Non-interest rate
indexed floaters link their coupon rate to a commodity price (e.g., oil).
d: Define accrued interest, full price, and clean price.
When a bond is traded in the secondary market, it is unlikely that the settlement date will
coincide with the coupon payment date. In the U.S., coupon payments are usually made
every six months, and when the bond trades between two consecutive coupon dates, the
seller is entitled to receive interest earned from the previous coupon date until the date of the
sale. This is known as accrued interest. Since the issuer will only pay interest to the owner of
the bond on the next coupon date, the interest amount has to be settled between the buyer
and the seller. This is accomplished with the help of what is called the full (or “dirty”) price.
This price includes the interest earned since the last coupon date but not yet received by the
seller, and is the sum of the value of the bond on the sale date (based on future cash flows)
and the accrued interest. The price without the accrued interest is known as the clean price.
When the bond is traded so that the buyer must pay the seller the accrued interest, it is said
to be trading cum-coupon. Otherwise, it is said to be trading ex-coupon. If the issuer of the
bonds is in default, i.e., it has not been making periodic obligatory coupon payments, the
bond is traded without accrued interest and is said to be trading flat.
e: Describe the provisions for paying off bonds, and distinguishing between a nonamortizing
security and an amortizing security.
•
Bullet maturity bonds pay the entire principal in one lump sum amount at the
maturity date.
•
Serial bonds pay the principal at different intervals. Bonds are issued in series with a
separate payment date specified for each series. One type of serial bonds is an
equipment trust certificate that is secured by the assets of the borrower.
•
Amortizing securities make periodic principal and interest payments. For example,
mortgage-backed and asset-backed securities in the U.S. make monthly payments
consisting of principal and interest components. By the end of the term to maturity,
the entire principal is paid off. The previous two cases, bullet and serial bonds,
represent examples of non-amortizing securities. In these two cases, the principal is
not amortized on a regular basis.
f: Explain the provisions for early retirement of debt, including call and refunding provisions,
prepayment options, and sinking fund provisions.
Sinking fund provisions require the retirement of a portion of a bond issue in specified
amounts prior to the maturity date. For example, a 20-year issue with a face amount of $300
million may require that the issuer retire $20 million of the principal amount every year
beginning in the 6
th
year.
Call provisions allow the issuer to purchase bonds from the lender(s) at a pre-specified
("call") price during the life of the bond. After the bonds have been issued, a subsequent drop
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