CFA Level 1
Fixed Income Investments - Basic Coupon Structures
Make sure that you understand the various coupon rate structures that can be developed in the bond market. Let's discuss each in detail:
- Zero-Coupon Bonds - These instruments pay no interest to the holder and are issued at a deep discount. As the bond nears maturity, its price increases to reach par value. At maturity, the bondholder will receive the par price. The interest earned is the difference between the purchase price of the bond and what the holders receives at maturity.
- Step-up Notes - The interest rate of these bonds increases or "steps-ups" at a stated date(s). The rate may remain at this level until maturity and in this case would be considered a "single step-up note". Step-up notes can also have a series of rate increases and are then referred to as "multiple step-up notes".
- Deferred Coupon Bonds - A structure that essentially incorporates features of both a zero coupon bond and a coupon paying bond. These bonds typical do not pay interest for the first couple of years. After this period the cash interest accrues at a stated rate and is usually paid semi-annually to the bondholders. The coupon rate is typically higher than other issues in order to entice investors to purchase these issues. Companies in the high yield arena typically issue these bonds to conserve their cash flows in the earlier years of their business life.
- Floating-Rate Bonds - These bonds have coupon rates that reset at predetermined times. The rate is usually based on an index or benchmark with some sort of spread added or subtracted to the benchmark.
To find the coupon rate of floating rate bonds, all one has to find out is what the benchmark or reference rate is trading at and add or subtract the stated amount of basis points or other influencing variable. Let's take a closer look at the above example of the Federal Fund Floater:
Example: Floating Rate Security: Federal Funds
Assume the coupon rate of a floating-rate bond is based on the Federal Funds rate plus 25 basis points at three-month intervals. If the Federal Funds are at 3%, what would the coupon rate for this bond be?
Coupon rate = Reference Rate + influencing variable.
Coupon rate = 3% (Fed Funds) + 25 basis points.
Coupon rate = 3.25%
The coupon rate for this bond would be 3.25% until the next reset date. Floating- rate securities come in many forms. Other forms of floating-rate securities involve caps and floors; these are discussed in detail below.
Caps and Floors
Some floating-rate securities have restrictions placed on how high or how low the coupon rate can become.
Caps - state how high the coupon rate can go. Once it hits that level, there can be no further increase in the rate. Caps are less advantageous for investors because the rate can only keep pace with market rates up to a point. On the other hand, they protect the issuer by keeping the cost of borrowing below a certain level.
Referring back to our Federal Funds example, let's add a cap of 3.90 % and assume that Fed Funds are trading at 3.75%. What is the coupon rate?
Coupon rate = 3.75%(Fed Funds) + 25 basis points.
Coupon rate = 4.00%
Even though the formula states a 4% coupon should be paid this period, the cap holds the coupon at 3.90%.
- Floor - states how low a coupon rate can go. Once the coupon rate hits the floor, it can no longer decline beyond that point. Floors are more advantageous to investors because as rates continue to decrease, the investor is protected from that decrease at a stated point.
Now lets add a floor of 2% and assume that Fed Funds are trading at 1.50%
Answer: Coupon rate = 1.50% (Fed Funds) + 25 basis points
Coupon rate = 1.75%
Even though the formula states a 1.75% coupon should be paid, there is a 2% floor in place, which means that the investor will receive 2% instead of the 1.75% derived from the formula.
Accrued Interest and Price Terminology
- Accrued interest - the amount of interest that builds up in between coupon payments that will be received by the buyer of the bond when a sale occurs between these coupon payments, even though the seller of the bonds earned it.
- Full Price - is sometimes referred to as a bond's dirty price, which is the amount the buyer will pay the seller. It equals the negotiated price of the bond plus the accrued interest.
- Clean Price - is simply the price of the bond without the accrued interest.