylowrisksecuritiesandarepurchasedbyinvestors
whentheyhavesurpluscash.

INDENTURE & COVENANTS

Indenture

It is the contract that specifies

Rights
Obligations

For

Issuers
Owners

Covenants:

(specific conditions)
Positive

Payment of
Principal +
Interest

Negative

Maintenance of
finantial Ratios!!

If you dont, you are

in technical default !

Restrictions on asset sales

Negative pledge of
collateral

Which are pledge as

colateral)

Same assets cant back

new issues

Restrictions on additional
borrowings

Unless certain conditions

are met

BASIC FEATURES

Straight (option free) bond or plain vanilla

Consider a x% coupon and matures y years

from today with a face value of $z issued by the
w

For example:

Consider a 5% coupon and matures 10 years from today

with a face value of $1000 issued by the U.S. Treasury

Try to make the graphic!

Coupon rate structures

Zero Coupon Bonds

No payments of interest

Step up Notes

Coupon rates increase over time

Deferred Coupon Bonds

Initial coupon payments are deferred

After that pay regularly
Coupon payments accrue at compound rate

FLOATING RATE SECURITIES

*To limit extreme fluctuations you may use caps, floors & collars

Floating Rate Securities

Coupon vary based on reference rate and a

agreed margin

Reference +
Rate
LIBOR
+

Agreed
Margin
3%

Inverse Floater

Increases the coupon rate when reference

interest rate decreases
Stated Margin

+-

Reference Rate

8%

U.S. Treasury

Inflation - Indexed

Formula based on inflation:

Stated Margin

+-

Reference Rate

1%

Annual Change in CPI

ACCRUED INTEREST, FULL PRICE &

CLEAN PRICE

Accrued Interest, Full Price & Clean Price

Accrued Interest:

Clean Price:

Interest earned from the previous coupon date till sale(%)

Agreed-upon price of the bond

Full or dirty price:

Total Amount paid

In U.S.A. Bonds usually trade with (without) the

right to the next coupon attached cum coupon (excoupon)

If the issuer is in default, then are no accrued

interest

How, when, and under what circumstances the

principal will be repaid

PROVISIONS

Amortizing

Periodic Interest + Principal

Expected to be paid (EX - ANTE!)

Example: conventional mortgage

Prepayment

Gives the option to accelerate the principal repayment

Whole or in part

It is not expected ex -ante but the borrower have the option

to do it
At any time !!!
Payment: Ex - post

Example: Mortgage backed securities (not bonds!)

Call provisions
Give the right (not the obligation) to the issuer to retire
all or a part of an issue prior to maturity.
Call

protection:

Period of years after issuance where bonds cant be called.

Currently

callable:

After the call protection

There may be several call dates, with a lower call price.

Ex ante!
Specific moments for redemption!!!
For example:

110 (% of par) at 5y;

105 at 10;
100 at 15y

Call provisions

Non refundable bonds

Bonds can be recalled for any reason other
than refunding with a lower coupon bond
issue.
So THE BOND MAY BE CALLABLE BUT NOT
REFUNDABLE

Sinking Fund Provisions

Provide for the repayment of principal through a
series of payments:
For

example: 120m face value - 10 year issue:

Must retire: 20M

Beggining: 6th year

Two ways
Cash

payments:

Issuer deposit the cash:

The trustee will retire the bonds at par by lotery
It benefits the issuer if bonds are above par

Delivery

of Securities:

The issuer buyback the bonds in the open market and

deliver them to the trustee, who will retire them.
It benefits the issuer if bonds are under par

Sinking Fund Provisions

0
-120

6
20

5
20

4
20

3
20

2
20

1
20

Accelerated Sinking Fund Provisions

Allow the issuer the choice of retiring more
than specified amount

Redemption price

Regular Reemption Price:

Under the call provisions

Special Redemption Price:

Redeemed to comply

Sinking fund provisions

Property sale mandated by government

Regulatory (antitrust)
Governments right of eminent domain

* Caps and Floors do not need to be exercised but are considered embedded options
because they are equivalent to a series of Interest rate call and put options

COMMON OPTIONS EMBEDDED IN A

BOND

Security owner options

Granted to security holder:
Conversion

Convert the bond into common shares of the

issuer

Exchange

Put

Option

Convert the bond into other than common shares

ot the issuer.

Provisions

Right to sell at aspecified price.

Floors

Option

Set a minimum on the coupon rate for a floating

rate

Security issuer options

Exercisable by the issuer: (Effects on value and
yield)
Call

provisions

Prepayment

Accelerated

Option
Sinking Fund

Caps

Maximum coupon for a floating rate

METHODS TO FINANCE PURCHASES

Margin Buying

Its about borrowing from a bank or a

broker to purchase securities

The securities act as a collateral!

In the U.S.A. margin is regulated by the FED,

under the SEA of 1934.

Repurchase Agreement (REPO)

Its when a institution sells a security with the
commitment to buy it back!
Repurchase

price __ selling price: because

interest is charged!
Repo

Are

Rate:

Overnight repo :1 day

Term Repo: more than 1 day

not regulated by the FED