Title LM01 Fixed-Income Instrument Features IFT Notes.pdf ✅

LM01 Fixed-Income Instrument Features 2025 Level I Notes © IFT. All rights reserved 1 LM01 Fixed-Income Instrument Features 1. Introduction ........................................................................................................................................................... 2 2. Features of Fixed-Income Securities ............................................................................................................ 2 3. Bond Indentures and Covenants ................................................................................................................... 5 Summary ...................................................................................................................................................................... 8 Required disclaimer: IFT is a CFA Institute Prep Provider. Only CFA Institute Prep Providers are permitted to make use of CFA Institute copyrighted materials which are the building blocks of the exam. We are also required to create / use updated materials every year and this is validated by CFA Institute. Our products and services substantially cover the relevant curriculum and exam and this is validated by CFA Institute. In our advertising, any statement about the numbers of questions in our products and services relates to unique, original, proprietary questions. CFA Institute Prep Providers are forbidden from including CFA Institute official mock exam questions or any questions other than the end of reading questions within their products and services. CFA Institute does not endorse, promote, review or warrant the accuracy or quality of the product and services offered by IFT. CFA Institute®, CFA® and “Chartered Financial Analyst®” are trademarks owned by CFA Institute. © Copyright CFA Institute Version 1.0
LM01 Fixed-Income Instrument Features 2025 Level I Notes © IFT. All rights reserved 2 1. Introduction This learning module introduces the features of fixed income instruments and the legal contracts that govern them. 2. Features of Fixed-Income Securities Fixed-income instruments, such as loans and bonds, are debt instruments that represent a contractual agreement in which an issuer borrows money from investors in exchange for interest and future repayment of principal. Basic Features of a Bond The basic features of a fixed-income security include: Issuer: Issuer is the entity that has issued the bond, or the one who has borrowed money. It is responsible for servicing the debt (paying interest and principal payments). Bonds can be classified into the following categories based on the type of the issuer:  Supranational organizations: Bonds issued by international organizations such as the World Bank and IMF.  Sovereign governments: Debt of national governments such as government of the United States, Germany, or Italy.  Non-sovereign governments: Bonds that are not issued by a national or central government. Instead, these are issued by states, provinces, municipalities, etc. For example, municipal bonds in the United States, etc.  Quasi-government entities: Bonds issued by agencies that are financed either directly or indirectly by the government. They are also called sub-sovereign or agency bonds. For example, Ginnie Mae, Fannie Mae, and Freddie Mac in United States.  Companies: Bonds issued by a corporate. A distinction is often made between financial issuers and non-financial issuers. All bonds are exposed to credit risk. ‘Credit risk’ is the risk that interest and principal payments will not be made by the issuer as they come due. Credit rating agencies such as Moody’s and S&P assign a rating to issuers based on this risk. Bonds can be classified into two categories based on their creditworthiness:  Investment grade.  Non-investment grade, or high-yield or speculative bonds. Maturity: The maturity date is the date on which the issuer will redeem the bond by paying the outstanding principal amount. Once a bond has been issued, the time remaining until maturity is known as the tenor of the bond.  If original maturity is one year or less, the bond is called money market security.
LM01 Fixed-Income Instrument Features 2025 Level I Notes © IFT. All rights reserved 3  If original maturity is more than a year, the bond is called capital market security. Par value: Also known as face value, maturity value, or redemption value.  It is the principal amount that is repaid to bondholders at maturity.  If market price > par value, the bond is trading at a premium.  If market price < par value, the bond is trading at a discount.  If market price = par value, the bond is trading at par. Coupon rate and frequency: Coupon rate is the percentage of par value that the issuer agrees to pay to the bondholder annually as interest. It can be a fixed rate or a floating rate. The coupon frequency may be annual, semi-annual, quarterly, or monthly. Based on the frequency of coupon payments, we can classify bonds into the following:  Plain vanilla bond: It is the most basic type of bond with periodic fixed interest payments during the bond’s life and the principal paid on maturity.  Floating-rate bond or floating-rate notes or floaters: Unlike vanilla bonds, the interest rate of a floating-rate bond is not fixed. The coupon payments are based on a floating Market reference rate (MRR) at the start of the period. Some bonds specify the coupon rate as two components: a market reference rate, plus a spread. The coupon rate and coupon interest paid in every period change as the reference rate changes.  Zero-coupon bonds or pure discount bonds: Bonds that have only one payment at maturity. These are bonds that do not make a coupon payment over a bond’s life, and are sold at a discount (less than the par value) at issuance. At maturity, the investor receives the par value of the bond. Think of it as interest getting accumulated during the bond’s life and being paid at maturity for a zero-coupon bond. Seniority: A single borrower may issue bonds with different seniority rankings. Seniority ranking determines who gets paid first, or who has the first claim on the cash flows of the issuer, in the event of default/bankruptcy/restructuring. Senior debt has a priority over other debt claims. Junior or subordinated debt has a lower priority and is paid only once the senior claim are satisfied. Contingency provisions: A contingency provision is a clause in a legal document that allows for some action if the event or circumstance does occur. It is also called an embedded option. The most common contingency provisions for bonds are: call, put, and conversion options. Yield Measures There are two widely used yield measures to describe a bond: current yield and yield to
LM01 Fixed-Income Instrument Features 2025 Level I Notes © IFT. All rights reserved 4 maturity. Current yield or Running yield Current yield is the annual coupon divided by the bond’s price and is expressed as a percentage. For example, consider a three-year, annual coupon bond with a par value of $100. The bond is issued at $95. The coupon rate is 10%, so the coupon payments are $10 every year. Current yield = 10 95 = 10.5% Yield to Maturity (YTM) Yield to maturity is the internal rate of return on a bond’s expected cash flows. In other words, it is the expected annual rate of return an investor will earn if the bond is held to maturity. It is also known as ‘yield to redemption’ or ‘redemption yield’. The IRR can be calculated easily using the financial calculator. Let us consider the same bond as in the current yield example: Input these values: CF0 = -95; CF1 = 10; CF2 = 10; CF3 = 110. Computing for IRR, you should get 12.08%. As you can see, YTM is higher than the coupon rate. For a discount bond such as this one, the YTM is higher than the coupon rate. A bond’s price is inversely related to its yield to maturity. Yield Curves The yield curve plots the YTMs of bonds on the y-axis versus maturity on the x-axis. Exhibit 4 from the curriculum shows a sample yield curve. This curve is constructed using six bonds issued by a single corporation. As seen in the graph, bonds with longer maturities have higher YTMs, indicating that investors are demanding higher expected returns to compensate for higher risk associated