Debt security

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The Law and Lore of Repackaging

The Jolly Contrarian holds forth™

Essays on subjects dear to the old codger’s heart

Transylvanian Bond.jpeg
A bond certificate with coupons yesterday.
“Bond” as explained to my neighbor Phil

A bond (also called a “note”, “MTN” or a “debt security”) is a form of loan. It is like an IOU from a company or a government. Instead of taking one big loan from a bank, a company issues lots of little loans, in the form of bonds to investors. To buy a bond is to lend money to the issuing company, who must repay that money by “redeeming” the bond its stated maturity date. In the good old days, bonds were security-printed certificates with the loan terms and conditions printed on them.

Repayment to bearer: The company will pay principal and interest to the “bearer” of a bond — that is, whoever holds it, and who turns up on the correct payment date and presents the bond to the issuer for redemption.

Interest coupons: If interest is payable, the bond will have coupons — literally, little perforated tabs that you can tear off and present separately — for each interest payment. Hence the expression “coupon” has become synonymous in modern finance with interest.

Transferability: Because the issuer pays whoever holds the bond, this means the bond is negotiable — any bondholder can sell its bond to another investor without the issuer’s permission or knowledge. The issuer doesn't care: it has to redeem the same number of bonds, whoever holds them.

Electronic trading: Nowadays, almost all bonds trade and settle electronically, inside clearing systems, so there are no certificates or coupons, and everything happens in the blink of an eye. But the principle is the same.

Financial concepts my neighbour Phil was asking about when I borrowed his mower.

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Debt security
/dɛt/ /sɪˈkjʊərɪti/ (n.)
A freely transferable financial instrument evidencing indebtedness. Contrast debt securities to equity securities — instruments such as shares, warrants units, which pay neither principal nor interest, but rather account for the overall performance of the company who issue them. Debt securities generally rank ahead of equity securities in the capital structure of the issuer. This is because an issuer must pays off creditors before shareholders.

Comes in a few different types:

By type of issuer

Government bonds - issued by sovereigns so existing free of capital structure, logically immune to insolvency, but practically distressingly capable of default (yes we're looking at you Argentina) and of course the “who’s Queen?” gambit.
Corporate bonds: Ordinary debt instruments raised by businesses for their basic capital and operatonal requirements.
Structured notes: Weird & wacky securitised derivatives, issued outta espievies.

By name

Categorisations that will appeal (and occur) only to etiquette freaks — the sort of folk who are jazzed by which side of your plate you take the bun from — and lawyers:
Bonds: A bond is a debt security, traditionally bearing a fixed rate of interest, and issued as a stand-alone (rather than off an MTN programme). Compare with a note — which traditionally bears interest at a floating rate, and a medium term note, which can be fixed, floating or structured with all kinds of exotic derivative payoffs, but is issued from a medium term note programme, rather than as a stand-alone issue.
Notes: A note is a debt security, traditionally bearing a floating rate of interest, and issued as a stand-alone (rather than a medium term note, which is issued off an MTN programme).
Medium term notes: A medium term note is a debt security, which may bear a fixed or floating rate of interest (or some other kooky derivative payoff), and is issued off an MTN programme). These tend to be shorter term becasuse the tenor doesn’t justify the expense and brain damage of a fully standalone bond issue (seeing as the legal terms and risks are more or less identical and standalone documentation, whilst painful, doesn’t do any better a job of addressing it, this is a bad reason, by the way, for issuing standalone bond issues, but let’s gloss over that).

By interest feature

Bonds may bear interest, or not bear interest (zero-coupon), and may pay interest by reference to a pre-determined fixed rate or an objectively determinable floating rate, or a “variable rate” determined by reference to some other market indicator, the construction of which is really limited only by the imagination of structured products traders.

By position in the capital structure

Secured: Notes that are secured on a portfolio of identified assets. In the real-life corporate world, secured bonds are rare. In the structured products world, where espievies are involved, they are common, but this has nothing really to do with capital structure: a repackaging vehicle doesn’t really have a capital structure worth mentioning, and even where it does (where there are senior and junior tranches) all of them are secured.
Senior unsecured or “pari passu”: Normal corporate bonds tend to be senior, unsecured obligations which rank equally with each other — pari passu in the vernacular — and ordinary creditor claims in the insolvency of the issuer.
Subordinated notes: Debt instruments that are not paid until the senior notes are paid in full. These typically pay a higher interest rate, are for a longer period (and are sometimes perpetual) and are there to give the issuer access to stable, long-term, cheap but otherwise equity capital-like funding. In the banking world these may form part of the banks alternative tier one or tier 2capital.

By funkiness

Vanilla: Normal corporate bonds just pay a fixed or floating rate and give you your money back at maturity. These are, technically, credit-linked — in that an investor’s return is dependent on the solvency of the issuer — but are otherwise pretty standardised in terms. Don’t expect investors to parse the prospectus too closely.
Repackagings: Proverbial “weird and wacky securitised derivatives” — jam a par asset swap in an espievie and away you go...
Securitisations: Monetising future cashflows, once so rock ’n’ roll that even Bowie was into it until someone had the idea of...

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  • Why aren’t debt securities traded on exchange?
  • The complicated relationship between debt securities and credit derivatives
  • What happens if an issuer holds its own debt securities? Is some dark magic invoked, or a portal opened to a nasty dimension in the space-tedium continuum?
  • American stiltery about merger of a contract of indebtedness into a negotiable instrument
  • Could a very short-term — say, ooh, less than one year — debt security count as a “deposit” under FSMA?

See also