Equity Linked Notes

An Equity Linked Note (ELN) is a debt instrument, usually a bond, that differs from a standard fixed-income security in that the final payout is based on the return of the underlying equity, which can be a single stock, basket of stocks or an equity index. A typical ELN is principal-protected, i.e. the investor is guaranteed to receive 100% of the original amount invested at maturity, but pays no interest.
Usually the final payout is the amount invested, times the gain in the underlying stock or index, times a note-specific participation rate (which can be more or less than 100%). For example, if the underlying equity gains 50% during the investment period and the participation rate is 80%, the investor receives 1.40 dollars for each dollar invested. If the equity remains unchanged or declines, the investor still receives one dollar per dollar invested (as long as the issuer does not default). Generally, the participation rate is better in longer maturity notes, since the total amount of interest given up by the investor is higher.
Equity linked note can be thought as a combination of a zero coupon bond and an equity option. Indeed, the issuer of the note usually covers the equity payout liability by purchasing an identical option. In some equity linked notes, the payout structure is more complicated, resembling an exotic option.
Most equity linked notes are not actively traded on the secondary market and are designed to be kept to maturity. However, the issuer or arranger of the notes may offer to buy back the notes. Unlike the maturity payout, the buy-back price before maturity may be below the amount invested.

Cross Currency Swap

CROSS CURRENCY SWAP
DESCRIPTION
Similar to an Interest Rate Swap but where each leg of the swap is denominated in a different currency. A Cross Currency Swap therefore has two principal amounts, one for each currency. Normally, the exchange rate used to determine the two principals is the then prevailing spot rate although for delayed start transactions, the parties can either agree to use the forward FX rate or agree to set the rate two business days prior to the start of the deal. With an Interest Rate Swap there is no exchange of principal at either the start or end of the transaction as both principal amounts are the same and therefore net out. For a Cross Currency Swap it is essential that the parties agree to exchange principal amounts at maturity. The exchange of principal at the start is optional (see Corporate example below).
Like all Swaps, a Cross Currency Swap can be replicated using on-balance-sheet instruments, in this case loan and deposits in different currencies. This explains the necessity for principal exchanges at maturity as all loans and deposits also require repayment at maturity. While the corporate or investor counterparty can elect not to exchange principal at the start, the bank needs to. This initial exchange can be replicated by the bank by entering into a spot exchange transaction at the same rate quoted in the Cross Currency Swap.
Loosely speaking, all foreign exchange forwards can be described as Cross Currency Swaps as they are agreements to exchange two streams of cashflows (in this case a stream of one!) in different currencies. Many banks manage Long Term Foreign Exchange Forwards as part of the Cross Currency Swap business given the similarities. Like all FX Forwards, the Cross Currency Swap exposes the user to foreign exchange risk. The swap leg the party agrees to pay is a liability in one currency, and the swap leg they have agreed to receive, is an asset in the other currency.
One of the major market users for Cross Currency Swaps are Debt issuers, particularly in the Euro-markets where issuers sell bonds in the "cheapest" currency and swap their exposure to their desired currency (see Pricing).
A Cross Currency Swap where both legs are floating rate is part of the Basis Swap product family. Cross Currency Swaps are also known as a CIRCA (a Currency and Interest Rate Conversion Agreement).
EXAMPLE
Investor
A fund manager is seeking to purchase 3 yr DEM assets with a minimum credit rating of AA and a yield in excess of LIBOR plus 12. A review of the DEM Floating Rate Note market and even the DEM fixed rate bond market swapped into floating rate using an Asset Swap, shows that no such assets exist in reasonable volume. A 3 yr GBP AA rated Corporate bond can be purchased at a yield of GBP LIBOR plus 18bp for a total price of GBP 10,000,000. The prevailing exchange rate is 2.50. The fund manager can purchase the bond for GBP10,000,000 and simultaneously enter into a Cross Currency Swap agreeing to pay GBP LIBOR plus 18bp and receive DEM LIBOR plus 15bp (see Pricing for an explanation of the price differential). The spot rate is set at 2.50 and the fund manager elects to exchange principal at the start.
The initial cashflows are as follows:

Investor buys bond:
-GBP 10,000,000
Cross Currency Swap:
+GBP 10,000,000

-DEM 25,000,000

The swap agreement nets out the initial GBP flow and replaces it with an equivalent DEM flow. Over the life of the bond, the fund manager pays the GBP coupons (LIBOR plus 18bp) to the bank counterparty and receives DEM LIBOR plus 15bp. At maturity, the following flows occur irrespective of the prevailing exchange rate:

Bond Redeems to Investor:
+GBP 10,000,000
Cross Currency Swap:
-GBP 10,000,000

-DEM 25,000,000

Again, the GBP bond flows are cancelled out by the swap flows leaving a DEM redemption to the investor. By using the Cross Currency Swap the fund manager has created a synthetic DEM Floating Rate Asset.
The fund manager does not wear any currency exposure as the currency exposure created by the swap (i.e. de asset, GBP liability) is offset by the currency exposure created by the purchase of the GBP bonds (i.e. GBP asset), leaving a net position only in the base currency of DEM. Of course, the investor bears the full credit risk of the underlying bond and should the bond default, the investor is still obliged to make all remaining payments under the swap or reverse the swap at its then book value.
Issuer
A New Zealand company is looking to raise NZD 100 million by issuing 10 year bonds. In the New Zealand domestic market, it would issue at a yield of LIBOR plus 25bp. Alternatively it can issue in Australia where there is a shortage of quality bonds, at a yield of 7.50%. It can then enter into a 10 year Cross Currency Swap for a notional amount of NZD 100 million agreeing to receive AUD 7.50% and pay NZD LIBOR plus 20bp (see Pricing). The prevailing spot rate is 1NZD = 0.90AUD. The initial cashflows are as follows:
Company issues bond:
+AUD 90,000,000
Cross Currency Swap:
-AUD 90,000,000

+NZD 100,000,000
The swap agreement nets out the initial AUD flow and replaces it with an equivalent NZD flow which the company can use to fund its operations as planned. Over the life of the bond, the company receives the AUD coupons from the bank counterparty that it owes to the bond investors, and pays instead NZD LIBOR plus 20bp.
At maturity, the company will receive the AUD bond principal amount it owes the Bond investors from the swap counterparty, and in return is required to pay NZD 100 million irrespective of the then spot rate. Using the Cross Currency Swap, the company has created a synthetic NZD liability.
Corporate
A multinational company uses USD as its base currency. The company has assets denominated in many different currencies, but the Board or Directors is particularly concerned about the assets denominated in Spanish Peseta, which represent over 20% of the company. While the assets are intended to be held for the long term the Board is concerned that any fluctuations in the spot rate will lead to an increase in the volatility of earnings. In total, there are ESP 120bn Spanish assets with no corresponding ESP liabilities. The majority of company liabilities are denominated in USD. The currency exchange rate is 1USD = 120ESP. The company has considered raising ESP debt in the Spanish market and repaying USD debt as a way to hedge this exposure, however the company is not well known in Spain and would need to pay LIBOR plus 45bp in order to do so. Alternatively, the company can enter into a Cross Currency Swap as follows:
ESP Principal:
ESP 120 billion
USD Principal:
USD 1 billion
Tenor:
10 years (to match the long term nature of the assets)
Company pays:
ESP LIBOR plus 5 bp
Company receives:
USD LIBOR
In this situation, the company would like to create a synthetic ESP liability to offset the ESP assets it owns. There is no new requirement to generate cash and so the company elects not to exchange principal at the start of the deal, so there are no initial cashflows. In effect, the company has transferred some of its USD liabilities into ESP liabilities to offset the ESP assets it owns and thereby reduce its currency exposure. From this point on, any currency loss on the assets will be offset by a corresponding currency gain on the Cross Currency Swap. In this example, the Cross Currency Swap has been used as an effective Foreign Exchange hedge much like the use of an FX forward contract.
PRICING
The pricing in a Cross Currency Swap reflect that level where the market is indifferent to receiving the cashflows on either leg (see Pricing section in Interest Rate Swap). Each leg of the swap can be considered on its own. At the inception of the swap, the present value of one leg (which is calculated using the prevailing zero coupon yield curve for that currency) must be equal to the present value of the other leg at the then prevailing spot rate. Using this simple logic, it would seem natural that a stream of LIBOR flat payments in one currency could be exchanged for a stream of LIBOR flat payments in another currency. This is not always true and the reason is generally a simple case of supply and demand. Where there is excessive demand for Cross Currency Swaps between two particular currencies (or FX Forwards for that matter), the price will tend to rise, and vice versa. This may or may not be to the advantage of the swap user. In general, the price difference is limited to plus or minus 10bp.
Like FX forwards, three things influence the price and value of a Cross Currency Swap:
(a) The yield on currency one(b) The yield in currency two(c) The spot exchange rate
TARGET MARKET
There are three clear target markets:
(a) Investors who wish to purchase foreign assets but seek to eliminate foreign currency exposure(b) Debt issuers who can achieve more favourable rates by issuing debt in foreign currency(c) Liability managers seeking to create synthetic foreign currency liabilities
ADVANTAGES
Off Balance Sheet
Can be cheaper than the cash markets (i.e. issuing foreign currency bonds directly)
Can elect to exchange principal at the start if desired
Simple documentation compared to cash markets (i.e. issuing a bond, arranging a loan)
Can be customised
Can be reversed at any time (albeit at a cost or benefit)
DISADVANTAGES
Unlimited loss potential
PRODUCT SUITABILITY
Simple Defensive/Simple Aggressive

Currency Swap - Part 2

A currency swap is a form of swap. It is most easily understood by comparison with an interest rate swap. An interest rate swap is a contract to exchange cash flow streams that might be associated with some fixed income obligations—say swapping the cash flows of a fixed rate loan for those of a floating rate loan. A currency swap is exactly the same thing except, with an interest rate swap, the cash flow streams are in the same currency. With a currency swap, they are in different currencies.
That difference has a practical consequence. With an interest rate swap, cash flows occurring on concurrent dates are netted. With a currency swap, the cash flows are in different currencies, so they can't net. Full principal and interest payments are exchanged without any form of netting.
Suppose the spot JPY/USD exchange rate is 109 JPY per USD. Two firms might enter into a currency swap to exchange the cash flows associated with
a five-year USD 100MM loan at 6-month USD Libor, and
a five year JPY 10,900MM loan at a fixed 3.15% semiannual rate.
All cash flows associated with those loans are paid:
initial receipt/payment of loaned principal,
payment/receipt of interest (in the same currency) on that loan,
ultimate return/recovery of the principal at the end of the loan.
Vanilla currency swaps are quoted both for fixed-floating and floating-floating (basis swap) structures. Fixed-floating swaps are quoted with the interest rate payable on the fixed side—just like a vanilla interest rate swap. The rate can either be expressed as an absolute rate or a spread over some government bond rate. The floating rate is always "flat"—no spread is applied. Floating-floating structures are quoted with a spread applied to one of the floating indexes.
Currency swaps can be used to exploit inefficiencies in international debt markets. Suppose a corporation needs an AUD 100MM loan, but US-based lenders are willing to offer more favorable terms on a USD loan. The corporation could take the USD loan and then find a third party willing to swap it into an equivalent AUD loan. In this manner, the firm would obtain its AUD loan but at more favorable terms than it would have obtained with a direct AUD loan. That advantage must, of course, be balanced against the transaction costs, pre-settlement risk and settlement risk associated with the swap. This is illustrated in Exhibit 1.


Swapping a USD Loan Into an AUD LoanExhibit 1


By entering into a swap with a third party, a corporation can convert an USD loan into an AUD loan.
Just as a vanilla interest rate swap is equivalent to a strip of FRA's, a vanilla fixed-floating currency swap is equivalent to a strip of currency forwards.

Currency Swap

A currency swap is a foreign exchange agreement between two parties to exchange a given amount of one currency for another and, after a specified period of time, to give back the original amounts swapped.
Currency swaps can be negotiated for a variety of maturities up to at least 10 years. Unlike a back-to-back loan, a currency swap is not considered to be a loan by United States accounting laws and thus it is not reflected on a company's balance sheet. A swap is considered to be a foreign exchange transaction (short leg) plus an obligation to close the swap (far leg) being a forward contract.
Currency swaps are often combined with interest rate swaps. For example, one company would seek to swap a cash flow for their fixed rate debt denominated in US dollars for a floating-rate debt denominated in Euro. This is especially common in Europe where companies "shop" for the cheapest debt regardless of its denomination and then seek to exchange it for the debt in desired currency.

CURRENCY SWAPS
In a previous article, we laid out a brief overview of the interest rate swaps market: an exchange of cash flows predicated on two different pre-set interest rate indices for a prescribed schedule of payments. Interest rate swaps are in the same currency. Now, we can introduce currency swaps: interest rate swaps in different currencies involving the exchange of principal amounts at inception and at maturity.

THE EXCHANGE OF PRINCIPAL AT INCEPTION AND AT MATURITY
In an interest rate swap, we were concerned exclusively with the exchange of cash flows relating to the interest payments on the designated notional amount. However, there was no exchange of notional at the inception of the contract. The notional amount was the same for both sides of the currency and it was delineated in the same currency. Principal exchange is redundant.
However, in the case of a currency swap, principal exchange is not redundant. The exchange of principal on the notional amounts is done at market rates, often using the same rate for the transfer at inception as is employed at maturity.
For example, consider the US-based company ("Acme Tool & Die") that has raised money by issuing a Swiss Franc-denominated Eurobond with fixed semi-annual coupon payments of 6% on 100 million Swiss Francs. Upfront, the company receives 100 million Swiss Francs from the proceeds of the Eurobond issue (ignoring any transaction fees, etc.). They are using the Swiss Francs to fund their US operations.
[Why issue bonds in Swiss Francs? The only rationale for doing this is because there are investors with Swiss Franc funds who are looking to diversify their portfolios with US credits such as Acme's. They are willing to buy Acme's Eurobonds at a lower yield than Acme can issue bonds in the US. A Eurobond is any bond issued outside of the country in whose currency the bond is denominated.]

Because this issue is funding US-based operations, we know two things straightaway. Acme is going to have to convert the 100 million Swiss Francs into US dollars. And Acme would prefer to pay its liability for the coupon payments in US dollars every six months.
Acme can convert this Swiss Franc-denominated debt into a US dollar-like debt by entering into a currency swap with the First London Bank.
Acme agrees to exchange the 100 million Swiss Francs at inception into US dollars, receive the Swiss Franc coupon payments on the same dates as the coupon payments are due to Acme's Eurobond investors, pay US dollar coupon payments tied to a pre-set index and re-exchange the US dollar notional into Swiss Francs at maturity.
Acme's US operations generate US dollar cash flows that pay the US-dollar index payments.
Currency swaps are used to hedge or lock-in the value-added of issuing Eurobonds. They are often negotiated as part of the whole issuance package with the main issuing financial institution.
FLEXIBILITY
Currency swaps give companies extra flexibility to exploit their comparative advantage in their respective borrowing markets.
Interest rate swaps allow companies to focus on their comparative advantage in borrowing in a single currency in the short end of the maturity spectrum vs. the long-end of the maturity spectrum.
Currency swaps allow companies to exploit advantages across a matrix of currencies and maturities.
The success of the currency swap market and the success of the Eurobond market are explicitly linked.
EXPOSURE
Because of the exchange and re-exchange of notional principal amounts, the currency swap generates a larger credit exposure than the interest rate swap.
Companies have to come up with the funds to deliver the notional at the end of the contract. They are obliged to exchange one currency's notional against the other currency's notional at a fixed rate. The more actual market rates have deviated from this contracted rate, the greater the potential loss or gain.
This potential exposure is magnified with time. Volatility increases with time. The longer the contract, the more room for the currency to move to one side or other of the agreed upon contracted rate of principal exchange.
This explains why currency swaps tie up greater credit lines than regular interest rate swaps.
PRICING
We price or value currency swaps in the same way that we learned how to price interest rate swaps, using a discounted cash flow analysis having obtained the zero coupon version of the swap curves.
Generally, currency swaps transact at inception with a net present value of zero. Over the life of the instrument, the currency swap can go in-the-money, out-of-the-money or it can stay at-the-money.
CONCLUSION
Currency swaps allow companies to exploit the global capital markets more efficiently. They are an integral arbitrage link between the interest rates of different developed countries.
The future of banking lies in the securitization and diversification of loan portfolios. The global currency swap market will play an integral role in this transformation. Banks will come to resemble credit funds more than anything else, holding diversified portfolios of global credit and global credit equivalents with derivative overlays used to manage the variety of currency and interest rate risk.

Bearer Share

A stock certificate which is the property of whoever happens to be in possession of it at any given time. Accordingly, no record of ownership is maintained by the issuing company.


Bearer shares are corporation stock certificates which are owned simply by the person who holds them, the "Bearer".
When corporations first came into existence, most shares were bearer shares. If you wanted to protect your interest in the corporation, you had to protect your bearer share certificates. To protect against theft and fraud, corporations starting keeping a register of the owners of the bearer shares which were issued, and notice had to be sent to the secretary of the corporation to record the change in ownership. Eventually, the corporation's stock ledger determined ownership, and shares only facilitated the transfer of ownership (and, indeed, today few people ever see the stock shares they own). Eventually, most U.S. states even dropped the provisions allowing bearer shares.
But recently they have made a comeback, spurred on by the so-called asset protection sector and those seeking privacy. Nevada, for instance, has built a healthy incorporation industry because Nevada corporation law allows bearer shares.
And the offshore jurisdictions have always allowed bearer shares; indeed, almost all the offshore corporation providers presume that offshore corporations will be issued with bearer shares only (and often send our clients corporations with bearer shares even when we specifically request otherwise).
But does the fact that you can get a corporation with bearer shares both in the U.S. and in the offshore jurisdictions mean that you should use bearer shares? No -- except in very specific circumstances you should avoid them like the plague.
For bearer shares suffer from a couple of very serious defects.
Presumption of Ownership -- Asset Protection
Of course, most structures utilizing bearer shares are for tax avoidance/evasion (or as Denver attorney Barry Engel says, "avoision") purposes, and asset protection only plays a secondary role (if at all). However, sometimes bearer shares are utilized primarily for asset protection purposes.
In either case, this is discouraged. Our real-world experience both in attacking and defending bearer share structures is that judges eventually gravitate towards the position that if they can't figure out who owns the corporation, they will presume that the defendant owns the corporation -- then the bearer shares become counterproductive because the burden is on the defendant to prove that someone else owns the corporation.
The Upshot: You are much better off having some identifiable person own the corporation (even if only in a nominee capacity) than you are to have nobody own the corporation.
Presumption of Ownership -- Income Tax
The first horrible tax trap for bearer shares is the IRS's ability to make a jeopardy assessment that the entire value of a bearer instrument is income, if the IRS catches you in possession of the instrument and you have denied ownership.
For instance, let's assume that you make $10 million on a stock deal, and like a good taxpayer pay your capital gains tax in that year. But then -- because you fear divorce -- you take your $10 million and you put it into a Bahamas IBC which is owned by bearer shares. The $10 million grow to $20 million in a couple of years. Unfortunately, your wife gets into your safe deposit box, and the IRS finds out about the bearer shares. Under IRC 6867, the IRS simply taxes the entire amount (not just the growth) at 39.6% plus penalties. And you will probably spend the remaining amount for criminal defense attorneys to fight the subsequent charges of tax evasion.
Gift Taxes
The second horrible tax trap is this: Every time bearer shares are handed over to and from a U.S. person -- except for a bona fide sale for value -- gift taxes must be paid! And, of course, if there is a sale then capital gains taxes must be paid.
For example, let's say you have $10 million in the Bahamas IBC as set forth above. You think you are about to get divorced, so you give the shares to your brother to hold for awhile. In the divorce proceedings, you answer "no" when asked if you own any foreign stock interests. After the divorce proceedings are over, your brother gives the shares back to you. Easy enough, eh?
Not quite. From a federal gift tax standpoint, in approximate numbers here's what happened:
First, when you gave the bearer shares to your brother, you triggered a 55% gift tax, meaning that you now owe $5.5 million to Uncle Sam.
Second, when your brother gave the bearer shares back, he triggered a 55% gift tax (again on the $10 million value), meaning that he now owes $5.5 million to Uncle Sam.
Thus, your simple little transfer to your brother and back triggered a total of $11 million in federal gift tax liability to you and your brother -- meaning that you and your brother are now $1 million in the hole! Needless to say, you would have done much better to split the $10 million with your ex-spouse in the divorce proceedings.
And if you don't report and pay the taxes generated by handing these shares back-and-forth it is big-time tax evasion. So, if you hear someone talk about bearer shares, ask them whether giving the shares to someone triggers federal gift taxes. If they say either "no" or that they don't know, then they have sufficiently displayed their ignorance in this area such that you should be quickly running away from them.
Foreign Transaction Reporting
Additionally, the unreported transfer of bearer shares across the U.S. border can be argued to violate the Treasury Department requirements for transactions in excess of $10,000, i.e., if you hold bearer shares for a corporation having more than $10,000 in value, you must report the shares when you bring them into or take them out of the country, or else face steep fines and possible criminal penalties.
Bearer Shares Are A Tool
Notwithstanding the foregoing, bearer shares are a tool and in certain circumstances can serve their purposes. But they should be avoided most planning purposes, and when they are utilized the downside should be carefully discerned in advance.
Terms
Bearer SharesShares which are owned by and give all their rights to the holder (the "bearer"), which ownership is not recorded on the company's books. Because of their primary uses for money laundering and tax evasion, nearly all jurisdictions have abolished bearer shares in favor of registered shares, the ownership of which are recorded on the company's books so that physical issuance of the shares is in many ways superfluous.

No Par Value Shares

What is Par Value?
A business corporation must sell shares of stock in order to capitalize the corporation, that is, provide the corporation with its own capital, separate from the money of its owners. This separation provides part of the support for shielding the shareholders from personal liability for the debts and obligations of the corporation.
Shares of stock sold by the corporation represent proportionate ownership interests held by shareholders in the corporation. "Par value" is a dollar value assigned to shares of stock which is the minimum amount for which each share may be sold. There is no minimum or maximum value that must be assigned. Shares may also have "no par value," which means that the Board of Directors will assign a value to the stock below which the shares cannot be issued.
There is no minimum number of shares that must be authorized in the articles of incorporation. One or more shares may be authorized. However, the corporation may not sell more shares than it is authorized to issue and it must receive consideration in exchange for its shares.

What is no Par Value Stock?

Since par value more or less means the price to be paid for the shares when purchased from the corporation, no par value stock is stock for which no fixed price is set. This is usually the case in small corporations where the owners issue themselves a number of shares and simply infuse money in the corporation when needed.
Corporations issue no par stock for flexibility. If the corporation's stock has no par value, then there is no set "price" for the stock. In this case, the directors can raise the "price" of the stock when the corporation becomes more valuable. You see, with no par value stock, the directors decide how much must be paid for the stock each time it is issued to a shareholder.
Must Stock Have a Par Value?
No. Most often in a small business corporation the stock is called "no par value stock" which simply means that there is no set amount of payment required to purchase the stock of the corporation. Each time stock is issued, the directors will decide how much must be received for the shares.

What is the difference between "par" and "no par" stock ?
Par value stock has a stated value on its face. No par value stock has no stated value and its worth depends on what an investor is willing to pay.

More on Bond....Contd...

Duration and Bond Price Volatility
More than once throughout this tutorial, we have established that when interest rates rise, bond prices fall, and vice versa. But how does one determine the degree of a price change when interest rates change? Generally, bonds with a high duration will have a higher price fluctuation than bonds with a low duration. But it is important to know that there are also three other factors that determine how sensitive a bond's price is to changes in interest rates. These factors are term to maturity, coupon rate and yield to maturity. Knowing what affects a bond's volatility is important to investors who use duration-based immunization strategies, which we discuss below, in their portfolios.

Factors 1 and 2: Coupon rate and Term to Maturity If term to maturity and a bond's initial price remain constant, the higher the coupon, the lower the volatility, and the lower the coupon, the higher the volatility. If the coupon rate and the bond's initial price are constant, the bond with a longer term to maturity will display higher price volatility and a bond with a shorter term to maturity will display lower price volatility. Therefore, if you would like to invest in a bond with minimal interest rate risk, a bond with high coupon payments and a short term to maturity would be optimal. An investor who predicts that interest rates will decline would best potentially capitalize on a bond with low coupon payments and a long term to maturity, since these factors would magnify a bond's price increase. Factor 3: Yield to Maturity (YTM) The sensitivity of a bond's price to changes in interest rates also depends on its yield to maturity. A bond with a high yield to maturity will display lower price volatility than a bond with a lower yield to maturity, but a similar coupon rate and term to maturity. Yield to maturity is affected by the bond's credit rating, so bonds with poor credit ratings will have higher yields than bonds with excellent credit ratings. Therefore, bonds with poor credit ratings typically display lower price volatility than bonds with excellent credit ratings.

All three factors affect the degree to which bond price will change in the face of a change in prevailing interest rates. These factors work together and against each other. Consider the chart below:


So, if a bond has both a short term to maturity and a low coupon rate, its characteristics have opposite effects on its volatility: the low coupon raises volatility and the short term to maturity lowers volatility. The bond's volatility would then be an average of these two opposite effects.

Immunization
As we mentioned in the above section, the interrelated factors of duration, coupon rate, term to maturity and price volatility are important for those investors employing duration-based immunization strategies. These strategies aim to match the durations of assets and liabilities within a portfolio for the purpose of minimizing the impact of interest rates on the net worth. To create these strategies, portfolio managers use Macaulay duration.

For example, say a bond has a two-year term with four coupons of $50 and a par value of $1,000. If the investor did not reinvest his or her proceeds at some interest rate, he or she would have received a total of $1200 at the end of two years. However, if the investor were to reinvest each of the bond cash flows until maturity, he or she would have more than $1200 in two years. Therefore, the extra interest accumulated on the reinvested coupons would allow the bondholder to satisfy a future $1200 obligation in less time than the maturity of the bond.

Understanding what duration is, how it is used and what factors affect it will help you to determine a bond's price volatility. Volatility is an important factor in determining your strategy for capitalizing on interest rate movements. Furthermore, duration will also help you to determine how you can protect your portfolio from interest rate risk.

Convexity

For any given bond, a graph of the relationship between price and yield is convex. This means that the graph forms a curve rather than a straight-line (linear). The degree to which the graph is curved shows how much a bond's yield changes in response to a change in price. In this section we take a look at what affects convexity and how investors can use it to compare bonds.

Convexity and Duration
If we graph a tangent at a particular price of the bond (touching a point on the curved price-yield curve), the linear tangent is the bond's duration, which is shown in red on the graph below. The exact point where the two lines touch represents Macaulay duration. Modified duration, as we saw in the preceding section of this tutorial, must be used to measure how duration is affected by changes in interest rates. But modified duration does not account for large changes in price. If we were to use duration to estimate the price resulting from a significant change in yield, the estimation would be inaccurate. The yellow portions of the graph show the ranges in which using duration for estimating price would be inappropriate.


Furthermore, as yield moves further from Y*, the yellow space between the actual bond price and the prices estimated by duration (tangent line) increases.

The convexity calculation, therefore, accounts for the inaccuracies of the linear duration line. This calculation that plots the curved line uses a Taylor series, a very complicated calculus theory that we won't be describing here. The main thing for you to remember about convexity is that it shows how much a bond's yield changes in response to changes in price.


Properties of Convexity
Convexity is also useful for comparing bonds. If two bonds offer the same duration and yield but one exhibits greater convexity, changes in interest rates will affect each bond differently. A bond with greater convexity is less affected by interest rates than a bond with less convexity. Also, bonds with greater convexity will have a higher price than bonds with a lower convexity, regardless of whether interest rates rise or fall. This relationship is illustrated in the following diagram:


As you can see Bond A has greater convexity than Bond B, but they both have the same price and convexity when price equals *P and yield equals *Y. If interest rates change from this point by a very small amount, then both bonds would have approximately the same price, regardless of the convexity. When yield increases by a large amount, however, the prices of both Bond A and Bond B decrease, but Bond B's price decreases more than Bond A's. Notice how at **Y the price of Bond A remains higher, demonstrating that investors will have to pay more money (accept a lower yield to maturity) for a bond with greater convexity.

What Factors Affect Convexity?
Here is a summary of the different kinds of convexities produced by different types of bonds:

1) The graph of the price-yield relationship for a plain vanilla bond exhibits positive convexity. The price-yield curve will increase as yield decreases, and vice versa. Therefore, as market yields decrease, the duration increases (and vice versa).




2) In general, the higher the coupon rate, the lower the convexity of a bond. Zero-coupon bonds have the highest convexity.

3) Callable bonds will exhibit negative convexity at certain price-yield combinations. Negative convexity means that as market yields decrease, duration decreases as well. See the chart below for an example of a convexity diagram of callable bonds.

Remember that for callable bonds, which we discuss in our section detailing types of bonds, modified duration can be used for an accurate estimate of bond price when there is no chance that the bond will be called. In the chart above, the callable bond will behave like an option-free bond at any point to the right of *Y. This portion of the graph has positive convexity because, at yields greater than *Y, a company would not call its bond issue: doing so would mean the company would have to reissue new bonds at a higher interest rate. Remember that as bond yields increase, bond prices are decreasing and thus interest rates are increasing. A bond issuer would find it most optimal, or cost-effective, to call the bond when prevailing interest rates have declined below the callable bond's interest (coupon) rate. For decreases in yields below *Y, the graph has negative convexity, as there is a higher risk that the bond issuer will call the bond. As such, at yields below *Y, the price of a callable bond won't rise as much as the price of a plain vanilla bond.

Convexity is the final major concept you need to know for gaining insight into the more technical aspects of the bond market. Understanding even the most basic characteristics of convexity allows the investor to better comprehend the way in which duration is best measured and how changes in interest rates affect the prices of both plain vanilla and callable bonds.

Debt securities with a maturity shorter than one year are typically bills. Certificate of deposit or commercial paper are considered money market instruments.

Traditionally, the U.S. Treasury uses the word bond only for their issues with a maturity longer than ten years, and calls issues between one and ten year notes. Elsewhere in the market this distinction has disappeared, and both bonds and notes are used irrespective of the maturity. Market participants use bonds normally for large issues offered to a wide public, and notes rather for smaller issues originally sold to a limited number of investors. There are no clear demarcations.

Also bonds usually have a defined term, or maturity, after which the bond is redeemed whereas stocks may be outstanding indefinitely. An exception is a consol bond, which is a perpetuity, a bond with no maturity. Consols is a British government bond (gilt), dating originally from the 18th century. In 1752, the Chancellor of the Exchequer and Prime Minister Sir Henry Pelham converted all outstanding issues of redeemable government stock into one bond, Consolidated 3.5% Annuities, in order to reduce the coupon rate paid on the government debt.

Consols still exists today: in its current form as 2½% Consolidated Stock (1923 or after), it remains a small part of the UK Government’s debt portfolio. As the bond has a low coupon, there is little incentive for the government to redeem it. Unlike most gilts, which pay coupons semi-annually, because of its age Consols pays coupons four times a year. Also, as a result of its uncertain redemption date, it is typically treated as a perpetual bond.

A perpetuity is an annuity in which the periodic payments begin on a fixed date and continue indefinitely. It is sometimes referred to as a "perpetual annuity". Fixed coupon payments on permanently invested (irredeemable) sums of money are prime examples of perpetuities. Scholarships paid perpetually from an endowment fit the definition of perpetuity.

The value of the perpetuity is finite because receipts that are anticipated far in the future have extremely low present value (today's value of the future cash flows). Additionally, because the principal is never repaid, there is no present value for the principal. The price of a perpetuity is simply the coupon amount over the appropriate discount rate or yield, that is

indenture or covenants - a document specifying the rights of bond holders. In the U.S. federal and state securities and commercial laws apply to the enforcement of those documents, which are construed by courts as contracts. The terms may be changed only with great difficulty while the bonds are outstanding, with amendments to the governing document generally requiring approval by a majority (or super-majority) vote of the bond holders.

A Bermudan callable has several call dates, usually coinciding with coupon dates.

A Death Put an optional redemption feature on a debt instrument allowing the beneficiary of the estate of the deceased to put (sell) the bond (back to the issuer) in the event of the beneficiary's death or legal incapacitation. Also known as a "survivor's option".

An IMRU callable can only be purchased by buyers of the highest quality (in financial terms) and remains the highest quality and hardest to obtain bond on the market. Originally concieved by financial guru M.Last with the help of A.Thein and T.Gardner.

Asset-backed securities are bonds whose interest and principal payments are backed by underlying cash flows from other assets. Examples of asset-backed securities are mortgage-backed securities (MBS), collateralized mortgage obligations (CMO) and collateralized debt obligations (CDO).

Everything about Bonds

Priority
In addition to the credit quality of the issuer, the priority of the bond is a determiner of the probability that the issuer will pay you back your money. The priority indicates your place in line should the company default on payments. If you hold an unsubordinated (senior) security and the company defaults, you will be first in line to receive payment from the liquidation of its assets. On the other hand, if you own a subordinated (junior) debt security, you will get paid out only after the senior debt holders have received their share.

Yield and Bond Price

The general definition of yield is the return an investor will receive by holding a bond to maturity. So if you want to know what your bond investment will earn, you should know how to calculate yield. Required yield, on the other hand, is the yield or return a bond must offer in order for it to be worthwhile for the investor. The required yield of a bond is usually the yield offered by other plain vanilla bonds that are currently offered in the market and have similar credit quality and maturity.

The multiplication by 100 in the formulas below converts the decimal into a percentage, allowing us to see the percentage return:




So, if you purchased a bond with a par value of $100 for $95.92 and it paid a coupon rate of 5%, this is how you'd calculate its current yield:



Notice how this calculation does not include any capital gains or losses the investor would make if the bond were bought at a discount or premium. Because the comparison of the bond price to its par value is a factor that affects the actual current yield, the above formula would give a slightly inaccurate answer - unless of course the investor pays par value for the bond. To correct this, investors can modify the current yield formula by adding the result of the current yield to the gain or loss the price gives the investor: [(Par Value – Bond Price)/Years to Maturity]. The modified current yield formula then takes into account the discount or premium at which the investor bought the bond. This is the full calculation:



Now we must also account for other factors such as the coupon payment for a zero-coupon bond, which has only one coupon payment. For such a bond, the yield calculation would be as follows:

n = years left until maturity

Calculating Yield for Callable and Puttable Bonds
Bonds with callable or puttable redemption features have additional yield calculations. A callable bond's valuations must account for the issuer's ability to call the bond on the call date and the puttable bond's valuation must include the buyer's ability to sell the bond at the pre-specified put date. The yield for callable bonds is referred to as yield-to-call, and the yield for puttable bonds is referred to as yield-to-put.

Yield to call (YTC) is the interest rate that investors would receive if they held the bond until the call date. The period until the first call is referred to as the call protection period. Yield to call is the rate that would make the bond's present value equal to the full price of the bond. Essentially, its calculation requires two simple modifications to the yield-to-maturity formula:


Note that European callable bonds can have multiple call dates and that a yield to call can be calculated for each.

Yield to put (YTP) is the interest rate that investors would receive if they held the bond until its put date. To calculate yield to put, the same modified equation for yield to call is used except the bond put price replaces the bond call value and the time until put date replaces the time until call date.

For both callable and puttable bonds, astute investors will compute both yield and all yield-to-call/yield-to-put figures for a particular bond, and then use these figures to estimate the expected yield. The lowest yield calculated is known as yield to worst, which is commonly used by conservative investors when calculating their expected yield. Unfortunately, these yield figures do not account for bonds that are not redeemed or are sold prior to the call or put date.

Now you know that the yield you receive from holding a bond will differ from its coupon rate because of fluctuations in bond price and from the reinvestment of coupon payments. In addition, you are now able to differentiate between current yield and yield to maturity. In our next section we will take a closer look at yield to maturity and how the YTMs for bonds are graphed to form the term structure of interest rates, or yield curve.

Term Structure of Interest Rates - Yield Curve

The term structure of interest rates, also known as the yield curve, is a very common bond valuation method. Constructed by graphing the yield to maturities and the respective maturity dates of benchmark fixed-income securities, the yield curve is a measure of the market's expectations of future interest rates given the current market conditions. Treasuries, issued by the federal government, are considered risk-free, and as such, their yields are often used as the benchmarks for fixed-income securities with the same maturities. The term structure of interest rates is graphed as though each coupon payment of a noncallable fixed-income security were a zero-coupon bond that “matures” on the coupon payment date. The exact shape of the curve can be different at any point in time. So if the normal yield curve changes shape, it tells investors that they may need to change their outlook on the economy.

There are three main patterns created by the term structure of interest rates:

1) Normal Yield Curve: As its name indicates, this is the yield curve shape that forms during normal market conditions, wherein investors generally believe that there will be no significant changes in the economy, such as in inflation rates, and that the economy will continue to grow at a normal rate. During such conditions, investors expect higher yields for fixed income instruments with long-term maturities that occur farther into the future. In other words, the market expects long-term fixed income securities to offer higher yields than short-term fixed income securities. This is a normal expectation of the market because short-term instruments generally hold less risk than long-term instruments; the farther into the future the bond's maturity, the more time and, therefore, uncertainty the bondholder faces before being paid back the principal. To invest in one instrument for a longer period of time, an investor needs to be compensated for undertaking the additional risk.

Remember that as general current interest rates increase, the price of a bond will decrease and its yield will increase.


2) Flat Yield Curve: These curves indicate that the market environment is sending mixed signals to investors, who are interpreting interest rate movements in various ways. During such an environment, it is difficult for the market to determine whether interest rates will move significantly in either direction farther into the future. A flat yield curve usually occurs when the market is making a transition that emits different but simultaneous indications of what interest rates will do. In other words, there may be some signals that short-term interest rates will rise and other signals that long-term interest rates will fall. This condition will create a curve that is flatter than its normal positive slope. When the yield curve is flat, investors can maximize their risk/return tradeoff by choosing fixed-income securities with the least risk, or highest credit quality. In the rare instances wherein long-term interest rates decline, a flat curve can sometimes lead to an inverted curve.

3) Inverted Yield Curve: These yield curves are rare, and they form during extraordinary market conditions wherein the expectations of investors are completely the inverse of those demonstrated by the normal yield curve. In such abnormal market environments, bonds with maturity dates further into the future are expected to offer lower yields than bonds with shorter maturities. The inverted yield curve indicates that the market currently expects interest rates to decline as time moves farther into the future, which in turn means the market expects yields of long-term bonds to decline. Remember, also, that as interest rates decrease, bond prices increase and yields decline.

You may be wondering why investors would choose to purchase long-term fixed-income investments when there is an inverted yield curve, which indicates that investors expect to receive less compensation for taking on more risk. Some investors, however, interpret an inverted curve as an indication that the economy will soon experience a slowdown, which causes future interest rates to give even lower yields. Before a slowdown, it is better to lock money into long-term investments at present prevailing yields, because future yields will be even lower.


The Theoretical Spot Rate Curve
Unfortunately, the basic yield curve does not account for securities that have varying coupon rates. When the yield to maturity was calculated, we assumed that the coupons were reinvested at an interest rate equal to the coupon rate, therefore, the bond was priced at par as though prevailing interest rates were equal to the bond's coupon rate.

The spot-rate curve addresses this assumption and accounts for the fact that many Treasuries offer varying coupons and would therefore not accurately represent similar noncallable fixed-income securities. If for instance you compared a 10-year bond paying a 7% coupon with a 10-year Treasury bond that currently has a coupon of 4%, your comparison wouldn't mean much. Both of the bonds have the same term to maturity, but the 4% coupon of the Treasury bond would not be an appropriate benchmark for the bond paying 7%. The spot-rate curve, however, offers a more accurate measure as it adjusts the yield curve so it reflects any variations in the interest rate of the plotted benchmark. The interest rate taken from the plot is known as the spot rate.


The spot-rate curve is created by plotting the yields of zero-coupon Treasury bills and their corresponding maturities. The spot rate given by each zero-coupon security and the spot-rate curve are used together for determining the value of each zero-coupon component of a noncallable fixed-income security. Remember, in this case, that the term structure of interest rates is graphed as though each coupon payment of a noncallable fixed-income security were a zero-coupon bond.

T-bills are issued by the government, but they do not have maturities greater than one year. As a result, the bootstrapping method is used to fill in interest rates for zero-coupon securities greater than one year. Bootstrapping is a complicated and involved process and will not be detailed in this section (to your relief!); however, it is important to remember that the bootstrapping method equates a T-bill's value to the value of all zero-coupon components that form the security.

The Credit Spread
The credit spread, or quality spread, is the additional yield an investor receives for acquiring a corporate bond instead of a similar federal instrument. As illustrated in the graph below, the spread is demonstrated as the yield curve of the corporate bond and is plotted with the term structure of interest rates. Remember that the term structure of interest rates is a gauge of the direction of interest rates and the general state of the economy. Corporate fixed-income securities have more risk of default than federal securities and, as a result, the prices of corporate securities are usually lower, while corporate bonds usually have a higher yield.



When inflation rates are increasing (or the economy is contracting) the credit spread between corporate and Treasury securities widens. This is because investors must be offered additional compensation (in the form of a higher coupon rate) for acquiring the higher risk associated with corporate bonds.

When interest rates are declining (or the economy is expanding), the credit spread between Federal and corporate fixed-income securities generally narrows. The lower interest rates give companies an opportunity to borrow money at lower rates, which allows them to expand their operations and also their cash flows. When interest rates are declining, the economy is expanding in the long run, so the risk associated with investing in a long-term corporate bond is also generally lower.

Now you have a general understanding of the concepts and uses of the yield curve. The yield curve is graphed using government securities, which are used as benchmarks for fixed income investments. The yield curve, in conjunction with the credit spread, is used for pricing corporate bonds. Now that you have a better understanding of the relationship between interest rates, bond prices and yields, we are ready to examine the degree to which bond prices change with respect to a change in interest rates.

Duration

The term duration has a special meaning in the context of bonds. It is a measurement of how long, in years, it takes for the price of a bond to be repaid by its internal cash flows. It is an important measure for investors to consider, as bonds with higher durations carry more risk and have higher price volatility than bonds with lower durations.

For each of the two basic types of bonds the duration is the following:

1. Zero-Coupon Bond – Duration is equal to its time to maturity.

2. Vanilla Bond - Duration will always be less than its time to maturity.

Let's first work through some visual models that demonstrate the properties of duration for a zero-coupon bond and a vanilla bond.

Duration of a Zero Coupon Bond


The red lever above represents the four-year time period it takes for a zero-coupon bond to mature. The money bag balancing on the far right represents the future value of the bond, the amount that will be paid to the bondholder at maturity. The fulcrum, or the point holding the lever, represents duration, which must be positioned where the red lever is balanced. The fulcrum balances the red lever at the point on the time line at which the amount paid for the bond and the cash flow received from the bond are equal. The entire cash flow of a zero-coupon bond occurs at maturity, so the fulcrum is located directly below this one payment.

Duration of a Vanilla or Straight Bond
Consider a vanilla bond that pays coupons annually and matures in five years. Its cash flows consist of five annual coupon payments and the last payment includes the face value of the bond.


The moneybags represent the cash flows you will receive over the five-year period. To balance the red lever at the point where total cash flows equal the amount paid for the bond, the fulcrum must be farther to the left, at a point before maturity. Unlike the zero-coupon bond, the straight bond pays coupon payments throughout its life and therefore repays the full amount paid for the bond sooner.
Factors Affecting Duration
It is important to note, however, that duration changes as the coupons are paid to the bondholder. As the bondholder receives a coupon payment, the amount of the cash flow is no longer on the time line, which means it is no longer counted as a future cash flow that goes towards repaying the bondholder. Our model of the fulcrum demonstrates this: as the first coupon payment is removed from the red lever and paid to the bondholder, the lever is no longer in balance because the coupon payment is no longer counted as a future cash flow.


The fulcrum must now move to the right in order to balance the lever again:


Duration increases immediately on the day a coupon is paid, but throughout the life of the bond, the duration is continually decreasing as time to the bond's maturity decreases. The movement of time is represented above as the shortening of the red lever. Notice how the first diagram had five payment periods and the above diagram has only four. This shortening of the time line, however, occurs gradually, and as it does, duration continually decreases. So, in summary, duration is decreasing as time moves closer to maturity, but duration also increases momentarily on the day a coupon is paid and removed from the series of future cash flows - all this occurs until duration, eventually converges with the bond's maturity. The same is true for a zero-coupon bond

Duration: Other factors
Besides the movement of time and the payment of coupons, there are other factors that affect a bond's duration: the coupon rate and its yield. Bonds with high coupon rates and, in turn, high yields will tend to have lower durations than bonds that pay low coupon rates or offer low yields. This makes empirical sense, because when a bond pays a higher coupon rate or has a high yield, the holder of the security receives repayment for the security at a faster rate. The diagram below summarizes how duration changes with coupon rate and yield.

Types of Duration
There are four main types of duration calculations, each of which differ in the way they account for factors such as interest rate changes and the bond's embedded options or redemption features. The four types of durations are Macaulay duration, modified duration, effective duration and key-rate duration.

Macaulay Duration
The formula usually used to calculate a bond's basic duration is the Macaulay duration, which was created by Frederick Macaulay in 1938, although it was not commonly used until the 1970s. Macaulay duration is calculated by adding the results of multiplying the present value of each cash flow by the time it is received and dividing by the total price of the security. The formula for Macaulay duration is as follows:

n = number of cash flows t = time to maturity C = cash flow i = required yield M = maturity (par) value P = bond price

Fortunately, if you are seeking the Macaulay duration of a zero-coupon bond, the duration would be equal to the bond's maturity, so there is no calculation required.

Modified Duration
Modified duration is a modified version of the Macaulay model that accounts for changing interest rates. Because they affect yield, fluctuating interest rates will affect duration, so this modified formula shows how much the duration changes for each percentage change in yield. For bonds without any embedded features, bond price and interest rate move in opposite directions, so there is an inverse relationship between modified duration and an approximate 1% change in yield. Because the modified duration formula shows how a bond's duration changes in relation to interest rate movements, the formula is appropriate for investors wishing to measure the volatility of a particular bond. Modified duration is calculated as the following:

Effective Duration
The modified duration formula discussed above assumes that the expected cash flows will remain constant, even if prevailing interest rates change; this is also the case for option-free fixed-income securities. On the other hand, cash flows from securities with embedded options or redemption features will change when interest rates change. For calculating the duration of these types of bonds, effective duration is the most appropriate.

Effective duration requires the use of binomial trees to calculate the option-adjusted spread (OAS). There are entire courses built around just those two topics, so the calculations involved for effective duration are beyond the scope of this tutorial. There are, however, many programs available to investors wishing to calculate effective duration.



Key-Rate Duration
The final duration calculation to learn is key-rate duration, which calculates the spot durations of each of the 11 “key” maturities along a spot rate curve. These 11 key maturities are at the three-month and one, two, three, five, seven, 10, 15, 20, 25, and 30-year portions of the curve.

In essence, key-rate duration, while holding the yield for all other maturities constant, allows the duration of a portfolio to be calculated for a one-basis-point change in interest rates. The key-rate method is most often used for portfolios such as the bond-ladder, which consists of fixed-income securities with differing maturities. Here is the formula for key-rate duration:

Brady Bonds2

Brady bonds are dollar-denominated bonds, issued mostly by Latin American countries in the 1980s, named after U.S. Treasury Secretary Nicholas Brady.

History

Brady bonds were created in March 1989 in order to convert bonds issued by mostly Latin American countries into a variety or "menu" of new bonds after many of those countries defaulted on their debt in the 1980's. At that time, the market for sovereign debt was small and illiquid, and the standardization of emerging-market debt facilitated risk-spreading and trading. In exchange for commercial bank loans, the countries issued new bonds for the principal and, in some cases, unpaid interest. Because they were tradeable and came with some guarantees, in some cases they were more valuable to the creditors than the original bonds.

The key innovation behind the introduction of Brady Bonds was to allow the commercial banks to exchange their claims on developing countries into tradeable instruments, allowing them to get the debt off their balance sheets. This reduced the concentration risk to these banks.

The plan included two rounds. In the first round, creditors bargained with debtors over the terms of these new claims. Loosely interpreted, the options contained different mixes of "exit" and "new money" options. The exit options were designed for creditors who wanted to reduce their exposure to a debtor country. These options allowed creditors to reduce their exposure to debtor nations, albeit at a discount. The new money options reflected the belief that those creditors who chose not to exit would experience a capital gain from the transaction, since the nominal outstanding debt obligation of the debtor would be reduced, and with it the probability of future default. These options allowed creditors to retain their exposure, but required additional credit extension designed to "tax" the expected capital gains. The principal of many instruments was collateralized, as were "rolling interest guarantees," which guaranteed payment for fixed short periods. The first round negotiations thus involved the determination of the effective magnitude of discount on the exit options together with the amount of new lending called for under the new money options.

In the second round, creditors converted their existing claims into their choice among the "menu" of options agreed upon in the first round. The penalties for creditors failing to comply with the terms of the deal were never made explicit. Nevertheless, compliance was not an important problem under the Brady Plan. Banks wishing to cease their foreign lending activities tended to choose the exit option under the auspices of the deal.

By offering a "menu" of options, the Brady Plan permitted credit restructurings to be tailored to the heterogeneous preferences of creditors. The terms achieved under these deals indicate that debtors used the menu approach to reduce the cost of debt reduction. Furthermore, it reduced the holdout problem where certain shareholders have an incentive to not participate in the restructuring in hopes of getting a better deal.

The principal amount is usually but not always collateralized by specially issued U.S. Treasury 30-year zero-coupon bonds purchased by the debtor country using a combination of International Monetary Fund, World Bank, and the country's own foreign currency reserves. Interest payments on Brady bonds, in some cases, are guaranteed by securities of at least double-A-rated credit quality held with the Federal Reserve Bank of New York.

Countries that participated in the initial round of Brady bond issuance were Argentina, Brazil, Bulgaria, Costa Rica, Dominican Republic, Ecuador, Mexico, Morocco, Nigeria, Philippines, Poland, Uruguay.

Types

There are two main types of Brady bonds:

• Par bonds were issued to the same value as the original loan, but the coupon on the bonds is below market rate, principal and interest payments are usually guaranteed.
• Discount bonds were issued at a discount to the original value of the loan, but the coupon is at market rate, principal and interst payments are usually guaranteed.

Other, less common, types include front-loaded interest-reduction bonds (FLIRB), new-money bonds, debt-conversion bonds (DCB), and past-due interest bonds (PDI). Brady Bond negotiations generally involved some form of "haircut" - meaning that the value of the Bonds resulting from the restructurings was less than the face value of the claims before the restructurings. For Par Bonds, creditors kept the same face value, but received a below-market interest rate, while for Discount bonds, investors received a market interest rate on a lower bond face value.

Guarantees attached to Brady bonds include collateral to guarantee the principal, rolling interest guarantees, and value recovery rights. Not all Brady bonds will necessary have all of these forms of guarantee and the specifics will vary from issuance to issuance.

Current status

Although the Brady Bond process ended during the 1990s, many of the innovations introduced in these restructurings (call options embedded in the bonds, "stepped" coupons, Pars and Discounts) were retained in the later sovereign restructurings in, for example, Russia and Ecuador. Ecuador, in 1999, became the first country to default on its Brady bonds. In 2003, Mexico became the first country to retire its Brady debt.

Brady Bond

Brady bond

Definition

U.S. dollar-denominated bond issued by an emerging market, particularly those in Latin America, and collateralized by U.S. Treasury zero-coupon bonds. Brady bonds arose from an effort in the 1980s to reduce the debt held by less-developed countries that were frequently defaulting on loans. The bonds are named for Treasury Secretary Nicholas Brady, who helped international monetary organizations institute the program of debt-reduction. Defaulted loans were converted into bonds with U.S. zero-coupon Treasury bonds as collateral. Because the Brady bonds were backed by zero-coupon bonds, repayment of principal was insured. The Brady bonds themselves are coupon-bearing bonds with a variety of rate options (fixed, variable, step, etc.) with maturities of between 10 and 30 years. Issued at par or at a discount, Brady bonds often include warrants for raw materials available in the country of origin or other options.

What Are Corporate Actions?

When a publicly-traded company issues a corporate action, it is initiating a process that will bring actual change to its stock. By understanding these different types of processes and their effects, an investor can have a clearer picture of what a corporate action indicates about a company's financial affairs and how that action will influence the company's share price and performance. This knowledge, in turn, will aid the investor in determining whether to buy or sell the stock in question.

Corporate actions are typically agreed upon by a company's board of directors and authorized by the shareholders. Some examples are stock splits, dividends, mergers and acquisitions, rights issues and spin offs. Let's take a closer look at these different examples of corporate actions.

Stock Splits
As the name implies, a stock split (also referred to as a bonus share) divides each of the outstanding shares of a company, thereby lowering the price per share - the market will adjust the price on the day the action is implemented. A stock split, however, is a non-event, meaning that it does not affect a company's equity, or its market capitalization. Only the number of shares outstanding change, so a stock split does not directly change the value or net assets of a company.

A company announcing a 2-for-1 (2:1) stock split, for example, will distribute an additional share for every one outstanding share, so the total shares outstanding will double. If the company had 50 shares outstanding, it will have 100 after the stock split. At the same time, because the value of the company and its shares did not change, the price per share will drop by half. So if the pre-split price was $100 per share, the new price will be $50 per share.

So why would a firm issue such an action? More often than not, the board of directors will approve (and the shareholders will authorize) a stock split in order to increase the liquidity of the share on the market.

The result of the 2-for-1 stock split in our example above is two-fold: (1) the drop in share price will make the stock more attractive to a wider pool of investors, and (2) the increase in available shares outstanding on the stock exchange will make the stock more available to interested buyers. So do keep in mind that the value of the company, or its market capitalization (shares outstanding x market price/share), does not change, but the greater liquidity and higher demand on the share will typically drive the share price up, thereby increasing the company's market capitalization and value.

A split can also be referred to in percentage terms. Thus, a 2 for 1 (2:1) split can also be termed a stock split of 100%. A 3 for 2 split (3:2) would be a 50% split, and so on.

A reverse split might be implemented by a company that would like to increase the price of its shares. If a $1 stock had a reverse split of 1 for 10 (1:10), holders would have to trade in 10 of their old shares for one new one, but the stock would increase from $1 to $10 per share (retaining the same market capitalization). A company may decide to use a reverse split to shed its status as a "penny stock". Other times companies may use a reverse split to drive out small investors.

Dividends
There are two types of dividends a company can issue: cash and stock dividends. Typically only one or the other is issued at a specific period of time (either quarterly, bi-annually or yearly) but both may occur simultaneously. When a dividend is declared and issued, the equity of a company is affected because the distributable equity (retained earnings and/or paid-in capital) is reduced. A cash dividend is straightforward. For each share owned, a certain amount of money is distributed to each shareholder. Thus, if an investor owns 100 shares and the cash dividend is $0.50 per share, the owner will receive $50 in total.

A stock dividend also comes from distributable equity but in the form of stock instead of cash. A stock dividend of 10%, for example, means that for every 10 shares owned, the shareholder receives an additional share. If the company has 1,000,000 shares outstanding (common stock), the stock dividend would increase the company's outstanding shares to a total of 1,100,000. The increase in shares outstanding, however, dilutes the earnings per share, so the stock price would decrease.

The distribution of a cash dividend can signal to an investor that the company has substantial retained earnings from which the shareholders can directly benefit. By using its retained capital or paid-in capital account, a company is indicating that it can replace those funds in the future. At the same time, however, when a growth stock starts to issue dividends, the company may be changing: if it was a rapidly growing company, a newly declared dividend may indicate that the company has reached a stable level of growth that it is sustainable into the future.

Rights Issues
A company implementing a rights issue is offering additional and/or new shares but only to already existing shareholders. The existing shareholders are given the right to purchase or receive these shares before they are offered to the public. A rights issue regularly takes place in the form of a stock split, and can indicate that existing shareholders are being offered a chance to take advantage of a promising new development.

Mergers and Acquisitions
A merger occurs when two or more companies combine into one while all parties involved mutually agree to the terms of the merge. The merge usually occurs when one company surrenders its stock to the other. If a company undergoes a merger, it may indicate to shareholders that the company has confidence in its ability to take on more responsibilities. On the other hand, a merger could also indicate a shrinking industry in which smaller companies are being combined with larger corporations. For more information, see "What happens to the stock price of companies that are merging together?"

In the case of an acquisition, however, a company seeks out and buys a majority stake of a target company's shares; the shares are not swapped or merged. Acquisitions can often be friendly but also hostile, meaning that the acquired company does not find it favorable that a majority of its shares was bought by another entity.

A reverse merger can also occur. This happens when a private company acquires an already publicly-listed company (albeit one that is not successful). The private company in essence turns into the publicly-traded company to gain trading status without having to go through the tedious process of the initial public offering.Thus, the private company merges with the public company, which is usually a shell at the time of the merger, and usually changes its name and issues new shares.

Spin Offs
A spin off occurs when an existing publicly-traded company sells a part of its assets or distributes new shares in order to create a newly independent company. Often the new shares will be offered through a rights issue to existing shareholders before they are offered to new investors (if at all). Depending on the situation, a spin-off could be indicative of a company ready to take on a new challenge or one that is restructuring or refocusing the activities of the main business.

Conclusion
It is important for an investor to understand the various types of corporate actions in order to get a clearer picture of how a company's decisions affect the shareholder. The type of action used can tell the investor a lot about the company, and all actions will change the stock itself one way or another.