3.2 Fixed Income Characteristics & Pricing

Fixed Income Characteristics & Pricing

Quick Summary: A bond is a formal debt contract under which an issuer borrows capital and commits to regular coupon payments and principal repayment at maturity. Credit seniority dictates the recovery waterfall in liquidation, from senior secured debt down to hybrid Tier 1 CoCos. In secondary market trading, bonds are quoted at their clean price, but transaction settlement requires the buyer to pay the dirty price (clean price plus accrued interest calculated under specific market day count conventions).

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1. Core Elements of a Bond Contract

A bond is a negotiable debt instrument representing a legally binding loan agreement between the borrowing entity (issuer) and the creditor (bondholder). The terms of the loan are codified in an indenture or trust deed.

Essential Bond Parameters

• Par / Nominal / Face Value: The principal amount specified on the security, representing the baseline upon which coupon cash flows are calculated and the sum repaid at redemption. By convention, UK Gilts and European sovereign bonds are standardly quoted per £100 or €100 nominal, whereas US corporate bonds and Eurobonds are standardly denominated in $1,000 or £1,000 units.
• Maturity Date: The final date on which the bond contract terminates and the issuer must repay the outstanding principal. Maturities are classified into:
  • Short-dated: Less than 5 years
  • Medium-dated: 5 to 12 years
  • Long-dated: Greater than 12 years (up to 30 or 50 years)
• Redemption Variations:
  • Bullet Redemption: The entire principal is repaid in a single lump sum on the final maturity date (the standard structure for most sovereign and corporate debt).
  • Amortizing / Sinking Fund Bonds: The issuer repays portions of principal periodically across the bond's life, reducing final refinancing risk.
  • Perpetual / Undated Bonds: The bond has no fixed redemption date; coupons continue in perpetuity unless the issuer exercises a contractual redemption option (e.g., historical UK Consols or modern bank Additional Tier 1 instruments).

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2. Capital Structure Waterfall & Creditor Seniority

When a corporate borrower becomes insolvent, available liquidation proceeds are distributed according to an absolute priority rule. The position of an instrument in this seniority waterfall directly influences its default risk, credit spread, and expected recovery rate.

+-----------------------------------------------------------------------------------------+
|                         CREDITOR LIQUIDATION WATERFALL                                  |
+-----------------------------------------------------------------------------------------+
|  1. SENIOR SECURED DEBT        - First-lien mortgages, covered bonds, equipment trusts  |
|                                  (Pledged collateral; highest recovery: ~60-80%)        |
|  2. SENIOR UNSECURED DEBT      - Standard corporate debentures, Eurobonds               |
|                                  (General credit obligation; average recovery: ~40-50%) |
|  3. SUBORDINATED DEBT          - Junior debt, Tier 2 bank capital                       |
|                                  (Repaid only after senior debt satisfied: ~15-30%)     |
|  4. CONTINGENT CONVERTIBLES    - Additional Tier 1 (AT1 CoCos)                          |
|     (HYBRID CAPITAL)             (Contractual equity conversion or write-down triggers) |
|  5. PREFERRED SHARES           - Preference stock (Fixed dividend, priority over equity)|
|  6. ORDINARY SHARES (EQUITY)   - Common stock (Residual claim; absorbs first loss: ~0%) |
+-----------------------------------------------------------------------------------------+

Detailed Seniority Tiers

1. Senior Secured Debt: Creditors hold a direct legal charge or pledge over specific tangible assets (e.g., property, aircraft, physical infrastructure). Covered bonds represent a premier class of secured debt where investors have dual recourse: first to the issuing bank, and second to a dedicated, ring-fenced cover pool of high-quality public loans or residential mortgages.
2. Senior Unsecured Debt: Carries no collateral pledge but represents a prior claim on the firm's unencumbered cash flows ahead of all junior stakeholders. This is the deepest segment of the corporate bond market.
3. Subordinated (Junior) Debt: Creditors agree contractually to rank behind all senior debt. In liquidation, subordinated debtholders receive nothing until senior claimants are repaid in full. In banking, subordinated debt is structured as Tier 2 capital under Basel regulations to absorb losses gone-concern.
4. Additional Tier 1 (AT1) Contingent Convertibles (CoCos): Hybrid regulatory capital instruments created post-2008 to absorb losses going-concern. AT1s are perpetual with discretionary non-cumulative coupons. If the bank's Common Equity Tier 1 (CET1) capital ratio drops below a regulatory or contractual trigger (typically 5.125% or 7.00% CET1), the CoCo automatically absorbs losses through either mandatory conversion into ordinary equity or a permanent or temporary principal write-down.
5. Equity: Preference shares rank ahead of ordinary shares for dividends and winding-up proceeds, while common equity represents the ultimate residual risk capital.

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3. The Spectrum of Bond Issuers

Fixed income markets feature diverse issuing entities, each presenting unique credit characteristics:

Sovereign Debt

Sovereign bonds represent direct borrowing by national governments in their domestic currencies:

• United Kingdom Gilts: Issued by the UK Debt Management Office (DMO). Named historically from the gilt-edged physical paper certificates. Gilts represent the baseline risk-free benchmark curve for sterling.
• United States Treasuries: Issued by the US Department of the Treasury. Comprise Treasury Notes (T-Notes) with maturities of 2, 3, 5, 7, and 10 years, and Treasury Bonds (T-Bonds) with maturities of 20 and 30 years.
• German Bunds (Bundesanleihen): Issued by the Federal Republic of Germany. Bunds serve as the undisputed safe-haven and pricing benchmark for the entire Eurozone bond market.
• French OATs (Obligations Assimilables du Trésor): French sovereign bonds, highly liquid across Europe.
• Japanese Government Bonds (JGBs): Issued by Japan's Ministry of Finance, underpinning the yen debt market.

Supranationals and Quasi-Government Issuers

• Supranational Institutions: International financial institutions formed by two or more sovereign states to promote economic development. Prominent issuers include the World Bank (IBRD), the European Investment Bank (EIB), and the Asian Development Bank (ADB). Supranationals typically carry AAA ratings due to multilateral sovereign capital backing.
• Quasi-Government / Agency Bonds: Entities with varying degrees of state sponsorship or explicit guarantees. Examples include Fannie Mae and Freddie Mac in the US, KfW (Kreditanstalt für Wiederaufbau) in Germany, and Network Rail in the UK.

Sub-Sovereign and Corporate Issuers

• Municipal / Local Authority Debt: Issued by local councils, cities, or US states to finance public infrastructure. In the US, municipal bonds often enjoy federal tax-exempt status.
• Corporate Bonds: Issued by non-financial corporations and commercial banks. These carry credit default risk and trade at a yield spread over equivalent sovereign benchmarks.

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4. Coupon Structures & Variations

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5. Bond Quoting Conventions: Clean Price vs. Dirty Price

In fixed income markets, understanding the distinction between the price quoted on a trading terminal and the actual cash amount paid at settlement is critical.

+-----------------------------------------------------------------------------------------+
|                                BOND SETTLEMENT PRICING                                  |
+-----------------------------------------------------------------------------------------+
|                                                                                         |
|     DIRTY PRICE (Settlement Price)  =  CLEAN PRICE (Quoted Price)  +  ACCRUED INTEREST   |
|                                                                                         |
+-----------------------------------------------------------------------------------------+

• Clean Price: The market price of the bond excluding any accrued interest. Financial news, market data screens (Bloomberg, Reuters), and broker quotes display the clean price. Quoting clean prices prevents artificial price oscillations: if bonds were quoted dirty, a bond's price would appear to creep upward every day between coupon payments and then plunge overnight on the ex-dividend date, obscuring real underlying market movements.
• Dirty Price (Gross / Settlement Price): The total cash consideration paid by the buyer to the seller on the settlement date. It includes the clean price plus the accrued interest earned by the seller up to the settlement date.

The Rationale for Accrued Interest

Bond coupons are paid periodically (annually or semi-annually) to whoever is registered as the legal owner on the record date. If an investor owns a bond for five months of a six-month coupon period and then sells it, the incoming buyer will receive the entire six-month coupon payment from the issuer a month later. To ensure fair economic allocation, the buyer must reimburse the seller for the interest accrued during the five months the seller held the security.

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6. Accrued Interest Mechanics & Day Count Conventions

Accrued interest is computed using the following general formula:

$\text{Accrued Interest} = \text{Coupon Payment} \times \left( \frac{\text{Days Accrued since Last Coupon}}{\text{Days in Current Coupon Period}} \right)$

Where the coupon payment is the annual coupon for annual-paying bonds, or half the annual coupon for semi-annual bonds.

Day Count Conventions

The method used to calculate the number of days accrued and the total days in the period depends on the market convention of the instrument:

Step-by-Step Calculation Example

Consider an investor purchasing a corporate bond with the following characteristics:

• Nominal Amount: £100,000
• Coupon Rate: 6.00% paid semi-annually (3.00% per period, or £3.00 per £100)
• Day Count Convention: 30/360
• Last Coupon Payment Date: 15 March
• Settlement Date: 25 July
• Clean Quoted Price: 98.25

Step 1: Calculate Days Accrued under 30/360

• From 15 March to 15 July: 4 full months $\times$ 30 days = 120 days
• From 15 July to 25 July: 10 days
• Total accrued days = $120 + 10 = 130\text{ days}$
• Total days in semi-annual period under 30/360 = $180\text{ days}$

Step 2: Calculate Accrued Interest per £100 Nominal $\text{Accrued Interest} = £3.00 \times \left( \frac{130}{180} \right) = £3.00 \times 0.7222 = £2.1667$

Step 3: Calculate Dirty Price per £100 Nominal $\text{Dirty Price} = \text{Clean Price} + \text{Accrued Interest} = £98.25 + £2.1667 = £100.4167$

Step 4: Calculate Total Settlement Cash Outlay $\text{Total Settlement Cash} = \frac{£100,000}{100} \times £100.4167 = 1,000 \times £100.4167 = £100,416.70$

Ex-Dividend Trading & Negative Accrued Interest

In conventional gilt markets, a bond enters an ex-dividend period (typically 7 business days prior to the coupon payment date). If an investor purchases a gilt during this window, the upcoming coupon is paid to the original seller because the registry records have closed.

Because the buyer does not receive the upcoming coupon, the accrued interest calculation flips sign: the buyer receives a discount known as negative accrued interest (rebate interest). In an ex-dividend transaction:

$\text{Dirty Settlement Price} = \text{Clean Price} - \text{Rebate Interest}$

This ensures that the settlement price appropriately reflects the economic reality that the buyer must wait until the following coupon date to receive income.