Understanding the terms and the return of fixed income securities or interest rate securities as they are frequently named can be confusing. This article provides a guide that should help you to understand some of the different features of the investments and how to interpret the returns quoted, and includes a list of key definitions.
Insurance Australia Group subordinated notes (sub debt) example
In March 2019, Insurance Australia Group launched a Tier 2 subordinated bond issue seeking to raise $450m. At the time the deal was announced, IAG indicated pricing of the subordinated notes was up to 245 basis points (bps) over the 90 day bank bill swap rate (BBSW). The coupon is floating rate and the bond has a 26.25 year non call six (26.25nc6.25) structure. The notes can be redeemed after a little over six years but only if early redemption is approved by APRA. The notes are also Basel III compliant, which means they include a non viability trigger and can be converted into ordinary shares at APRA’s discretion.
Demand for the notes was good and the issue was over subscribed. A total of $450m of Tier 2 subordinated bonds were issued. Given the demand, the coupon settled lower at 235bps over BBSW.
BBSW (and thus the total coupon payable) for floating rate notes is set on the first day of issue for the coming quarter. At the first coupon payment date and each quarter thereafter it will be recalculated for the coming quarter based on the fluctuating BBSW rate. So interest income will depend on BBSW although the margin over BBSW (of 235bps) will not change for the life of the bond.
The subordinated bonds started trading in the over the counter market late March 2019. They had a first issue or par value of $100, and if investors hold the notes until first call which is the expected maturity date, this is the amount they can expect to be returned to them.
When new bonds start to trade in the secondary market, the price of the bonds moves up and down, and impacts the returns investors achieve if they purchase the bonds in the secondary market. There are three main returns quoted for bonds: “yield to maturity” (YTM), “yield to worst” (YTW) and “running yield”. Yield to maturity includes the capital gain or loss on the bond price, as few bonds ever trade at par value of $100 except at first issue, plus the interest until maturity. Yield to worst is commonly used for bonds with a call date, or multiple call dates where the bond can be repaid prior to final maturity and is the worst yield an investor can expect over the life of a bond.
Running yield is the expected income if you buy the bond and hold it for a year and is dependent on the price you pay for the bond in the market. Running yield is similar to dividend yield.
The return that is most relevant to you will depend on your investment strategy and the type of bond. If you buy with the intention of not trading and holding to maturity, then the YTM or YTW is the figure that will matter to you. If you’re more interested in income alone and might sell prior to maturity then running yield will be your focus. Depending on market conditions and various other factors, YTM can be higher than running yield and vice versa.
Because floating rates note coupons fluctuate over time with the BBSW, brokers use forward expectations of BBSW to calculate estimated returns over the life of the bond. Fixed rate bond coupons on the other hand do not fluctuate.
Key definitions
Basis points (bps)
The basis point is commonly used for calculating changes in interest rates, equity indices and the yield of a fixed income security. The relationship between percentage changes and basis points can be summarised as follows:
A bond whose yield increases from 3.5% to 4% is said to increase by 50 basis points; or interest rates that have dropped by 1% are said to have decreased by 100 basis points.
Bank bill swap rate (BBSW)
The bank bill swap rate (BBSW) rate is a major interest rate benchmark for the Australian dollar and is widely referenced in many financial contracts. BBSW is calculated based on observable market transactions during a rate-set window of 8:40:00 am until 10:00:00am and involves a large number of participants. The benchmark is anchored to real transactions at traded prices. The ASX is now the administrator of BBSW. For more information please see the WIRE note, “BBSW changes complete”.
The purpose of BBSW is to provide independent and transparent reference rates for the pricing and revaluation of Australian dollar derivatives and securities.
Call date
Any bond can have call dates but they are commonly found in subordinated bonds and hybrids . This is the first date the issuer of the security has the option to repay investors. If a callable security is not repaid at the first opportunity, maturity is therefore extended and could see a decline in the value of the security on the secondary market.
Coupon
Is the rate of interest paid on a fixed income investment or bond. Coupons can be paid annually, semi annually or quarterly or as agreed in the terms of the security. The coupon rate can be fixed or floating for the term of the security. If it is a floating rate then it is likely that it will be linked to a benchmark such as the 90 day BBSW, expressed, for example, as BBSW +3.25%. The coupon rate is set by the issuer based on a number of factors including prevailing market interest rates and the company’s credit rating. Fixed rate bonds in Australia predominantly pay a semi annual coupon whereas floating rate bonds predominantly pay a quarterly coupon. Indexed linked bonds usually pay quarterly coupons.
For example, a $500,000 bond with a fixed rate semi annual coupon of 4% will pay two $10,000 coupons each year.
Cumulative / Non cumulative
Cumulative
Missed dividend payments/distributions must be made up at a later date.
Non cumulative
Missed dividend payments/distributions are forgone. The issuer of the security is not obliged to pay the unpaid amount to the holder.
Face value
Is the initial capital value of the bond and the amount repaid to the bondholder on its maturity, usually $100.
Discount to face value
Bonds may trade at a discount to face value in secondary markets where coupon, demand and market perception of the entity influence the price of secondary trades. Bonds usually have a face value of $100. If a bond is acquired at a discount price, say of $75, then the bondholder will make a capital gain of $25 assuming the company makes a full repayment of $100 face value at maturity.
Premium
A bond's value in the secondary market can be greater than its face value. The bond is then deemed to be selling at a premium. This will occur if the coupon is higher than the yield of a fixed income security.
Fixed/floating interest rates
Rates on bonds can be fixed (set at the time of issue), floating or inflation linked. If they are floating then they will be set as a constant margin to a variable benchmark such as the 90 day bank bill rate expressed, for example, BBSW +2.25%.
Maturity
This is the date when the bond is due for repayment by the issuer. The principal plus any outstanding interest will be repaid on this date.
Subordinated notes /subordinated debt
A bond or loan that ranks below senior debt and creditors. In the event of a wind up (insolvency) of an issuer, subordinated debt is not paid until all senior secured, senior debt and unsecured creditors are paid first.
Source: FIIG Securities
Non viability trigger
Is an untested structural feature of subordinated debt and hybrid securities implemented to meet Basel III/ APRA regulations to provide loss absorbing capital for the financial institution when it is considered non viable or requires public funds or support to survive. The point of non viability is unknown and at the discretion of APRA. Once deemed the securities convert to ordinary shares. This could result in up to a 100% loss of capital.
Perpetual security
A security with regular periodic payments for an infinite number of periods with no maturity date.
Purchase price
Purchase price is the amount that a bondholder pays to purchase a bond. Price can be quoted on a ‘clean’ basis meaning that this is the capital price of the bond, or it can be quoted on a ‘dirty’ basis meaning that it includes both the capital price plus the accrued interest.
Return
The amount earned on an investment or made on a transaction (realised or unrealised) relative to the amount of money invested. Generally assessed as yield to maturity.
Running yield
Running yield uses the current price of a bond instead of its face value and represents the return an investor would expect if he or she purchased a bond and held it for a year. It is calculated by dividing the coupon by the market price.
Yield to call
Many bonds are callable at the option of the company before the final maturity date. That is, the bonds can be repaid early. For example, subordinated bonds issued by banks and other financial institutions often have call dates, which may be five, ten, twenty or more years until final maturity.
The company has the option but not the obligation to repay at the call date. With some bonds, the call dates continue after the first call date and are every interest payment date thereafter until maturity. With others, there may be only an annual opportunity.
Yield to maturity
The return an investor will receive if they buy a bond and hold the bond to maturity. It is the annualised return based on all coupon payments plus the face value or the market price if it was purchased on a secondary market. Yield to maturity thus includes any gain or loss if the security was purchased at a discount (below face value) or premium (above face value). It refers to the interest or dividends received from a security and is usually expressed annually or semi annually as a percentage based on the investment’s cost, its current market value or its face value. Bond yields may be quoted either as an absolute rate or as a margin to the interest rate swap rate for the same maturity. It is a useful indicator of value because it allows for direct comparison between different types of securities with various maturities and credit risk. Note that the calculation makes the assumption that all coupon payments can be reinvested at the yield to maturity rate. Also, the yield and coupon are different.
Yield to worst
Yield to worst is the yield in the worst case scenario, that is, if the issuer decides to call a bond at the worst possible time. Alternatively, the issuer may choose not to call a bond, which means investors receive a lower yield than if they had called it.
Yield to worst could be the same as yield to call if the first call is the worst outcome for an investor; it could be the same as yield to maturity if the investor is worst off when the company chooses not to call at all; or it could be lower than both of them where the investor is worst off if the company calls on the second or subsequent call date.
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