Unit 4: Bonds

Student Workbook
Unit 4 Learning
Objective
Learning Outcomes
Chapter
Section
Understand the characteristics and terminology of bonds
Unit Aim: To understand the different • Coupon
types of bonds, their characteristics and the 4.1.1 • Redemption 2
• Nominal value
advantages and disadvantages of investing in
• Yields (covered in section 4.4)
bonds
Understand the definition and features of government types:
Relevance of this unit to the course: 4.2.1 • Types 3
Whilst this unit focusses on bonds, the Know the definitions and features of the following types of bond:
concepts of potential investment yield and • Domestic
risks of investing are transferrable to units 5, • Foreign
6, 7 and 10. • Eurobond
• Asset-backed securities including covered bonds
4.3.1 • Zero cupon 4
• Convertible
• Preferred
• Floating rate notes
• Medium term notes
• Permanent interest bearing shares
Know the potential advantages and disadvantages of investing in different
4.4.1 types of bonds 5

4.4.2 Be able to calculate the flat yield of a bond 5

Understand the role of credit rating agencies and the difference between
4.4.3 investment and non-investment grades
5
2
How to use this student workbook
Throughout this student workbook, look out for the different icons to support your learning:

Understand and learn – these sections will help you to develop your knowledge and
understanding of the assessed learning objectives.

Apply and practise – Practise and test your newly acquired learning by undertaking a range
of activities to help you prepare for the multiple choice assessment at the end of the course.

Further your knowledge – Consolidate your understanding of key concepts by reading and
interacting with current, credible resources to help further enhance your learning.

3
Introduction to bonds
Imagine you are going to borrow some money from
a friend on the condition that you pay interest on the
loan. Create an informal “IOU” (I owe you) agreement
for both parties. What information would you want to
include?

4
Module Learning Outcome 4.1
– Characteristics of bonds
4.1.1: Understand the characteristics and terminology of bonds
• Coupon • Redemption • Nominal value 5
What are bonds?
Watch the CISI video explaining bonds and Redemption date
summarise the following key terms discussed:

Nominal value

Coupon rate

6
Bond characteristics
Watch the basics of bonds video and read the section 3. What are bonds also known as?
about the characteristics of a bond in chapter 4 of
the course workbook. Now answer the following
questions:

1. Define a bond
4. D
 o bonds or equities form a larger part of the market in terms of
global investment value? Explain your answer.

2. What are the reasons for issuing bonds?

7
*CISI is not responsible for the accuracy, legality or content of any external sources referenced in this workbook
Bond characteristics – True or false?
True False

Bonds are loans used to raise money from banks

Bonds are tradable financial instruments

Bonds can also be known as fixed interest securities

A bond will always trade at its nominal or face value

Investors need to always refer to the original borrower before making an
investment in bonds
Bond prices respond to changes in interest rates
The nominal value of a bond is the amount that will be repaid on the
bond’s redemption date

8
Further your knowledge
– Bond types and characteristics
Complete the bond types and characteristics
micromodule (6 mins) on the CISI learning platform
in the professional refresher section.

9
Module Learning Outcome 4.2
– Government Bonds
4.2.1 – Understand the definition and features of government types:
• Types of government bonds 10
Government bonds
Watch the CISI YouTube video introducing 3. W
 hen tax revenues are lower, are governments more or less
likely to issue more bonds?
government bonds and answer the following
questions:

1. Why do governments issue bonds?

4. When interest rates increase, what happens to gilt prices?

2. Why are UK government bonds known as gilts?

11
Example of a UK government bond
1. What does the title of the bond tell you?
0.375% TREASURY STOCK, 2030

£10,000
2. What does “at par” mean?
Repayable at par on 7 December 2030
Coupons payable 7 June and 7 December

Price: £100.70
3. O
 n the example of the bond to the left, highlight and label:
Value £10,070.00
A. The coupon
B. The redemption date
C. The nominal value
D. The stock name

12
Types of government bonds
Read the section about the different types of government bonds in chapter 4 of the course
workbook and summarise the key features below

Conventional Bonds Index Linked Bonds

13
Conventional and index linked bonds
UK government bonds are also know as ‘gilts’. Read the section about different types of government
bonds in chapter 4 of the course workbook and answer the following questions:

1. Which type of gilt represents the majority of gilts in the UK? 3. When might index linked bonds be more attractive to investors?

2. How is the price of a conventional gilt quoted? 4. What does ‘Stripping a gilt’ mean?

14
Example of a UK government bond
3. How much interest does the bondholder receive on 7th June?
5% TREASURY STOCK, 2029
D
C
B
A
£10,000
D
C
B
A
Repayable at par on 7 December 2029
Coupons payable 7 June and 7 December
D
C
B
A 4. What is the convention for quoting prices of UK gilts?
Price: £101.25
Value £10,125.00
D
C
B
A
1. Identify and label the name of the
A. gilt
B. coupon rate
5. What do you notice about the value of the bond?
C. redemption date
D. nominal amount

2. How often is interest normally paid on UK gilts?

15
Further your knowledge
The Debt Management Office (DMO) issues UK
government bonds on behalf of the government.
To extend your learning and learn more about
government bonds visit the DMO website:

*CISI is not responsible for the accuracy, legality or content of any

16
external sources referenced in this workbook
Module Learning Outcome 4.3 – Corporate Bonds
4.3.1: Understand the definitions and features of the following types of bond:
• Domestic • Asset-backed securities • Convertible • Medium term notes
• Foreign including covered bonds • Preferred • Permanent interest bearing
• Eurobond • Zero coupon • Floating rate notes share 17
Corporate bonds
Watch the introduction to corporate bonds on the CISI YouTube channel and answer the following questions:

1. Why do companies issue corporate bonds? 3. Where are corporate bonds usually traded?

2.  hat terms (time to maturity) are corporate bonds usually

W 4. Explain the 3 types of corporate bond discussed in the video.
issued with?

18
Corporate bonds
Read the introduction about corporate bonds in chapter 4 of the course workbook and answer the following
questions:

1. What is a commercial paper? 3.  bond can offer a fixed or floating security to investors. What is
A
the difference?

2. How are most corporate bonds traded?

4. Is a call provision of benefit to the bond’s issuer or to the
investor? Explain your reasons why.

19
Features of corporate bonds – True or false?
Read the section about the features of corporate bonds in chapter 4 of the course workbook and decide
whether the statement is true or false.

True False

1. Security is not typically offered to investors when a company issues

bonds
2. Banks will act as a guarantee if the issuer defaults

3. A sinking fund requirement is a type of call provision

4. A floating charge implies that specific assets are charged as security
for the loan
5. Put provisions are attractive to investors because they increase the
chances of selling a bond issue

20
Types of corporate bonds
Using the section about different types of bonds in chapter 4 of the course workbook, list the key features in
the table below.

Features

Medium Term Notes (MTNs)

Fixed Rate Bonds

Floating rate Notes (FRNs)

Convertible Bonds

Preferred Bonds

Zero Coupon Bonds

Permanent Interest-Bearing Shares (PIBS)

21
Convertible Bonds
1. Describe an investor’s choices when holding convertible bonds 2. Why are convertible bonds attractive to investors?
Choice 1:

Choice 2: 3. Why are convertible bonds beneficial for the issuer?

22
Eurobonds
Using the section about different types of bonds in chapter 4 of the course workbook, list the key features in
the table below.

1. Identify 5 features of Eurobonds 2. What is a ‘negative pledge’ clause?

1:

2:

3:

4:
3. What are the most common types of Eurobond issued?
5:

23
Asset-Backed Securities
Asset-Backed securities are made up of ‘bundles’ of assets
credit card
mortgages
illiquid
accounts
balance
financial
Collateralised
mortgage
Europe sheet
institutions
receivable
debt
priority
Assets in the bundle can include , and
credit card
mortgages
illiquid
accounts
balance
financial
Collateralised
mortgage
Europe sheet
institutions
receivable
debt
priority credit card
mortgages
illiquid
accounts
balance
financial
Collateralised
mortgage
Europe sheet
institutions
receivable
debt
priority
credit card
mortgages
illiquid
accounts
balance
financial
Collateralised
mortgage
Europe sheet
institutions
receivable
debt
priority
The largest market is for backed securities
credit card
mortgages
illiquid
accounts
balance
financial
Collateralised
mortgage
Europe sheet
institutions
receivable
debt
priority
Covered bonds are a type of asset-backed security widely used in Europe. They are issued by

credit card
mortgages
illiquid
accounts
balance
financial
Collateralised
mortgage
Europe sheet
institutions
receivable
debt
priority
Covered bonds are considered particularly safe because:

a) they remain on the issuer’s

credit card
mortgages
illiquid
accounts
balance
financial
Collateralised
mortgage
Europe sheet
institutions
receivable
debt
priority
b) are against a pool of assets that can cover claims at any point of time
credit card
mortgages
illiquid
accounts
balance
financial
Collateralised
mortgage
Europe sheet
institutions
receivable
debt
priority
c) give bondholders a claim on the asset pool if the issuer defaults
credit card
mortgages
illiquid
accounts
balance
financial
Collateralised
mortgage
Europe sheet
institutions
receivable
debt
priority

24
Comparing corporate bonds
Selima is considering investing in corporate bonds but she is not sure about her options.
She has £20,000 to invest and has asked you to recommend some options for her to consider.

1.  s her financial advisor, what further information and/or

A 2.  hat corporate bonds might you suggest she considers and
W
questions might you want to ask Selima? why?

3.  hat alternatives to corporate bonds could Selima also

W
consider?

25
The difference between gilts and corporate bonds
Consider the following statements and indicate the correct term.

1. Corporate bond prices are volatile than gilt prices

less
more
2. Corporate bond yields tend to be than gilt yields
lower
higher
3. The corporate bond market is liquid than the gilt market
less
more
4. Corporate bonds are considered risky than gilts?
less
more
Can you explain why?

26
Further your knowledge – Bond essentials
Complete the bond essentials module (30 mins) on
the professional refresher section of the CISI learning
platform. This module explores the main types of
bonds and key terminology.

27
Module Learning Outcome 4.4 – Bonds
4.4.1: Be able to explain the potential advantages and disadvantages of investing in different types of bonds
4.4.2: Be able to calculate the flat yield of a bond
4.4.3: Understand the role of credit rating agencies and the difference between investment and non-investment grades 28
Advantages and disadvantages of bonds
Watch the video about the advantages and disadvantages of bonds on the CISI YouTube
channel and read section 4.4.1 in the course workbook. Answer the following questions:

1. S ummarise the benefits/advantages and disadvantages when 2. Explain the impact of a changing interest rate on bond prices.
investing in bonds.

29
Risks of investing in bonds
Write a brief description of each risk. See if you can think of an example for each.
Default Risk Commercial Risk

Interest Rate Risk Early Redemption Risk

Seniority Risk Market/Price Risk

Liquidity Risk Inflation Risk

Currency Risk

30
Yields
Read section 5.2 in chapter 4 of the course workbook about flat yields in the course workbook and fill in the
blanks below.

Yields are a measure of on bonds

Running
Initial
Fixed
High
Redemption
Coupons
Yield
Percentages
Returns

A flat yield is also be known as an yield or a yield

Running
Initial
Fixed
High
Redemption
Coupons
Yield
Percentages
Returns Running
Initial
Fixed
High
Redemption
Coupons
Yield
Percentages
Returns

Yields are expressed as

Running
Initial
Fixed
High
Redemption
Coupons
Yield
Percentages
Returns

Returns from bonds are expressed in terms of .

Running
Initial
Fixed
High
Redemption
Coupons
Yield
Percentages
Returns

Yields are NOT the same as

Running
Initial
Fixed
High
Redemption
Coupons
Yield
Percentages
Returns

The percentage interest paid on a bond is known as the yield

Running
Initial
Fixed
High
Redemption
Coupons
Yield
Percentages
Returns

The yield measures both the income and the capital return of a bond held till it matures
Running
Initial
Fixed
High
Redemption
Coupons
Yield
Percentages
Returns
31
Coupon or Yield?
Look at the statements below and decide whether they come under the heading - coupon or yield?

Coupon Yield

A rate that will change as bond prices change

Usually paid in two equal, semi-annual instalments

Represents investor’s real return on their money

Expressed as a percentage of a £100 nominal holding

A fixed interest rate that applies to a bond throughout it’s term

Rate based on the face value of the bond

Rate based on the actual buying/ market price of the bond

Will usually reflect interest rates at time of first issue

32
Flat Yields
A flat yield (also known as a running or floating The formula for calculating flat yields is shown below
yield) is a calculation of the interest paid on a bond
as a percentage of its market price.

They are different from redemption yields whose coupon

calculation incorporates both the income and capital Flat Yield = X 100
return of a bond, assuming that the investor holds market price
the bond till its maturity.

Remember that a coupon reflects the interest rate

payable on the nominal not the market price paid. A
yield will only be the same as a coupon when a bond
is bought at its nominal (face) value.

* The bond’s market price is typically stated as the price payable to purchase £100 nominal/ face value 33
Calculating Flat Yields
Using the formula, calculate the flat yield for the scenarios below. Use the examples provided in chapter 4 of
the course workbook to help.

1.  corporate bond issued by ABC plc has a 6% coupon and has a

A 3. 0.375% Treasury Stock 2035 is currently priced at £101.00.
current trading price of £132.

4.  corporate bond issued by ZYX plc was priced last year at

A
2.  corporate bond issued by XYZ plc with a 2034 redemption
A £125.00 with a coupon of 8%. Right now the bond is trading at
date has a 2.6% coupon and a current trading price of £70. £127.00 per £100 nominal.

34
The role of credit rating agencies
The price of a corporate bond is primarily determined
by the issuer’s credit rating. A credit rating offers an
assessment of the probability of the issuer defaulting
on their payment obligations.

Bonds are assessed and given a credit rating when

they are first issued and reassessed if circumstances
change. Their rating can be upgraded or downgraded
which will impact their trading price. There are three
most prominent credit rating agencies globally.
Extend your learning by looking at their websites:

Standard and Poor

Moodys
Fitch Rating
*CISI is not responsible for the accuracy, legality or content of any external 35
sources referenced in this workbook
Understanding credit ratings
Using the Bond Credit Table in chapter 4 of the course workbook, complete the following questions.

1. U
 sing Standard & Poor’s ratings, which bonds are considered 4. W
 ill an upgrade in a bond’s rating mean investors can expect
investment grade? higher or lower yields?

2. W
 hat terms are used for bonds from companies rated between 5. W
 hich investment grade bonds offer the least risk and most
BB to D? liquidity?

3. W
 ill a downgrading in a bond’s rating mean a rise or a fall in
bond prices?

36
Watch the CISI TV video about bonds, specifically
produced for the ‘Level 3 – Introduction to securities
and investment’ qualification to help prepare you for
the multiple choice exam.

37
Further your knowledge – Bonds
Complete the professional refresher modules on
the CISI learning platform below to further your
knowledge about bonds.

Economic factors and bonds module (2hrs 30 mins)

This module examines some of the economic factors that affect the
bond market and its operation, the strategies and returns that exist
within the overall marketplace.

Green bonds and asset-backed securities module (2hrs)

This module explores alternative bonds for investors concerned with
the environmental impact and ethical, responsible investing.

38
Gender bonds, ESG bonds and much more…Take
a look at the CISI TV channel to explore the diverse
world of bonds.

39
Movie time
Relax and put your feet up, it’s time for a movie.
Our unit 4 choice is Wall Street starring Charlie
Sheen & Michael Douglas – A young and impatient
stockbroker is willing to do anything to get to the
top, including trading on illegal inside information
taken through a ruthless and greedy corporate raider
who takes the youth under his wing.

*CISI is not responsible for the accuracy, legality or content 40

of any external sources referenced in this workbook
End of Unit 4
Multiple Choice Assessment 41
Test your knowledge
1. Bonds are issues on behalf of the UK 2. Which of the following terms DOES NOT
government by: refer to the original value of a bond?

A. The Financial Conduct Authority A. Nominal

B. Debt Management Office B. Coupon
C. Local Authorities C. Par Value
D. Prudential Regulation Authority D. Principal

42
Test your knowledge
3. If the market interest rate for a bond is 4. Which of the following statements is
higher than the coupon, the bond will NOT TRUE:
sell at:
A. E urobonds have a par value and a
A. a discount redemption date
B. a premium B. Eurobonds are long term, interest
bearing bonds
C. par
C. Eurobonds can be traded at any
D. either a discount or a premium time but their price is set
D. Eurobond issuers can chose a
currency appropriate for their needs 43
Test your knowledge
5. Permanent Interest-Bearing Shares
(PIBS) are peculiar to which market?:

A. The US dollar market

B. The OTC (over the counter) market
C. The UK sterling market
D. The secondary market

44
Test your knowledge
6. When a bond is ‘stripped’ or broken down into its individual cash flows,
which can be traded separately as zero-coupon bonds, the process is
known as which of the following:

A. S ingle Trading of Registered Interest and Principal

B. S eparate Trading of Registered Interest and Principal
C. S elective Trading of Registered Interest and Principal
D. S plit Trading of Registered Interest and Principal

45
Test your knowledge
7. The UK Government issues ‘2% 8. A British company issuing bonds to
CPI 2040’. Which of the following Japanese investors in Japanese yen
statements is NOT true? would be known as a:

A. T his bond will appeal to long term A. Eurobond

investors such as pension funds
B. Domestic Bond
B. This bond has a set redemption date
C. Foreign Bond
C. B
 oth the coupon and the
redemption amount are uplifted by D. Convertible Bond
the CPI
D. Only the coupon is uplifted by the CPI
46
Test your knowledge
9. Fluctuations in interest rates cause 10. Company XYZ plc issues a bond priced
bond prices to change. What is this £75 with a coupon of 2.5% and a 2029
known as: redemption date. What is the flat yield
of the bond:
A. Inflation Risk
A. 5.37%
B. Market Risk
B. 3.57%
C. Seniority Risk
C. 3%
D. Liquidity Risk
D. 1.87%

47
Test your knowledge
11. Standard & Poor’s ratings have given 12. Which of the following is NOT a
a country’s bonds a ‘B’ rating. Which of characteristic of a Eurobond:
the following best describes this bond?
A. T hey are denominated in a currency
A. Non investment grade different from that of the financial
centre(s) in which they are issued
B. Junk
B. They provide fixed or floating
C. Medium grade security to bond holders
C. They are often issued in a number of
D. Investment grade
financial centres simultaneously
D. They can take the form of
convertible bonds 48
Test your knowledge
13. Which of the following statements is 14. When interest rates rise:
NOT TRUE about index linked bonds:
A. B
 ond prices fall and yields rise to
A. T heir coupons can be linked to
attract investors
inflation indices
B. Only coupons are uplifted by the B. Bond prices rise and yields rise to
related index attract investors
C. The nominal is adjusted upwards to C. Bond prices rise and yields fall to
reflect inflation between the issue attract investors
and redemption dates
D. Both the coupon and the D. Bond prices and yields tend to stay
redemption amount are increased the same
by the amount of inflation 49
Test your knowledge
15. What is the only way to increase the 16. The convention in bonds markets is to
yield of an issued bond: quote prices:

A. To increase the price A. per £100 nominal of stock

B. To reduce the price B. per £1000 nominal of stock
C. To change the nominal C. per £10 nominal of stock
D. To change the redemption date D. per £1 nominal of stock

50
Test your knowledge
17. 2% (RPI) Treasury Stock 2030’ is an 18. A company issues a bond using specific
example of which type of bond: assets as security. This is an example of a:

A. Conventional A. Fixed charge

B. Index-linked B. Floating charge
C. Perpetual C. Third party guarantee
D. Corporate D. An invisible charge

51
Test your knowledge
19. When a corporate bond has a call 20. A bond which is offered to investors
provision written into it, which of the continually over a period of time by an
following is NOT true: agent of the issuer is known as which of
the following?
A. There is more flexibility for the issuer
B. T he investor is disadvantaged and A. An ETF
will likely demand a higher yield
B. A PIBS
C. T he bondholder is able to require
the issuer to redeem earlier C. A FRN

D. T he issuer has the option to buy D. A MTN

back all or part of the bond issue
before maturity 52
Test your knowledge
21. Which type of corporate bond have 22. Permanent Interest-Bearing Shares are
variable rates of interest, linked to a issued by:
benchmark rate:
A. UK Building Societies
A. Permanent Interest-Bearing Shares
B. UK Banks and Building Societies
B. Floating Rate Notes
C. The Debt Management Office
C. F ixed-Rate Bonds
D. Corporations
D. Zero Coupon Bonds

53
Test your knowledge
23. Which of the following is a unique 24. Which of the following is a unique
feature of Permanent Interest-Bearing feature of Preferred bonds?
Bonds?
A. Variable rate coupons
A. Pays dividends
B. Are irredeemable
B. No set redemption date
C. Pay dividends
C. A
 re irredeemable
D. Issued at discount to their par value
D. Issued at discount to their par value

54
Test your knowledge
25. Which of the following is a feature of
Zero Coupon bonds?

A. They are issued above their par value

B. T hey can be converted to preference
shares on a specified date
C. T hey are issued at discount to par
value
D. They are repaid below par value

55
Test your knowledge
26. Which of the following is NOT a feature of a covered bond?

A. T he asset pool must provide sufficient collateral to cover bondholder claims

throughout the term
B. They remain on the issuer’s balance sheet
C. H
 olders of covered bonds have a priority claim on the cover if the issuer
defaults
D. T hey are generally regarded as a less safe investment when compared to
traditional Asset-Backed securities

56
Test your knowledge
27. A company issues a bond priced £90, 28. Generally speaking, the greater the
paying 3.5% coupons half yearly with level of security provided for a bond
redemption in 2027. What is the flat should result in which of the following:
yield of the bond?
A. A higher coupon paid to investors
A. 0
 .39%
B. A lower cost of borrowing for issuers
B. 3
 .89%
C. A
 higher cost of borrowing for
C. 3
 8.90% issuers
D. 0.039% D. A shorter maturity date for the bond

57
Test your knowledge
29. Which of the following is an advantage for a company issuing convertible
bonds?

A. S hare prices could rise

B. F inance might be raised relatively cheaply
C. I f it is wound ups the bondholder will possibly get some or all of his
money back before the shareholders
D. I f the company has problems, the investor can retain the bond and may
still receive coupons

58
Test your knowledge
30. 30. A bond issued by a German
company to German investors in Euros
is known as which of the following:

A. A
 foreign bond
B. A
 domestic bond
C. A
 Eurobond
D. A
 covered bond

59
Monitoring my progress – Unit 4
My multiple choice assessment mark is / 30

I am happy with the progress that I made on the multiple choice assessment
Yes No

To improve my knowledge and understanding, I now need to….

1.
2.
3.

60
Need more help?
If you feel that your multiple choice score can
be improved further, complete the end of unit 4
multiple choice questions in the course workbook.

61
Answers
Page 7 other forms of income that they receive. Issuance of bonds is high when tax revenues are
1. Define a bond? A loan used by companies or governments to raise funds. The investor lends significantly lower than government spending.
money in return for the promise to have the loan repaid on a fixed date plus (usually) a series 2. Why are UK government bonds known as gilts? When physical certificates were issued,
of interest payments. historically they used to have a gold or gilt edge to them, hence they are known as gilts.
2. What are the reasons a bond might be issued? A company may need to raise money to 3. When tax revenues are lower, are governments more or less likely to issue more bonds?
finance investment or a government may issue bonds to finance spending and investment More
plans and bridge the gap between their actual spending and the tax alongside other forms 4. When interest rates increase, what happens to gilt prices? When interest rates rise, gilt prices
of income that they receive. tend to fall
3. What are the two main types of bonds? Corporate and government bonds
Page 12
4. Do bonds or equities form a larger part of the market in terms of global investment value?
• What does the title of the bond tell you? 0.375% is the coupon; issued by the Treasury
Bonds
(government bond); 2030 is the redemption date
Page 8 • What does at par mean? At the face value
• Bonds are loans used to raise money from banks FALSE
Label answers
• Bonds are tradable financial instruments TRUE
• 0.375% = A – The coupon: The nominal interest rate payable on the stock. Rate is quoted
• Bonds can also be known as fixed interest securities TRUE
gross and usually is paid in two separate and equal half-yearly interest payments
• A bond will always trade at its nominal or face value FALSE
• £10,000 = C – The nominal value: The amount of stock purchased and should not be
• Investors need to always refer to the original borrower before making an investment in
confused with the amount invested or the cost of purchase. This is the amount on which
bonds FALSE
interest will be paid and the amount that will eventually be repaid (also known as the par or
• Bond prices respond to changes in interest rates TRUE
face value of the bond)
• The nominal value of a bond is the amount that will be repaid on the bond’s redemption
• 7 December 2030 = B – The redemption rate: This is the date the stock will be repaid.
date TRUE
Repayment takes place at the same time as the final interest payment.
Page 11 • TREASURY STOCK = D – The stock name: The name given to identify the stock
1. Why do governments issue bonds? Governments issue bonds to finance their spending and
investment plans and to bridge the gap between their actual spending and the tax alongside 62
Answers
Page 13 Page 18
Conventional Bond features: 1. Why do companies issue corporate bonds? To raise funds for investment
• Simplest form of UK government bond 2. What terms (time to maturity) are corporate bonds usually issued with? Longer terms -
• Fixed coupon usually more than 12 months
• Single repayment date 3. How are most corporate bonds traded? In the over the counter (OTC) market
• Represent approx 75% bonds in issue 4. Explain the 3 types of corporate bond discussed in the video. – Domestic, foreign, Eurobonds
• Can be stripped into individual cash flows
Page 19
• Price quoted in terms of price per £100 face/par value/ nominal
1. What is a commercial paper? A shorter term debt instrument (usually less than 12 months)
Index-linked Bond features: 2. How are most corporate bonds traded? In the over the counter (OTC) market
• Coupon and Redemption amount adjusted in line with UK RPI 3. A bond can offer a fixed or floating security to investors. What is the difference? Fixed
• Single repayment date securities play that specific assets (eg a building) of the company are charged as security
• Attractive in periods when a government’s control of inflation is uncertain for the loan. A floating charge means that the general assets of the company are offered as
• Attractive long term investments eg pension funds security for the loan - this might include cash at the bank, trade debtors and stock
• Minority of gilts in issue 4. Is a call provision of benefit to the bond’s issuer or to the investor? A call provision is
attractive to the issuer as it gives the option to refinance the bond (ie replace it with one at a
Page 14
lower rate of interest) when interest rates are lower than the coupon that is being paid. This
1. Which type of gilt represents the majority of gilts in the UK? Conventional
is a disadvantage to the investor who will probably demand a higher yield as compensation.
2. How is the price of a conventional gilt quoted? Price per £100 face value
3. When might index linked bonds be more attractive to investors? When a government’s Page 20
control of inflation is uncertain because they provide extra protection to the investor 1 – false
4. What does ‘Stripping a gilt’ mean? Stripping conventional bonds into their individual cash 2 –true
flows which can then be traded separately as zero coupon gilts 3 – true
4 – false
5 – true
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Answers
Page 21 o If the company hits problems, the investor can retain the bond - interest will be earned
Medium Term Notes: and, as bondholder, the investor will rank ahead of existing shareholders if the company
• Standard corporate bonds with maturities up to 5 years goes bankrupt
• Also applied to instruments with maturities as long as 30 years • For the company, relatively cheap finance is acquired
• Offered to investors continually over a period of time by an agent of the issuer, instead of in a • Investors will pay a higher price for a bond that is convertible because of the possibility of
single tranche of one sizeable underwritten issue capital gain
• Market originated in the US to close a funding gap between commercial papers and long • Prospect of dilution of current shareholder interests, as convertible bond holders exercise
term bonds their options, has to be borne in mind

Floating Rate Notes: Preferred Bonds

• Usually referred to as FRNs • Known as ‘preferreds’
• Bonds with variable rates of interest • Similar characteristics to shares and bonds and have potential to offer investors higher yields
• Rates of interest will be linked to a benchmark rate such as the Sterling Overnight Index than holding the company’s ordinary shares or bonds
Average (SONIA) in the UK and Secured Overnight Reference Rate (SOFR) in the US. • Bonds that have equity-like features
• A FRN will usually pay interest at the benchmark plus a quoted margin or spread • Generally issued by large banks and insurance companies
• Usually undated/perpetual
Convertible Bonds:
• Usually carry callable rights for the issuer within first 5-10 years
• Issued by Companies
• A specific equity-like feature is the fact that they pay dividends as opposed to coupons
• Give the investor holding the bond 2 choices:
• Within the issuer’s capital structure preferreds rank lower than senior debt but higher than
o To simply collect the interest payments an then the repayment of the bond on maturity
equity
o To convert the bond into a predefined number of ordinary shares in the issuing company,
on a set date or dates, or between a range of set dates, prior to the bond’s maturity Zero Coupon Bonds
• Attractions to the investor are: • Bond that pays no interest
o If the company prospers, the share price will rise and, if it does so sufficiently, conversion • Issued at a discount to their par value
may lead to capital gains • Repay/ redeem at par value
• All return is provided in the form of capital growth rather than as income - may be treated 64
differently for tax purposes
Answers
Permanent Interest-Bearing Shares Page 23
• Peculiar to UK Sterling Market 5 features of Eurobonds:
• Issued by Building Societies 1. Eurobonds are large international bond issues often made by governments and
• Carry fixed coupons multinational companies. The eurobond market developed in the early 1970s to
• Irredeemable - have no redemption date - so do not have to be repaid accommodate the recycling of substantial OPEC (Organization of the Petroleum Exporting
• Name ‘shares’ is a misnomer - it is a bond, pays interest, and is taxable as a bond Countries ) US dollar revenues from Middle East oil sales at a time when US financial
institutions were subject to a ceiling on the rate of interest that could be paid on dollar
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deposits. Since then it has grown exponentially into the world’s largest market for longer-
Choice 1: Simply collect the interest payments and then the repayment of the bond on maturity
term capital, as a result of the corresponding growth in world trade and even more
Choice 2: Convert the bond into a predefined number of ordinary shares in the issuing company,
significant growth in international capital flows. Most of the activity is concentrated
on a set date or dates, or between a range of set dates, prior to the bond’s maturity
in London. Often issued in a number of financial centres simultaneously, the defining
Why is this attractive to an investor? characteristic of Eurobonds is that they are denominated in a currency different from that
of the financial centre or centres in which they are issued. An example might be a German
Attractions to the investor are: company issuing either a euro or a dollar or a sterling bond to Japanese investors.
• If the company prospers, the share price will rise and, if it does so sufficiently, conversion may
2. The term ‘eurobond’ is a bit of a misnomer, as eurobond issues, and the currencies in which
lead to capital gains
they are denominated, are not restricted to those of European financial centres or countries.
• If the company hits problems, the investor can retain the bond - interest will be earned and,
For example, a dollar-denominated bond sold outside the US (designed to borrow US dollars
as bondholder, the investor will rank ahead of existing shareholders if the company goes
circulating outside the US) would typically be referred to as a eurodollar bond. The ‘euro’
bankrupt
prefix simply originates from the depositing of US dollars in the European eurodollar market,
Why is this beneficial for the issuer? and has been applied to the eurobond market since. So, a euro sterling bond issue is one
denominated in sterling and issued outside the UK, though not necessarily in a European
Relatively cheap finance is acquired
financial centre.

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Answers
3. Eurobonds issued by companies often do not provide any underlying collateral, or security, What are the most common types of Eurobond issued? Most eurobonds are issued as
to the bondholders but are almost always credit-rated by a credit rating agency (see section conventional bonds. Other common types include FRNs, Zero Coupon Bonds, Convertible
5.3). To prevent the interests of these bondholders being subordinated (made inferior) to bonds and dual-currency bonds.
those of any subsequent bond issues, the company makes a ‘negative pledge’ clause. This
Page 24
prevents the company from subsequently making any secured bond issues, or issues which
Asset-Backed securities are made up of ‘bundles’ of illiquid assets
confer greater seniority (ie, priority) or entitlement to the company’s assets, in the event of its
Assets in the bundle can include mortgages, credit card debt and accounts receivable
liquidation, unless an equivalent level of security is provided to existing bondholders.
The largest market is for mortgage backed securities
4. The eurobond market offers a number of advantages over a domestic bond market that Covered bonds are a type of asset-backed security widely used in Europe. They are issued by
make it an attractive way for companies to raise capital, including: financial institutions
• a choice of innovative products to more precisely meet issuers’ needs Covered bonds are considered particularly safe because they remain on the issuer’s Balance
• the ability to reach potential lenders internationally rather than just domestically sheet are collateralised against a pool of assets that can cover claims at any point of time give
• anonymity to investors as issues are made in bearer form bondholders a priority claim on the asset pool if the issuer defaults
• gross interest payments to investors
• lower funding costs due to the competitive nature and greater liquidity of the market Page 26
• the ability to make bond issues at short notice, and less regulation and disclosure. Corporate bond prices are more/less volatile than gilt prices More
5. Most eurobonds are issued as conventional bonds (or ‘straights’), with a fixed nominal value, Corporate bond yields tend to be higher/lower than gilt yields Higher
fixed coupon and known redemption date. Other common types include floating rate notes,
The corporate bond market is more/less liquid than the gilt market Less
zero coupon bonds, convertible bonds and dual-currency bonds – but they can also assume
a wide range of other innovative features. Corporate bonds are consider more/less risky than gilts? Can you explain why? More. There
is more risk that the company will not be in a position to repay the loan than there is with the
What is a negative pledge clause? To prevent the interests of bond holders being subordinated
government and gilts. Corporate bonds generally have a default risk and price risk. Highly
to those of any subsequent bond issues, the company makes a ‘negative pledge clause’ to
rated government bonds are said to have only price risk as there is little or no risk that the
prevent the company from subsequently making any secured bond issues which get priority or
government will fail to pay the interest or repay the capital on bonds.
entitlement to the company’s assets, in the event of its liquidation, unless an equivalent level
of security is provided to existing bond holders. A negative pledge clause is part of the loan
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contract.
Answers
Page 29 Page 32
Advantages Initial Yield
Their main advantages are: • A rate that will change as bond prices change
• for fixed-interest bonds, a regular and certain flow of income • Represents investor’s real return on their money
• for most bonds, a fixed maturity date (but there are bonds which have no redemption date, • Rate based on the actual buying/market price of a bond
and others which may be repaid on either of two dates or between two dates – some at the
Coupon
investor’s option and some at the issuer’s option)
• Usually paid in two equal, semi annual instalments
• a range of income yields to suit different investment and tax situations, and
• Expressed as a percentage of a £100 nominal holding
• the relative security of capital for more highly rated bonds.
• A fixed interest rate that applies to a bond throughout its term
Disadvantages • Rate based on the face value of a bond
Their main disadvantages are: • Will usually reflect interest rates at time of first issue
• the ‘real’ value of the income flow is eroded by the effects of inflation (except in the case of
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index-linked bonds)
1. 4.55%
• bonds carry various elements of risk (see section 5.1.3).
2. 3.71%
Page 31 3. 0.36%
Yields are a measure of returns on bonds 4. 6.30%
An flat yield can also be known as an Initial yield or a Running yield
Yields are expressed as Percentages
Returns from bonds are expressed in terms of Yield
Yields are NOT the same as Coupons
The Redemption yield measures both the income and the capital return of a bond held till it
matures

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Page 36 Test your knowledge
1. Using Standard & Poor’s ratings, which bonds are considered investment grade? BBB 1B 24C
and above 2B 25C
2. What terms are used for bonds from companies rated between BB to D? Non 3A 26D
investment Grade/ Speculative/ Junk for worst rated 4C 27A
3. Will a downgrading in a bond’s rating mean a rise or a fall in bond prices? Fall 5C 28B
4. Will an upgrade in a bond’s rating mean investors can expect higher or lower yields? 6B 29B
Lower 7D 30B
5. Which investment grade bonds offer the least risk and most liquidity? AAA 8A
9B
10B
11A and B
12B
13B
14A
15B
16A
17B
18A
19C
20D
21B
22A
23C

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