Financial Markets Operations Management (40 page)
Read Financial Markets Operations Management Online
Authors: Keith Dickinson
Bond issuers have an obligation to service their debts on a predefined basis. In the case of a fixed-income bond, the amount of coupon and the payment date of the coupons are known in advance. As a consequence, there is no need for the bond issuer to make an announcement of this event. Depending on whether the bonds are in bearer form or in registered form, the bondholder will either have to claim the coupon (bonds in bearer form) or will automatically be paid by the issuer (bonds in registered form).
Traditionally, the custodian bank that held the bond certificates on behalf of the bondholder (the investor) would separate the appropriate coupon (known as
coupon clipping
) from the host bond and present it to the bond issuer's paying agent. The paying agent would pay the amount of coupon noted on the coupon itself to the custodian (and the custodian would credit the funds to the investor's cash account).
Interest on bonds accrues on a daily basis and the corresponding accounting entries are posted to match. On the coupon payment date, the accrued interest account is debited and the bond interest account credited with the full amount.
Most bonds today are held centrally by a central securities depository and this makes the collection of coupon payments much more efficient. However, in situations where the bonds are held by the investor (or his custodian), it is possible to present the coupons to the paying agent after the coupon payment date. In this situation, the paying agent will pay the coupon but will not pay any interest on the coupon itself; in other words, there is a funding implication through the late presentation of the coupon to the paying agent. There is a time limit for presenting coupons and this is usually in terms of a number of years; time enough for even the most inefficient custodian or forgetful investor to claim the dividend. This time limit is referred to as a
prescription period
.
Depending on the market convention for any particular bond, coupons are paid annually, semi-annually or quarterly. Therefore, the first coupon will be paid twelve months, six months or three months after the date on which the bond was issued. There are occasionally exceptions when the first coupon is paid either before or after the expected first coupon date. We refer to these as either a
first short coupon
or a
first long coupon
. Whether short or long, once the first coupon has been paid, the normal payment frequency follows.
On 21 November 2011, GDF Suez issued a EUR 1 billion note due on 21 January 2020.
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The main provisions relating to interest payable are shown in
Table 11.12
.
TABLE 11.12
GDF Suez note
| Issue Date | 21 November 2011 |
| Coupon Rate | 3.125% p.a. |
| Payment Dates | 21 January each year from and including 21 January 2013 to and including the maturity date |
| First Coupon Payment Date | 21 January 2013 |
| Day-Count Convention | Actual/Actual (ICMA) |
| Fixed Coupon Amount | EUR 3,125.00 per EUR 100,000 nominal amount subject to the “broken amount” |
| Broken Amount | EUR 3,647.26 per EUR 100,000 falling on 21 January 2013 |
The
broken amount
represents the coupon from the issue date, 21 November 2011, up to 21 January 2013; a period of approximately one year and two months.
An issuer might wish to issue a bond in September 2013 with interest paid semi-annually, for example, in June and December. Within the provisions of the issue terms and conditions, the first coupon would be paid in December 2013 â approximately three months after the bond was issued. Thereafter, subsequent coupons would be paid in June 2014, December 2014, etc.
FRNs are medium- to long-term debt obligations with variable interest rates that are adjusted periodically (typically every one, three or six months). The interest rate is usually fixed at a specified spread (margin) quoted in basis points over a specified money market reference rate such as:
- London Interbank Offered Rate (LIBOR): LIBOR is the average interbank interest rate at which a selection of banks on the London money market are prepared to lend to one another. LIBOR comes in 15 different maturities and in 10 different currencies. LIBOR is regarded as one of the benchmark rates.
- Euro Interbank Offered Rate (Euribor): Euribor is the average interbank interest rate at which European banks are prepared to lend Euros to one another. Euribor, like LIBOR, comes in 15 different maturities. Euribor is also regarded as a benchmark rate.
- 13-week US Treasury bill:
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Short-term debt issued by a government's Treasury department.
Examples of FRNs include the issuance on 26 September 2013 by the Swedish Internet-based bank, Skandiabanken, of two FRNs raising Norwegian Kroner 3 billion:
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- NKR 2 billion FRNs (3-month Nibor + 49bp) due September 2018;
- NKR 1 billion FRNs (3-month Nibor + 30bp) due September 2016.
With FRNs, there are two aspects to be concerned with: firstly, there is the coupon for the period about to end and, secondly, there is the fixing of the interest rate for the period about to start. Although the coupon rate does change (floats) from one period to another, the coupon is reset (“fixed”) for one particular coupon period.
This is a straightforward process that we covered in Section 11.5.4 above.
Consider the security shown in
Table 11.13
.
TABLE 11.13
ABC Bank plc FRN due January 2022
| Aggregate Nominal Amount | EUR 1.5 billion |
| Issue Date | 17 January 2012 |
| Interest Commencement Date | 17 January 2012 |
| Board Lot Size: | EUR 1,000 |
| Interest Basis | 3-month Euribor + margin of 1.55% per annum (155 basis points) |
| Reference Rate | 3-month Euribor |
| Interest Determination date(s) | Two TARGET settlement days prior to the commencement of each interest period |
| First Interest Payment Date | 17 April 2012 |
| Day-Count Convention | Actual/360 |
| Business Day Convention | Modified following business day convention |
| Interest Rate Determination | Screen rate determination |
Let us assume that today is the coupon payment date and that it is 17 October 2013. We are holding a position of EUR 1 million nominal amount of this FRN. What will be the coupon payment amount? To answer this we need to know the coupon rate from our securities database. For today's coupon payment, the coupon rate would have been fixed three months ago, i.e. commencing 17 July 2013. Taking the three-month Euribor rate in July of 0.222% plus the margin, the interest rate for the period ending 17 October 2013 would have been 1.7720% per annum. In this case, the coupon on our holding of EUR 1 million would be EUR 4,528.44 (see
Table 11.14
).
TABLE 11.14
ABC FRN coupon payment
| Nominal Amount | Coupon Rate | Days in Coupon Period (Actual) | Coupon Payment |
| EUR 1,000,000 | 1.772% | 92 | EUR 4,528.44 |
For value date 17 October 2013 we will receive EUR 4,528.44 (ACT/360 day convention) and this will be credited to our income account.
In addition to receiving the coupon for the previous period, we have to reset (fix) the coupon rate for the next three-month period. We have to know when to reset the coupon rate and the source of the reference rate.
It is normal business practice to reset two business days before the start of the interest period. In terms of the source of the interest rate, you have to refer to the terms and conditions contained in the issuing prospectus. Referring to the above details of ABC FRN, you will note that the interest determination date is two TARGET settlement days prior to commencement.
To finish off this subsection, it is worth knowing that there are variants of FRNs, some of which are noted below:
- Drop-lock bond:
This is a bond that automatically converts to a fixed-rate bond if the interest rate used to reset the floating rate falls to a predetermined level. The new fixed rate stays in place until the bond reaches maturity. - Mismatch FRN:
An FRN where the coupon is based on, say, six-month LIBOR but reset every two months. - Capped FRN:
An FRN where the coupon cannot rise above a maximum rate. - Floored FRN:
An FRN where the coupon cannot fall below a minimum rate. - Mini-max (or collared) FRN:
An FRN where the coupon cannot rise above a maximum rate or fall below a minimum rate. - Flip-flop FRN:
An FRN backed by two different bonds, one with a variable interest rate and one with a fixed interest rate. The bondholder may choose which interest rate at any time, depending on which one is higher for a given period. - Convertible-rate FRN:
An FRN that allows issuers and bondholders to convert from a floating rate of interest to a fixed rate, or vice versa. - Inverse FRN:
An FRN in which the coupon moves inversely to the movement of the reference rate; if the reference rate moves down, the coupon rate increases. - Variable rate note:
An FRN with a spread over the reference rate which is not fixed. - Perpetual FRN:
An FRN that has no redemption date.
With the exception of bonds that have no redemption date (perpetual and un-dated bonds) the issuer is obligated to repay the bond on the predetermined date as set out in the issuing prospectus. As this is an obligation, this event type is both mandatory and predictable. Depending on the rules of the (I)CSD that is holding the bonds, the investor's holding will be frozen shortly before the redemption date. This prohibits any further deliveries of the bond.
The securities database will hold details of the redemption date and should be diarised so that the Front Office can reinvest the redemption proceeds. In the vast majority of cases, the redemption value is at par (i.e. 100% of the face value). The exceptions occur when the bond is redeemed early; see below for more details.
In the example used above, the ABC Bank FRN is due to be redeemed in full on 17Â January 2022 and in the same way that the coupons on physical certificates were presented to the paying agent for the coupon payments, the host bond is likewise surrendered to the paying agent. If, for any reason, this is delayed, then the bondholder is still entitled to receive the redemption proceeds but, as before, with no extra interest. The prescription period for the bond tends to be longer than for its coupons â sometimes in the region of 20 years or so. This should never have to happen in the financial markets, but could possibly happen if a private investor were to hold the physical certificates either at home or with, say, a solicitor.
Bonds that have a single redemption date are known as
straight bonds
. There are bonds that can be repaid early either because the issuer wishes to do so or, separately, because the investor wishes. We refer to these types of bonds as having either a
call option
or a
put option
respectively.
The issuer will call a bond early if it is to the issuer's advantage; this, of course, will be to the disadvantage of the investor. For this reason, the redemption price will usually be slightly
greater
than par. For example, ABC Company, which issued a bond due for final redemption on 30 June 2020, has written into the terms and conditions that the bond can be redeemed early on any coupon payment date commencing 30 June 2016. If this bond has an annual coupon payment date, then the repayment schedule shown in
Table 11.17
might be arranged.
TABLE 11.17
Bond (with call option) early redemption schedule
| Possible Call Date | Redemption Price | Comment |
| 30 June 2016 | 102.0000% | Early redemption opportunity §1 |
| 30 June 2017 | 101.5000% | Early redemption opportunity §2 |
| 30 June 2018 | 101.0000% | Early redemption opportunity §3 |
| 30 June 2019 | 100.5000% | Early redemption opportunity §4 |
| 30 June 2020 | 100.0000% | Final redemption date |
By contrast, the investor will “put” a bond back to the issuer early if it is to the investor's advantage; this, of course, will be to the disadvantage of the issuer. For this reason, the redemption price will usually be slightly
lower
than par. For example, XYZ Company, which issued a bond due for final redemption on 30 June 2020, has written into the terms and conditions that the bond can be redeemed early on any coupon payment date commencing 30 June 2016. If this bond has an annual coupon payment date, then the repayment schedule shown in
Table 11.18
might be arranged.
TABLE 11.18
Bond (with put option) early redemption schedule
| Possible Call Date | Redemption Price | Comment |
| 30 June 2016 |  98.0000% | Early redemption opportunity §1 |
| 30 June 2017 |  98.5000% | Early redemption opportunity §2 |
| 30 June 2018 |  99.0000% | Early redemption opportunity §3 |
| 30 June 2019 |  99.5000% | Early redemption opportunity §4 |
| 30 June 2020 | 100.0000% | Final redemption date |
(Please note that the calculation of the redemption price is outside the scope of this text.)
If an issuer calls a bond early, this will be a mandatory event (although voluntary from the issuer's perspective) and the investor will have no choice in the matter. The investor's holding will be debited from his depot a few days before the bond is repaid and on the appropriate date, the redemption proceeds plus the final coupon will be credited to the investor's cash account. From an accounting entry point of view, the bond redemption proceeds are credited to a capital account and the coupon to an income account. The Corporate Actions Department needs to be aware that a bond is about to be called early and they should make sure that the Front Office is also aware.
An early redemption on a bond with a put option will be a voluntary event from the investor's perspective (and therefore mandatory for the issuer). The Corporate Actions Department will be informed by its custodian or (I)CSD of the opportunity to put the bond back to the issuer and a decision date will be advised. The Corporate Actions Department will seek a decision whether to put the bond or not, from the appropriate decision-maker (Front Office or client). If the decision is made to put the bond, then an instruction must be sent to the custodian or (I)CSD. On receipt of the instruction, the custodian will deliver the bond from the depot and present it to the issuer's paying agent, in exchange for which the redemption proceeds plus coupon will be paid.
If an instruction to put the bond is either not submitted to the custodian or submitted late, then no action will be taken by either the custodian or the paying agent. This means, of course, that the decision-maker will not receive the expected cash proceeds but will still retain the bond. The choices available to the decision-maker will be either to sell the bond in the open market or wait for the next opportunity to put the bond back to the issuer; in the case of our example, this will be in 12 months' time.