Fixed-income securities represent debt. The major categories include:
Bonds: A bond pays interest on a regular basis and returns the principal amount that was invested on its maturity date. Bonds are typically classified using the basic features discussed in the foregoing section 1.1, i.e. the issuer, currency denomination, priority ranking, coupon rate, and redemption features.
Issuer: By issuer we refer to the borrower of a debt. Bonds can be issued and classified by the type of issuer such as: Corporate bonds, Municipal or government bonds and supranational bonds. Government securities form the bulk of the bonds traded in the global debt market. They include:
International bond issues: Eurobonds, Foreign bonds and Global bonds.
Currency denomination: As mentioned earlier, bonds can be issued in any currency.
Bonds issued in the local currency and issued in the national debt market are called domestic bonds.
Those issued in a foreign country and denominated in the foreign country’s currency are known as foreign bonds, such as Yankee bonds of US.
While those issued under the international regulations (not under one country) and denominated in a currency different from the country in which they trade are referred to as Eurobonds.
Eurobonds are referred by their currency of denomination such as Eurodollar, Euroyen, and so on.
A Eurobond trading in a country rather than the one whose currency it’s denominated are called global bonds.
Priority: – Bonds can also be classified according to their ranking in case of liquidation of the issuer.
Junior/Subordinated bonds – junior bonds are unsecured securities which are paid only after senior bond have been paid off. In case of liquidation and assets are insufficient to cover all liabilities, it’s the junior bonds which carry higher risk of default.
Senior/Unsubordinated bonds – Senior bonds are bonds which have high priority and must be paid first before other level priority debts are honored. They are mostly secured by the borrower’s assets.
Redemption Features – Bonds may also be classified by the following features:
Callable – Callable bonds give the issuer the right to pay off the bond before the maturity date, usually with 10 to 30 days’ notice. This is the “call,” or redemption, feature. A callable bond permits the issuer to refinance or re-issue the bond. This is an advantage to the issuer when current interest rates are lower than the interest rate of the original bond.
Convertible – A convertible bond can be exchanged for common shares of the issuer. This is called the conversion privilege.
Conversion can occur until the conversion privilege ends.
Investors accept a slightly lower yield in exchange for the conversion feature.
In case of a stock split, the conversion privilege is adjusted to reflect the effects of the split.
The conversion feature benefits issuers and investors.
Issuers:
Can borrow at a lower cost and issue equity on better terms than by selling common shares.
Do not necessarily have to pay interest that has accrued since the last interest payment date. Instead, on conversion, the holder receives dividends declared and paid after the conversion date.
Can call the issue, since most convertibles are callable.
Investors:
Have the safety and income of a bond.
Have the option to convert into common shares, with a potential increase in their value. For this reason, convertible debentures are known as two-way securities.
Puttable feature – Puttable bond (put bond, puttable or retractable bond) is a bond that gives the holder of the right, but not the obligation, to demand early repayment of the principal. The put option is exercisable on one or more specified dates.
A retractable bond is issued as a long-term bond in which the debt can be retracted to an earlier date, called the retraction date. Thus, a retractable bond is a long-term bond that can be made into a short-term bond.
On the opposite side, an extendible bonds and debentures are short term, but the investor has the option to extend the debt (by the extension date) to a longer term, in return for the same (or slightly higher) rate of interest. Bonds with an extendible feature change from short-term bonds to long-term bonds.
Debentures: A debenture is a type of bond that is secured by a non-physical asset (e.g. the issuer’s credit rating). In practice, debentures are referred to as bonds, except where the distinction is important.
Most debentures are issued by creditworthy corporations that can sell their bonds for a low yield without pledging collateral. However, some debentures are issued by companies that have already issued mortgage bonds or have already pledged much of their property for loans. These debentures are subordinated to the secured credit.
To make their bonds more saleable, less creditworthy corporations include a number of provisions in the indenture to protect the holders of the debentures. For instance, the issuer may be required to maintain a net working capital that is at least as great as the amount of debentures outstanding. Or the issuer may not be able to pay more than a certain percentage of its current earnings in the form of stock dividends. If the company has no pledged property, then it may guarantee that the owners of the debentures will have a security interest in the company’s property that is at least as great as any secured creditors in the future.
Money-market funds: Money market is the market for buying and selling short-term loans and securities. The buyer of the money market instrument is the lender of money and the seller is the borrower of money.
Capital markets are the other part of the financial markets, which consists of longer term or riskier securities, such as stocks, bonds, currencies, and derivatives.
The main function of the money markets is to provide liquidity, so that those who have it can earn interest on it and those who need it can get it by paying the interest.
Money market instruments can be negotiable or non-negotiable. Negotiable money market instruments, such as commercial paper or negotiable certificates of deposit, can be traded in secondary markets; nonnegotiable money market instruments cannot be traded, so there is no secondary marketplace and must be held until maturity, such as interbank loans, repos, and federal funds.
A few money market instruments — certificates of deposit, federal funds, and repurchase agreements — are add-on instruments that are sold at par value: interest is added on to the principal when the loan is repaid.
Treasury bills are issued by the government and have terms of 30, 91, or 182 days, and are virtually free of credit risk. They are the most actively traded money market securities with very low bid/ask spreads due to their liquidity, and they are also exempt from state or municipal taxes. Retail investors can buy T-bills directly from the Treasury.
Mortgages: A mortgage bond provides the bondholders with a 1st lien on the corporate property. A lien, in this case, gives the bondholders the right to sell the property if the corporation defaults on its payments. Even if a corporation does default, the corporate trustee, who represents the interests of bondholders, rarely has to seize property and sell it for the benefit of bondholders. Most often, the company reorganizes and arranges other means of paying the bondholders, since the lien gives it a strong incentive to satisfy the claims of the bondholders.
Mortgage bonds are often issued as a means of continuous financing and expansion because it is cheaper than issuing new stock, and ownership interest is not diluted. To reduce costs and time to issuance, mortgage bonds are usually issued as a series of bonds that have the same indenture and have the same claim to property. As each issue matures, another issue based on the same mortgage—called a blanket mortgage—is issued. If property is sold or released from the mortgage, either other property is substituted or some bonds are retired to maintain the adequacy of the collateral.
There are some common indenture provisions designed to protect the bondholders even more. The after-acquired clause stipulates that property acquired after the 1st lien will also be subject to the lien. Additional issues cannot be more than 60% of the secured property value acquired after the 1st lien.
Another common clause is that earnings of the period preceding a new issue must be greater than some specified multiple of the annual interest paid on all bonds.
The indentures of most mortgage bonds allow additional bonds to be issued to replace retired bonds.
Some bonds are backed by 2nd or 3rd mortgages and are indicated by a variety of names: first and consolidated, first and refunding, and general and refunding mortgage bonds. Although some of these bonds have a 1st lien on property, much of the collateral is subordinated to bonds based wholly on 1st liens. Consequently, these bonds generally pay a higher yield and have a greater credit risk.
Preferred shares. A preferred share is considered a hybrid security, or even as a form of mezzanine debt – in between debt and equity. Althought it’s considered as a stock, in terms of sharing in dividend distribution, it imposes a legal obligation of repayment on the corporation.
In addition, preferrence shareholders have no ownership rights and rank above the common equity holders in case of liquidation of the corporation.
On the other hand, preferred shares lack the strict legal sense of a debt due to their perpentual nature among other features as discussed below:
Dividends, equivalent to interest payments, are paid quarterly instead of semi-annually.
Preferred stock is issued in smaller denominations—usually $25 or $100, although some issues can have much larger denominations.
Dividend payments can be suspended when the company is financially distressed.
Because dividends are a distribution of a company’s earnings — not the payment of interest — the payments cannot be deducted from the company’s taxes.
Most preferreds have no stated maturity; thus, they are sometimes referred to as a perpetuity.
The specific features of preferred stock are specified in the preferred stock contract.