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alleviate credit risk. Secured bonds are backed by assets or financial guarantees pledged to ensure debt payment. Examples of collateral-backed bonds include collateral trust bonds, equipment trust certificates, mortgage-backed securities, and covered bonds.

      ● Credit enhancement can be internal or external. Examples of internal credit enhancement include subordination, overcollateralization, and excess spread. A surety bond, a bank guarantee, a letter of credit, and a cash collateral account are examples of external credit enhancement.

      ● Bond covenants are legally enforceable rules that borrowers and lenders agree on at the time of a new bond issue. Affirmative covenants enumerate what issuers are required to do, whereas negative covenants enumerate what issuers are prohibited from doing.

      ● An important consideration for investors is where the bonds are issued and traded, because it affects the laws, regulation, and tax status that apply. Bonds issued in a particular country in local currency are domestic bonds if they are issued by entities incorporated in the country and foreign bonds if they are issued by entities incorporated in another country. Eurobonds are issued internationally, outside the jurisdiction of any single country, and are subject to a lower level of listing, disclosure, and regulatory requirements than domestic or foreign bonds. Global bonds are issued in the Eurobond market and at least one domestic market at the same time.

      ● Although some bonds may offer special tax advantages, as a general rule, interest is taxed at the ordinary income tax rate. Some countries also implement a capital gains tax. There may be specific tax provisions for bonds issued at a discount or bought at a premium.

      ● An amortizing bond is a bond whose payment schedule requires periodic payment of interest and repayment of principal. This differs from a bullet bond, whose entire payment of principal occurs at maturity. The amortizing bond's outstanding principal amount is reduced to zero by the maturity date for a fully amortized bond, but a balloon payment is required at maturity to retire the bond's outstanding principal amount for a partially amortized bond.

      ● Sinking fund agreements provide another approach to the periodic retirement of principal, in which an amount of the bond's principal outstanding amount is usually repaid each year throughout the bond's life or after a specified date.

      ● A floating-rate note or floater is a bond whose coupon is set based on some reference rate plus a spread. FRNs can be floored, capped, or collared. An inverse FRN is a bond whose coupon has an inverse relationship to the reference rate.

      ● Other coupon payment structures include bonds with step-up coupons, which pay coupons that increase by specified amounts on specified dates; bonds with credit-linked coupons, which change when the issuer's credit rating changes; bonds with payment-in-kind coupons that allow the issuer to pay coupons with additional amounts of the bond issue rather than in cash; and bonds with deferred coupons, which pay no coupons in the early years following the issue but higher coupons thereafter.

      ● The payment structures for index-linked bonds vary considerably among countries. A common index-linked bond is an inflation-linked bond or linker whose coupon payments and/or principal repayments are linked to a price index. Index-linked payment structures include zero-coupon-indexed bonds, interest-indexed bonds, capital-indexed bonds, and indexed-annuity bonds.

      ● Common types of bonds with embedded options include callable bonds, putable bonds, and convertible bonds. These options are “embedded” in the sense that there are provisions provided in the indenture that grant either the issuer or the bondholder certain rights affecting the disposal or redemption of the bond. They are not separately traded securities.

      ● Callable bonds give the issuer the right to buy bonds back prior to maturity, thereby raising the reinvestment risk for the bondholder. For this reason, callable bonds have to offer a higher yield and sell at a lower price than otherwise similar non-callable bonds to compensate the bondholders for the value of the call option to the issuer.

      ● Putable bonds give the bondholder the right to sell bonds back to the issuer prior to maturity. Putable bonds offer a lower yield and sell at a higher price than otherwise similar non-putable bonds to compensate the issuer for the value of the put option to the bondholders.

      ● A convertible bond gives the bondholder the right to convert the bond into common shares of the issuing company. Because this option favors the bondholder, convertible bonds offer a lower yield and sell at a higher price than otherwise similar non-convertible bonds.

      PROBLEMS

      This question set was developed by Lee M. Dunham, CFA (Omaha, NE, USA), and Elbie Louw, CFA, CIPM (Pretoria, South Africa). Copyright © 2013 CFA Institute.

      1. A 10-year bond was issued four years ago. The bond is denominated in US dollars, offers a coupon rate of 10 % with interest paid semi-annually, and is currently priced at 102 % of par. The bond's:

      A. tenor is six years.

      B. nominal rate is 5 %.

      C. redemption value is 102 % of the par value.

      2. A sovereign bond has a maturity of 15 years. The bond is best described as a:

      A. perpetual bond.

      B. pure discount bond.

      C. capital market security.

      3. A company has issued a floating-rate note with a coupon rate equal to the three-month Libor + 65 basis points. Interest payments are made quarterly on 31 March, 30 June, 30 September, and 31 December. On 31 March and 30 June, the three-month Libor is 1.55 % and 1.35 %, respectively. The coupon rate for the interest payment made on 30 June is:

      A. 2.00 %.

      B. 2.10 %.

      C. 2.20 %.

      4. The legal contract that describes the form of the bond, the obligations of the issuer, and the rights of the bondholders can be best described as a bond's:

      A. covenant.

      B. indenture.

      C. debenture.

      5. Which of the following is a type of external credit enhancement?

      A. Covenants

      B. A surety bond

      C. Overcollaterization

      6. An affirmative covenant is most likely to stipulate:

      A. limits on the issuer's leverage ratio.

      B. how the proceeds of the bond issue will be used.

      C. the maximum percentage of the issuer's gross assets that can be sold.

      7. Which of the following best describes a negative bond covenant? The issuer is:

      A. required to pay taxes as they come due.

      B. prohibited from investing in risky projects.

      C. required to maintain its current lines of business.

      8. A South African company issues bonds denominated in pound sterling that are sold to investors in the United Kingdom. These bonds can be best described as:

      A. Eurobonds.

      B. global bonds.

      C. foreign bonds.

      9. Relative to domestic and foreign bonds, Eurobonds are most likely to be:

      A. bearer bonds.

      B. registered bonds.

      C. subject to greater regulation.

      10. An investor in a country with an original issue discount tax provision purchases a 20-year zero-coupon bond at a deep discount to par value. The investor plans to hold the bond until the maturity date. The investor will most likely report:

      A. a capital gain at maturity.

      B. a tax deduction in the year the bond is purchased.

      C. taxable income from the bond every year until maturity.

      11. A

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