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Debt Securities Notes

Law Notes > Banking Law Notes

This is an extract of our Debt Securities document, which we sell as part of our Banking Law Notes collection written by the top tier of King's College London students.

The following is a more accessble plain text extract of the PDF sample above, taken from our Banking Law Notes. Due to the challenges of extracting text from PDFs, it will have odd formatting:

Terminology:
● Debt securities:
○ Tradable instruments.
○ Loans embodied in tradable instruments.
● Bonds:
○ Longer-term debt securities, usually in the range of 10 to 30 years or even longer.
○ May be secured or unsecured.
● Notes:
○ Shorter maturity, usually in the range of 1 to 10 years.
○ Floating interest rate.
○ Usually issued as part of a (securitisation) programme.
● Commercial papers:
○ 1 year or less.
Issuers and investors:
● Issuers:
○ Large public non-financial companies (that are often rated by Credit Rating
Agencies). This is because the process of issuing debt securities is pretty costly.
○ Financial institutions.
○ Governments (e.g. US Treasury bonds, UK gilts, German bunds, etc.).
○ Municipal entities.
● Investors:
○ Institutional investors (such as pension funds, insurance companies, etc.).
○ Bank and non-bank financial institutions (such as hedge funds).
○ Retail investors.
Wide Variety:
● Covenants and warranties tend to be less restrictive with debt securities than with loans.
○ Why is this so?
○ This is because debt securities are transferable and there is an active secondary market for them. It is much easier for investors to "exit" their investment.
○ Because of the sheer number of investors in, and the fundamentally liquid nature of, debt securities, the associated covenants and warranties must be standardised or it will otherwise be too cumbersome for these securities to be traded.
● Interest and payment structure:
○ Plain vanilla bonds. ■ Bearer's securities in the past: the cash flow rights to interest and principal passes together with the property in the paper itself.
■ There are small coupons that are detachable from the paper that each represent interest payments, and the paper itself represent payment of the principal.
■ C.f. the registered securities of today.
○ Zero coupon bonds.
■ I.e. no coupon payments; only a lump sum payment of the principal amount at the end.
■ E.g. Treasury bonds issued by the US government.
○ Coupon bonds.
○ Fixed or floating interest rate.
○ High-yield (junk) bonds.
■ They are usually contractually or structurally subordinated. They are riskier, and therefore carry a higher rate of return (and therefore the label of "high-yield").
■ Some of them are rated so poorly by rating agencies that they are considered "junk".
○ Loan notes.
○ Payment-in-kind notes.
■ Helps private equity companies to avoid capital gain tax hikes.
○ Perpetuities (i.e. consoles).
■ They never pay back the principal, but pay back the coupon rate indefinitely into the future.
■ They most closely resemble equity, and are oftentimes considered hybrid instruments.
● Redemption:
○ "Call option" for the issuer.
■ The issuer may use early redemption when interest rates go down,
and he can obtain the same capital more cheaply from other sources in the market.
○ "Put option" for the holder.
■ The bond holder is thereby entitled to force early redemption by the issuer.
■ They may use early redemption when interest rates go up, and they can obtain greater returns by lending to other sources.
● Security and subordination:
○ Asset-backed securities.
○ Securitisation.
○ Deep subordination.
● Hybrids: ○ Option to convert to, or to exchange into, equity.
○ Equity warrants.
○ Contingent convertible securities (CoCos).
■ They convert automatically into equity thereby recapitalise the financial institution in question. They are therefore regarded as additional Tier 1 capital.
■ That conversion is pegged to certain benchmarks, such that, if triggered, CoCos will automatically convert from debt into equity so as to (i) reduce the financial institution's debts and (ii) increase its equity cushion.
■ This helps the financial institution to meet the requirements regarding regulatory capital.
Bond prices and interest rates
● A bond specifies the fixed amounts to be paid and the exact dates of payment.
● E.g. £100 face value, 5% annual coupon bond with 5 year maturity.
○ 5% = Coupon yield.
○ Yield to maturity = The rate of return that the bondholder receives by holding the bond to maturity.
● What is the bond price if the discount rate is 4%, 5%, or 6%?
○ Discount rate is what we figure out through the CAPM formula.
○ It is the opportunity cost of incurred by us in investing our money in the bond.
○ P = 100/(1 + r)5 + 5∑j=15/(1 + r)j
■ P(4%) = 104.45
■ P(5%) = 100
■ P(6%) = 95.79
■ This means the, as the interest rate goes up, the opportunity cost goes up, and bond price goes down.
○ Some conclusions:
■ Rising bond prices means falling yields.
■ Falling bond prices means rising yields.
■ Bond price = face value; Coupon rate = yield to maturity.
● E.g. £100 face value, 5% annual coupon bond with 5 year maturity.
○ Coupon rate = yield to maturity.
○ Yield to maturity (interest rate) decreases/increases to 4%/6%.
○ Sell after one year.
● For what price can the bond be sold after 1 year?
○ After one year holding period, selling a 4-year bond:
P = 100/(1 + r)4 + 4∑j=15/(1 + r)j
○ P(4%) = 103.63

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