Education

Australian Business Number issued by the Australian Taxation Office (ATO) 

The amount of interest that has been accumulated from the last coupon payment date to the settlement date when the bond is traded.

Any APRA approved instruments issued under the BASEL 111 framework e.g capital notes and converting preference shares.

Refers to an "authorised deposit taking institution" (as defined in the Banking Act)

Australian Financial Services License - granted by ASIC.

APIR Product and Participant Code issued by APIR Systems Ltd

Banks and other financial institutions administered by APRA who hold determined levels of regulatory capital

The Australian Prudential Regulation Authority (APRA) - oversees banks, credit unions, building societies, general insurance and reinsurance companies, life insurance, friendly societies and most members of the superannuation industry.

The Australian Prudential Regulation Authority (APRA) is the prudential regulator of the Australian financial services industry. It oversees banks, credit unions, building societies, general insurance companies and most of the superannuation industry.

Australian Registered Scheme Number issued by ASIC

Australian Securities and Investments Commision.

Appears on contract notes where the dealer has bought or sold securities on their own account (using their balance sheet).

Asset-backed securities, called ABS, are bonds or notes backed by financial assets other than residential or commercial mortgages-an investor is purchasing an interest in pools of loans or other financial assets. Typically these assets consist of receivables other than mortgage loans, such as credit card receivables, auto loans and consumer loans. As the underlying loans are paid off by the borrowers, the investors in ABS receive payments of interest and principal over time.

Refers to Australian Securities Exchange (ASX) Limited. The ASX is an Australian public company that operates Australia's primary securities exchange. ASX can refer to the public company itself or the securites market it operates.

Refers to Austraclear Limited. Austraclear operates a system in Australia for holding securites and electronically recording and settling transactions in those securities between members of that system. Austraclear is owned by ASX Limited, however, only settles securities that are not traded on the Australian Securities Exchange. It is similar to the CHESS system within the ASX.

Commonwealth Government Bonds (CGS) are medium to long term debt issued by the Treasury through the Australian Office of Financial Management (AOFM). These securities pay a fixed coupon semi-annual in arrears, which are redeemable at face value on the specified maturity date and are the most liquid fixed income security in the Australian. Bonds issued by the Commonwealth Government are considered a key benchmark when measuring relative yields on other fixed income securities and this helps set pricing.

Australian Government bonds are available to investors through the ASX in the form of Exchange Traded Treasury Bonds (eTBs). One unit of an eTB provides the holder with beneficial ownership of $100 Face Value of Treasury Bonds in the form of a CHESS Depositary Interest (CDI). This enables the holder to receive coupon Payments each six months and principal repayment at maturity from the Treasury Bond over which the CDI has been issued. All CGS/eTB issues are supported by the Commonwealth Government Consolidated Revenue Fund.

The Reserve Bank of Australia (RBA) maintains the Commonwealth Inscribed Stock Registry and bondholders within this registry eight days prior to the coupon interest payment date (the record date) are entitled to the interest payment. This is referred to as the ex-interest date and if securities are traded within the eight date, the new bondholder is not entitled to the upcoming interest payment.

CGS yields are highly correlated with market expectations of the future RBA cash rate and other global factors such as other sovereign bond yields and foreign monetary policy.

Figure 1. Historical Commonwealth Government Securities Outstanding

Due to the Federal Government’s ability to raise taxes and print money, CGSs are considered to be a risk-free investment and are authorised by the Commonwealth Inscribed Stock Act 1911. According to the act, principal and interest of CGSs are guaranteed by the Commonwealth’s Consolidated Revenue Fund and authority is granted to the present treasurer of the Commonwealth of Australia regarding future issuance of CGSs.

e.g banks and other deposit -taking institutions.

The average time to receive each dollar of principal and interest over the life of a security.

A short term transferable instrument issued by banks.

A bank capital security is a term which defines both Tier 1 and Tier 2 regulated capital instruments for APRA approved authorised depository institutions (ADI's). They are also known as bank hybrids, bank capital notes and convertible preference shares. As a general rule they sit below deposits, senior debt and other liabilities but above common equity. By way of example tier1 securities may be subordinated, unsecured , perpetual debt of a bank and be exchangeable under certain conditions for equity or be redeemed at the option of the bank at a future date.

Refers to the Banking Act (1959) (Cth) or successor legislation.

The revised framework issued between 2010-2012 by the BASEL Committee for the calculation of capital adequacy for banks. It is a global, voluntary regulatory standard on bank capital adequacy, stress testing and market liquidity risk. It was agreed upon by the members of the Committee in 2010–11, and was scheduled to be introduced from 2013 until 2015; however, changes from 1 April 2013 extended implementation until 31 March 2018 and again extended to 31 March 2019.^[1][2] The third installment of the Basel Accords was developed in response to the deficiencies in financial regulation revealed by the late 200's financial crisis. Basel 3 was supposed to strengthen bank capital requirements by increasing bank liquidity and decreasing bank leverage.

Smallest measure used in quoting yields on bonds and notes. One basis point is 0.01% of yield. For example, a bond's yield that changed from 5.52% to 5.72 % would be said to have moved 20 basis points.

The average mid rate of bank bills of a nominated term (normally 90 or 180 days).

A security that has no identification as to owner. It is presumed to be owned by the bearer or the person who holds it..

The interest rate reference point such as BBSW /bank bills/commonwealth bonds against which other securities are compared.

One who benefits from owning a security, even if the security's title of ownership is in the name of a custodian company.

Price at which a buyer is willing to purchase a security.

A short-term direct tradeable obligation of banks

A bond is a debt security or loan by the issuer and is an obligation by the issuer to pay a specified distribution at regularly defined intervals and to pay the principle (original loan) at maturity. Australian bonds are issued by Australian federal and state governments and Australian corporations. Investors generally purchase these securities to provide capital stability, cashflow, liquidity and diversity in their investment portfolio. Bonds can be listed on the ASX , but the majority of bonds in Australia trade in the  over-the-counter (OTC) market. In some circumstances the same bond may be offered in both markets i.e Commonwealth Treasury Exchange Traded Bonds (eTB's) , so it is worth checking which price is the most advantageous.

Registered investment companies (or trusts) whose assets are invested in diversified portfolios of bonds.

A legal document which details the mechanics of the bond issuer, security features, covenants, events of default and other key features of the issue's legal structure. Indentures and trust agreements are functionally similar types of documents, and the use of each depends on the individual issue and issuer.

A firm or person who acts as an intermediary buying and selling securities on an agency basis rather than for its own account.

An amount charged by a dealer or intermediary for transacting on behalf of an investor client

A security with a fixed maturity and no call feature.

In relation to a date on or by reference to which a payment on a Subordinated Note is to be made or calculated, the convention specified in the Pricing Supplement for the adjustment of that date if it would otherwise fall on the date that is not a Business Day, and:

1. if "Following" or no convention is specified, means that the date is postponed to the next Business Day
2. if "Modified Following" is specified, means that the date is postponed to the next Business Day unless that day falls in the next calendar month in which case that date is brought forward to the preceding Business Day
3. if "Preceding" is specified, means that the date is brought forward to the preceding Business Day
4. if "No Adjustment" is specified, means that the date is not adjusted

Refers to a security with a favourable outlook.

Actions taken to repay the principal amount prior to the stated maturity date, in accordance with the provisions for ŇcallÓ stated in the prospectus or information memorandum. Another term for call provisions is redemption provisions.

Bonds that are subject to payment of the principal amount (and accrued interest) prior to the stated maturity date. Bonds can be callable under a number of different circumstances, including at the option of the issuer, or on a mandatory or extraordinary basis.

The date at which some bonds are redeemable by the issuer prior to the maturity date.

A dollar amount, usually stated as a percentage of the principal amount called, paid as a penalty or a premium for the exercise of a call provision.

The specified price at which a bond will be redeemed or called prior to maturity.

The risk that declining interest rates may accelerate the redemption of a callable security, causing an investor's principal to be returned sooner than expected. As a consequence, investors may have to reinvest their principal at a lower rate of interest.

CIBs (also see indexed linked securities and index ratio) pay a pre-determined coupon based on a capitalising principal amount where the capitalisation/indexation is a factor usually based on the rate of consumer price inflation (CPI) as a reported function of inflation as per indexation by the Australian Bureau of Statistics. Interest is payable on the current indexed capital amount  at a fixed coupon rate - this is called the 'base payment'. For example, a capital indexed bond might have a base capital value of $100 in year one and a coupon of 4%. If, in year one, the CPI increases by 5%, then the base capital value would rise from $100 to $105. If the base capital value were to remain the same, the 4% coupon would then be paid on the new base of $105. As the inflation indexation factor is usually based on the rate of consumer price inflation (CPI) a positive cpi figure increases the principal value of the security over time . The indexation of outstanding principal is based on lagged movements in the relevant cpi quarterly series. Indexation results in part of the periodic return being effectively capitalised into the outstanding principal therefore. During negative periods of inflation the coupon will be paid on a decreasing principal. Specifically with Commonwealth Government CIB's (eTIB's) , the final payment can never be less than the original capital value at issue i.e $100.

Traditionally a longer term debt security paying regular interest for a specified term , but today has several meanings whereby the security can be either debt or possibly equity that coverts to shares of a company upon specific circumstances.

The value of the security estimated by the market excluding accrued interest. It is based on a number of variables including current market interest rates relative to the coupon rate, time of maturity, ranking and credit quality.

Refers to the way a corporation finances it's assets through the combination of equity ,debt or hybrid securities (excludes accrued interest).

A security backed by a pool of bonds, loans and other assets.

(i) a change in the ownership of a corporation; (ii) a change in the effective control of a corporation; and (iii) a change in the ownership of a substantial portion of the assets of a corporation.

Clearing house electronic subregister system operated by ASX settlement.

This is similar to a settlement date, but occurs for a new issuance of bonds. The closing may be as long as 30 days in case of a competitively sold issue.

Securities or property pledged by a borrower to secure payment of a loan. If the borrower fails to repay the loan, the lender may take ownership of the collateral.

The process by which a borrower pledges securities or property or other types of financial assets in order to provide security or collateral toward repayment of a loan or debt.

The fee paid to a dealer or broker when acting as agent in a transaction, as opposed to when the dealer acts 'as principal' in a transaction

A share representing participation in the ownership of an enterprise, generally with the right to participate in dividends and in most cases to vote on major matters affecting shareholder interests.

The highest quality of capital available to banks, which is freely available to absorb losses. It comprises ordinary share capital, retained earnings and reserves.

Issued by the Commonwealth Government of Australia and supported by the consolidated revenue account.

Interest that is calculated on the initial principal and is reinvested at the coupon rate at pre determined intervals and repaid in total at maturity.

Refers to the terms and conditions, as supplemented, modified or replaced to a Subordinated Note by the Pricing Supplement.

The measure of changes, over time, in retail prices of a constant basket of goods and services representative of consumption expenditure by resident households in Australian metropolitan areas. _

A document used by securities dealers and brokers to state in writing the terms of settlement and based on a previous arrangement to buy or sell a security.

The exchange of a bond (or note) into a type of equity usually at a predetermined price on or before a predetermined date.

A conversion condition is a condition precedent to conversion. In the context of capital securities it means that before conversion into ordinary shares can happen there are a number of conditions which must be met first. In the new Basel III eligible securities the standard conditions are:

• First Mandatory Conversion Condition: the VWAP on the 25th Business Day immediately preceding the scheduled Mandatory Conversion (or exchange) Date is greater than 56.00% of the Issue Date VWAP;
• Second Mandatory Conversion Condition: the VWAP during the period of 20 Business Days prior to the scheduled Mandatory Conversion (or exchange) Date is greater than 50.51% of the Issue Date VWAP; and
• Third Mandatory Conversion Condition: The ordinary share of the issuer must be listed and have not been suspended for a per of 5 continuous days prior to the conversion date.

The VWAP is always specific to the individual security (not the issuer) and investors should check the documentation to retrieve it.

A discount applied to the underlying stock price upon conversion of a hybrid security.

The Conversion Number is calculated according to the following formula, subject to the Conversion Number being no greater than the Maximum Conversion Number:

1. Conversion Number for each Note = Nominal Amount / ((1-% Discount) x VWAP);
2. VWAP refers to the VWAP of the issuers ordinary shares over the latest period of 5 business days on which trading of the issuers ordinary shares took place before (but not including) the conversion date;
3. Nominal Amount;

The Maximum Conversion Number:

Nominal Amount ($) / ( variable % x Issue Date VWAP). Issue Date VWAP refers to the VWAP of the issuers ordinary shares over the 20 business days on which trading of the issuer ordinary shares took place before (but not including) issue date of the notes.

A corporate bond that may be converted into shares of another security under stated terms, often into the issuing company's common stock.

A security ranking ahead of common equity for the payment of dividends and principal and have a prior claim over the company's assets - converts at some point into the ordinary shares of a company.

A measure of the change in a security's duration with respect to changes in interest rates. The more convex a security is, the more its duration will change with interest rate changes.

A debt obligation (bond) issued by a corporation, maybe senior secured, senior unsecured or subordinated. Senior corporate bonds are secured against company property and rank ahead of other secured creditors.

The Australian fixed income market is a significant source of funds for Australian and international corporations. Senior debt is issued by corporations to finance projects and other day-to-day business activities. These types of securities can generally take four forms:

In terms of the capital structure,

Senior Secured

• Covered Bonds – The obligations of a covered bond are secured against a pool of assets. This means in the event of default investors have first claim to repayment from the underlying assets. In Australia these bonds are commonly issued by airports and in 2011 the Commonwealth Government gave domestic banks the right to issue these securities also. However, this has been capped by the Australian Prudential Regulation Authority (APRA) at 8% of total assets to protect depositors.

Senior Unsecured

• Fixed Rate Bonds – similar to Commonwealth Government Securities, corporate fixed rate bonds pay a constant semi-annual interest payment until maturity. However, this coupon can be subject to step-up or step-down conditions dependent on certain security-specific clauses.
• Floating Rate Notes – These securities generally pay interest on quarterly basis equal to an appropriate floating benchmark rate with a fixed margin. The benchmark rate is usually the 90-Day Bank Bill Swap Rate which resets every quarter. As a result, distribution income will fluctuate with movements in interest rates. This effectively mitigates the interest rate risk inherent in fixed coupon bonds. Floating rate notes can also be subject to changes in fixed margin depending on certain conditions.
• Indexed-Linked Bonds – As previously mentioned, corporations can issue inflation-linked bonds. These bonds are generally structured in the same manner described in the preceding section.

Figure 1. Corporate Australian Dollar Denominated Bond Issuance 2015.

Refers to the Corporations Act 2001 (Cth).

The amount of interest due and the date on which payment is to be made. Coupons are generally payable quarterly or semi-annually.

The actual dollar amount of interest paid to an investor. The amount is calculated by multiplying the interest of the bond by its face value.

The coupon rate is the rate of interest or distribution paid by the issuer. The rate is usually expressed as a percentage of the face value of the security.The three types of coupon payments are:

• Floating rate: where distributions are based off a benchmark usually AFMAs Bank Bill Swap Rate (90 Days or 180 Days) and consist of a predetermined margin plus the benchmark (i.e 90-Day BBSW plus 1.0%).
• Fixed rate: the coupon rate is fixed at a predetermined rate for the duration of the debt security. (i.e 4.0% Fixed)
• Indexed : coupons are indexed each quarter to take into account movements in the cpu

The issuer's pledge, in the financing documents, to do or to avoid from doing certain practices and actions (e.g limiting borrowings to a max. % of the capital of a company).

covered bonds are debt securities by banks that are usually fully collateralized by residential or commercial mortgage loans institutions. Interest on the covered bond is paid to investors from the issuer's cash flows, while the cover pool serves as secured collateral. Covered bonds typically have high credit ratings and offer a lower yield due to their highly secure nature.

The use of the credit of a stronger entity to strengthen the credit of a weaker entity in bond or note financing. This term is used in the context of bond insurance, bank facilities and government programs.

A company that analyses the credit worthiness of a company or security, and indicates that credit quality by means of a grade, or credit rating.

Designations used by ratings services to give relative indications of credit quality.

The risk for bond investors that the issuer may default on its obligation (default risk) or that the bond value will decline and/or that the bond price performance will compare unfavourably to other bonds against which the investment is compared , due either to perceived increases in the risk that the issuer will default (credit spread risk) ,or that a company's credit rating will be lowered (downgrade risk).

A yield difference to a benchmark such as BBSW or comparable securities that reflects the issuer's credit quality i.e poorer credit issuers should generally attract a higher credit spread compared to better quality issuers.

Where one security may deteriorate in relative terms to another

Deferred distributions accumulate and continue to accrue interest at the prevailing distribution rate until paid.

A financing structure under which existing securities are called or mature and are refinanced with another security issue

For the purpose of calculating an amount for any period of time (Calculation Period), the day count front specified in the Pricing Supplement, and:

1. If "Actual/365" or "Actual/Actual" is specified, it means the     actual number of days in the calculation period divided by 365 or, if any portion of the Calculation Period falls in a leap year, the sum of: 

• the actual number of days in the portion of the Calculation Period fallin in a leap year divided by 366 and;
• the actual number of days in the portion of the Calculation Period falling in a non-leap year divided by 365​

2. If no day count fraction is specified, the actual number of days in the Calculation Period divided by 365

3. If "RBA Bond Basis" is specified, one divided by the number of Interest Payment Dates in a year.

A securities firm or department of a commercial bank that engages in the underwriting, trading and sale of securities.

Unsecured debt obligations, issued against the general credit of a corporation, rather than against a specific asset.

Debt covenants, also called banking covenants or financial covenants, are agreements between a company and its creditors that the company should operate within certain limits for example, agree to limit other borrowings or to maintain a certain gearing level. Other common limits include levels of interest cover, working capital and debt service cover. These levels can be written into a prospectus or information memorandum to protect security holders.

Statutory or constitutional limit on the principal amount of debt that an issuer may incur (or that it may have outstanding at any one time).

Loans, bonds, leases, and other debt instruments owed by a corporation. Debt obligations are carried on a company's books as a liability.

Ability of the borrower to service principal and interest payments on a security.

The ratio of net revenues to the debt service requirements.

Amounts required to service debt, often expressed in the context of a time frame (such as Ňannual debt service requirementsÓ).

A large discount to the original issue or par value of a security - due to either deterioration in the credit of the issuer or an adverse movement in interest rates.

Failure to pay principal or interest when due. Defaults can also occur for failure to meet non-payment obligations, such as reporting requirements, or when a material problem occurs for the issuer, such as a bankruptcy.

Possibility that a security issuer will fail to pay principal or interest when due.

Termination of the rights and interests of the trustee and bondholders under a trust agreement or indenture upon final payment or provision for payment of all debt service and premiums, and other costs, as specifically provided for in the trust instrument.

The face value or par value, of a bond or note that the issuer promises to pay on the maturity date. The prospectus or Information Memorandum outlines the initial minimum tradeable amount and denominations thereafter i.e $500,000 and multiples of $10,000 thereafter

A financial product that derives its value from an underlying security. The most heavily traded interest rate derivative is the bank bill futures contract by way of example.

The amount by which a security is trading at less than it's issue or 'par' price i.e a bond that was issued at $100 is now available at $98 capital price(excluding it's accrued interest) . If the security was issued with a 5% coupon and has two years to run the discount of $2 would give this security a yield to the buyer of approximately 6% p.a.

A dividend or interest rate return or coupon payment.

If distributions on a hybrid security are suspended ,the issuer cannot pay dividends on junior or equal ranking capital - depends on the terms of the issue.

Possibility that a bond's rating will be lowered because the issuer's financial condition, or the financial condition of a party to the financial transaction, deteriorates.

The weighted maturity of a fixed-income investment's cash flows ,taking into account all coupon interest payments and the maturity date - used in the estimation of the price sensitivity of fixed-income securities for a given change in interest rates i.e shorter duration bonds are less sensitive to market interest rate movements than long bonds.

Refers to the date on which a Subordinated Note is to be redeemed as specified in the Early Redemption Notice.

A provision within a bond giving either the issuer or the bondholder an option to take some action. The most common embedded option is a call option, giving the issuer the right to call, or retire the security before the scheduled maturity date.

A specialised portfolio of higher yielding securities purchased as a substitute for cash at a bank , term deposits or cash management accounts in order to increase investment income.

Refers to what will occur in the event in which an issuer is unable to pay its debt security obligations. These terms are usually found in the issuer's information memorandum or product discloser statement (PDS).

The risk that an issuer's ability to make debt service payments will change because of unanticipated changes, such as a corporate restructuring, a regulatory change or other changes in their circumstances

The term "exchange" or "exchangeable" in the content of securities documentation can have varied meanings and investors should check the individual prospectus for its meaning. It can mean any of the following:

• Conversion
• Redemption
• Resale

A fund that tracks an index, a commodity or a basket of assets. It is passively-managed like an index fund, but traded like a stock on an exchange, experiencing price changes throughout the day as they are bought and sold. Bond ETFs like bond funds, hold a portfolio of bonds and can differ widely in their investment strategies.

Otherwise known as the par value (i.e., principal, or maturity, value) of a security appearing on the face of the instrument. In most cases this is $100.

The date on which the principal must be paid to investors, which is later than the call or reset date i.e many securities have a first call date at the issuers discretion - if not called the bond may not then mature until the final or legal maturity date.

An agreement with a dealer to buy or sell securities for a stated price for a period of time i.e the offer is "good for one hour "

The date at which an issuer may redeem the security earlier than the final maturity date

In Australia the fixed income asset class receives comparatively less media attention than equities. For this reason, many investors find fixed income jargon, research and its related concepts confusing and hard to understand. However, in periods of extreme volatility relatively safe income securities can be the backstop to portfolio losses by offsetting the underperformance of other asset classes.

While equities are viewed as a growth asset, fixed income is classified as a defensive asset. As a result, capital protection, income generation and diversification are first priority when investing in fixed income securities to minimise volatility and reduce the probability of capital loss. This will ensure that a steady income will be paid over the life time of the security and more importantly, the principal will be paid back at maturity.

Although this seems simple enough, misunderstanding of these key principles is one of the major downfalls of Australian investors. While a truly balanced portfolio would include both equity and fixed income, selection criteria is quite different. As fixed income is primarily a defensive asset class, the primary objective of analysis is to avoid bad issuers rather than seeking growth prospects (as priortised in equity analysis). The real driver of fixed income value is the probability of the underlying issuer deteriorating over the life of the security.  While you may be successful with a 60%-win rate in equities, this success would be a failure in the world of fixed income. It is therefore imperative that investors understand this concept before they venture into the Australian fixed income market.

Structural Differences

• Term: Fixed Income securities have a fixed term while equities are viewed as a perpetual investment
• Income: Fixed Income securities offer agreed periodic interest payment schedule over the term of the investment. On the other hand, there is no promise of dividends for equity holders.
• Return: Specified rate of return depending on the capital price of the fixed income securities and value of scheduled interest payments. There is no specified return for equity holders and future value is much more uncertain and subject to greater volatility.
• Capital: Fixed Income investors received full capital repayment at the end of their investment in the absence of the issuer defaulting. Equity investors receive the end market value of their shares.
• Ranking: In the event of default, claims made by debt investors rank ahead of equities.

Figure 1. Fixed Income Performance Vs Equity Performance

The coupon interest rate has been set at the time of issue and will remain fixed for the life of the security. Commonwealth and State Government bonds are predominately issued with a fixed coupon rate. (see fixed rate v floating rate securities - pros and cons)

Fixed rate securities have a 'known' interest rate, coupon or distribution set for the life of the security.

Pros

1.Investors can precisely forecast their investment income going forward

2.Purchased when interest rates are high, locks in attractive returns going forward

3.In a falling interest rate market may give the opportunity to realise capital gains

Cons

1.Too much exposure to fixed rate securities when interest rates are rising may result in poor performance in comparison to a balanced portfolio that includes floating rate securities   

2.Sale of fixed rate securities in a rising interest rate environment may result in capital losses (due to the inverse relationship of yields and prices)

Floating rate securities (or FRN's) pay a margin (set at issue) over a benchmark such as 90 day BBSW . As such the returns will alter (or float) with underlying movements in short term rates.

Pros

1. Returns from these securities will generally outperform fixed rate securities in a rising interest rate market.

2. Generally are less price volatile as coupons/distributions are reset to market every 90 days

3. Can be a proxy hedge against rising inflation

4. An easier investment choice than fixed rate when direction of long term rates is difficult to determine

Cons

1. Underperform fixed rate securities in a declining interest rate market

2. Difficult to determine exact income over the life of a floating rate security

3. Changes in the ongoing trading margin requires monitoring over time (as do fixed rate securities)  

FRN's pay interest that varies over the life of the security. There are two components, a fixed interest  margin over a benchmark such as BBSW (set at the time of issue) and the benchmark rate itself (e.g BBSW ) .The coupon interest paid on a FRN security therefore rises and falls with the movement in market rates . A large percentage of issues are FRN's - these provide investors protection when market rates are rising ,as opposed to fixed rate bonds which can lose capital value as rates rise.

Refers to the structure which is established in the bond resolution or trust documents which sets forth the order in which funds generated by a company will be allocated to various purposes.

(Bank bill rate + margin)X (1- Tax rate).

Franking credits ( also known as Imputation Credits) are a type of tax credit that allows Australian Companies to pass on tax paid distributions at the company level to shareholders. The benefits are these franking credits can be used to reduce income tax paid on other dividends or potentially be received as a tax refund.

The value of an asset at a specified date in the future, calculated using a specified yield or rate of return.

A financial ratio that compares shareholder's equity to borrowed funds. As such, the gearing ratio is a measure of the firm's debt leverage and therefore a measure of business risk.

The issuance platform used when issuing "global" debt into the international marketplace or a particular foreign market.

Refers to any country, state or political subdivision or any government or central bank or any governmental, semi-governmental, international, judicial, administrative, municipal, local governmental statutory, fiscal, monetary or supervisory authority, body or entity.

Securities issued by the Federal and State governments.

Yield expressed inclusive of any franking credits.

Refers to a particular private or public company and each of its subsidiaries.

Bonds issued by lower-rated corporations, sovereign countries and other entities offering a higher yield than more creditworthy securities; sometimes known as junk bonds.

Holder Identification Number for ordinary shares or notes held on the CHESS subregister.

Refers to, in relation to any Subordinated Note, a person whose name for the time being is recorded in the Register as the owner of the Subordinated Note.

A neutral recommendation - the security is neither a buy or a sell and could remain in a portfolio.

Issuer legal document which details the mechanics of the bond issuer, security features, covenants, events of default and other key features of the issue's legal structure. Bond resolutions and trust agreements are functionally similarly types of documents, and the use of each depends on the individual issue and issuer.

Payments from these bonds (also known as Inflation Indexed Annuities IIA) consist of a portion of the principal plus an interest component similar to a principal reducing mortgage. The principal component plus the interest rate( in the absence of inflation) is called the base payment or base annuity. The base payments are indexed by inflation over the life of the bond, resulting in a steady increase in payments over the term ,if inflation is greater than zero. The principal or face value of an IAB is returned over the life of the bond such that no principal remains upon the final payment date/scheduled maturity date. This is the opposite of a CIB where the principal value increases over the life of the bond (assuming the cpi is greater than zero)

The factor or index that adjusts the capital price of an inflation linked security to inflation i.e if the index factor was 1 at the start of the year and inflation was 2.5%, it would be 1.025 at the end of the year. This change results in a coupon based on the face value times the index factor; in year two this would be $102.50, so the fixed coupon set when the security was issued is paid based on the higher capital amount.

Inflation-Linked Bonds (also known as ‘linkers’) can either by issued by Commonwealth of Australia, State Governments or corporations. These securities are structured so their coupon payments are linked to the current inflation rate. When coupons are set at a fixed rate, inflation erodes the purchasing power of interest payments over time. Inflation-Linked Bonds mitigate this risk and can be particularly useful for those invests at or near retirement. The value of these instruments are linked to inflation expectations.

The face value of a Linker is typically adjusted each quarter for movements in the Consumer Price Index (CPI). This equates to the Nominal Value (NV). Fixed rate interest payments are usually paid quarterly in arrears on the nominal value. If deflation occurs and the nominal value falls below the face value of bond the interest payments will be based on face value. At maturity the holder receives the nominal value or the initial face value (whichever is greater). The CPI measures the price changes of a ‘basket’ of goods that cover a large proportion of expenditure for the average Australian household. Since the adoption of a 2-3% inflation by the Reserve Bank of Australia (RBA) in 1996, the CPI has broadly tracked an annual increase broadly within this range. 

Figure 1. CPI (excluding volatile items) against the RBA Target Inflation Range

Although corporations can issue linkers, these securities are primarily dealt with by the Federal and State governments. In 2009, the AOFM made a commitment to increase inflation-linked bond issuance. This is shown in Figure 2.

Figure 2. Treasury Inflation Linked Bonds Outstanding

Generally the term given to securities that adjust with movements in the cpi .

A portfolio that consists mainly of floating rate and cpi indexed linked securities .

An Information Memorandum (IM) is a document given by a company to prospective clients after the investors as a marketing document which provides a selective overview of the attractive features of a company. This document aims to attract people to invest in the different issues and securities outlined by the IM.

A legal document stating the objectives, risks and terms of investing in a corporate security. This includes items such as the financial statements, management biographies, detailed description of the business, etc. An IM serves to provide buyers with information on the offering and to protect the sellers from the liability associated with selling unregistered or unlisted securities. The majority of securities issued in Australia are unlisted 'over the counter' and use an IM as an offering document.

Longer term securities used to finance large infrastructure projects such as transportation, communications and the provision of services such as water and energy.

An amount paid to investors for the use of money, usually expressed as an annual percentage rate.

The date specified in the Pricing Supplement as its Interest Commencement Date or as the date from which interest accrues or is taken to have accrued on the fixed income security. If no such date is specified, the Interest Commencement Date is the issue date.

EBITDA / Net Interest Expense.

Each date specified in or determined in accordance with the applicable Pricing Supplement to be an Interest Payment Date or date for the payment of interest on a fixed income security, subject to adjustment in accordance with the applicable Business Day Convention.

Each successive period beginning on and including an Interest Payment Date and ending on but excluding the next succeeding Interest Payment Date. This is provided that the first Interest Period commences on and includes the Interest Commencement Date of the security and the final Interest Period ends on but excludes the Maturity Date of the security (or, if earlier, the day on which it is or is required to be redeemed).

Interest rates change in response to a number of factors, including revised expectations of inflation, the level of economic activity and the volume of new securities coming to market.

 The SWAP rate is the benchmark rate used to settle all SWAP, Forward Rate Agreement (FRA), Interest Rate Options for all inter-bank transactions and many corporate transactions. It is the Australian equivalent of the LIBOR (London Inter Bank Offer Rate) and SIBOR (Singapore Inter Bank Offer Rate): the interest rate that banks charge each other on inter bank loans. The swap curve in Australia covers terms from 30 days to 15 years and is a predictor of where banks will lend to each other in the future. Most fixed income investments are categorised for their credit quality in terms of their margin over the bank swap curve (except for Commonwealth Treasury Bonds which are priced at a margin below the curve due o their superior credit quality).

Short-term interest rates exceed long-term interest rates. (See Ňpositive yield curve")

Those securities rated Baa3 or better by Moody's, or BBB- or better by Standard & Poor's Corporation (see "ratings").

Identifies the details of an issuer of securities and details of the interest rate paid , maturity and a security identity code.

The date on which a security is deemed to be issued from which date the security holder is entitled to receive interest payments.

A government entity, agency, authority or corporation that borrows through the sale of securities.

Groups of separate underwriting firms that jointly guarantee the placement of securities into the market place for the issuer.

A security with a claim on a corporation's assets and income that is subordinate to that of a senior security. For example, common stock is junior to preferred stock, which is junior to unsecured debt, which is junior to secured debt.

A term given to debt obligations paying interest above the return on more highly rated bonds - (see high-yield bonds).

(see final maturity date).

The use of borrowed money to increase investing power (see gearing ratio).

A contract under which one party (the insurer) accepts significant insurance risk from another party (the policyholder) by agreeing to compensate the policyholder if a specified uncertain future event (the insured event) adversely affects the policyholder.

an insurance contract, or a financial instrument with a discretionary participation feature, regulated under the Life Insurance Act 1995, and similar contracts issued by entities operating outside Australia

The ability to trade bonds efficiently without causing any major changes in their prices. Also the daily volumes which trade in any given security on a regular basis.

Liquidity risk is almost always overlooked in research but it is a vital consideration for investors in a portfolio sense. In our experience understanding liquidity risk is critical to meeting you portfolio objectives over a specific timeline. Not managing liquidity requirements properly has in the past caused the closure of funds and is therefore extremely important for investors to consider whether the amount of liquidity in a fund’s holdings matches the amount of liquidity offered to its investors. As a direct investor this is equally important but you as an individual have a choice rather than a pooled vehicle and therefore liquidity events can also create opportunity.

The analysis of liquidity risk in Australia is made difficult because it is less transparent than other countries (this is in relation to over the counter markets). Liquidity risk can almost be measured in the listed market through bid and offer spreads and the daily turnover as a proportion of available stock. However, even this is not accurate as a liquidity event will cause volatility to rise and the bid/offer spread (if there is a bid) widens.

In terms of participating in over the counter markets there are two points worth considering:

• Liquidity is skewed:  It is readily available when not needed, and impossible to find when it is needed. Therefore, demand for liquidity is highly skewed (and arguably correlated with credit risk).
• Implications – An individual can manage and value their own liquidity. However, a fund cannot. A fund redemption dictates a liquidity event but liquidity risk will only become apparent in times of a liquidity shortage. 

Investors will be biased to underestimate liquidity In a similar vein, the skewness of liquidity means that most of the time, the cost of liquidity will be lower than the long term average (with occasional periods where it is much higher).

First trading day of new security listed on the ASX.

A term given when securities are owned by a dealer or investor and held on their balance sheet.

Debt which matures later than one year.

The underwriter that serves as the lead underwriter for an account. The ŇmanagerÓ generally negotiates the interest rate and purchase price in a negotiated transaction or serves as the generator of the consensus for the interest rate and purchase price to be bid in a competitive bidding situation. See also Ňjoint lead managers."

A type of convertible security that has a required conversion features where securities are converted into ordinary shares of the company. This can occur either on a contractual conversion date or later when conversion conditions are satisfied.

The Marginal Cost of Funding is explained as the cost to the issuer of new wholesale funding (non deposit funding) relative to its overall wholesale funding position. For example if the average cost of funding for an issuer is 1.20% (over the risk free benchmark or equivalent) and a new funding was costing 1.0% then we would say the marginal cost of funding is below the average cost of funding meaning that this is a positive for the issuer.

A measure of the ease with which a security can be traded in the primary and secondary market without an undue price concession. (also see liquidity).

The last reported price for which a security was traded through an exchange or 'over the counter'. Price is generally per $100 of face value and includes two components:- i) capital value: the value of the security determined by applying the Yield to Maturity prevailing in the market at the time. It is based on a number of variables including current market interest rates relative to the coupon rate, time of maturity, ranking and credit quality. ii) accrued interest: the amount of interest accumulated on a security since the last payment. A security price should increase daily by the amount of interest that has accrued.

Potential price fluctuations in a bond due to changes in the general level of interest rates.

The date when the principal amount of a security becomes due and payable, if not subject to prior call or redemption.

The maximum number of shares allocated under the conversion terms of a convertible security.

A debt security ( generally longer than one year) that is issued under a program that allows an issuer to offer notes continuously to investors through a group of managers.

A portfolio of securities constructed to serve a special purpose or to be used as a general guide when investing in securities.

The duration of a security modified to take into account current prices and yields.

Mortgage-backed securities, called MBS are bonds or notes backed by mortgages on residential or commercial properties-an investor is purchasing an interest in pools of loans or other financial assets. As the underlying loans are paid off by the borrowers, the investors in MBS receive payments of interest and principal over time.

Market for new issues of bonds and notes (see primary market).

A bond that cannot be called for redemption at the option of the issuer before its specified maturity date.

A security where the holder does not receive compensation for any unpaid or omitted dividends.

(see High-Yield Bonds)

The point of non-viability (PNV) is the second line of defence before a public injection of funds is necessary to support the issuer. This point has not been clearly defined and will remain subjective for APRA's purpose (which is ultimately to protect the public from having to support a failing banking institution). It is our opinion that the point of non-viability is before default or insolvency (but probably after the capital trigger) because it is in the interest of APRA to maintain solvency in domestic banking institutions. A non-viability trigger event has been defined in securities prospecti as when APRA notifies an institution in writing that it believes:

• Conversion or write-off of some or all loss absorbing securities (preference shares/ capital notes) is necessary because, without it, the institution would become non-viable; or
• A public sector injection of capital, or equivalent support, is necessary because, without it, the institution would become non-viable.

The non-viability trigger ultimately gives APRA discretion to convert (or write off) these securities into equity when it deems it appropriate. The use of this trigger event may not be limited to its concerns about the institutions capital levels and could extend to concerns about the bank's funding and liquidity. International examples of this are SNS Reaal being nationalised due to losses on commercial property, inability to refinance and/or add new capital into the business. Prior to being nationalised its T1 Capital ratio was 8.8% suggesting it was healthy in terms of capital. Another example is the failure of Lehman Brothers in 2008 which has a reported Tier 1 Capital Ratio of 10.7% at the time of failure. These examples show that non-viability will be triggered due to factors such as liquidity and funding risks. These ratios were materially above the minimum requirement but htey still failed. This suggests that other factors such as liquidity and funding risks can be key drivers of a non-viability event. This is also why APRA is not specific about how to define a non-viability trigger event.

At BondAdviser we believe that forward-looking analysis of an issuers capital management, funding and liquidity plans (as well as asset growth) are key factors to identifying risk risks. There is significant downside risks for capital instrument investors (whether they are preference shares of capital notes) if an issuer approaches non-viability in the eyes of APRA and once problems arise it is quite possible that the secondary market liquidity for the banks new capital instruments would be poor.

Importantly, the time distinction between the capital trigger event and non-viability trigger event would, in all likelihood, be small. A slow deterioration in capital would be captured by the capital trigger, but a sharp deterioration where asset write-offs are very large would be captured by non-viability. As with the capital trigger event, conversion will occur using the same predefined calculation, with the number of shares received being a function of a calculation known as the conversion number. This conversion number has a maximum limit (known as the maximum conversion number) which will automatically write down the value of your investment depending on the common equity share price over the preceding five days. As non-viability conversion is forced, we assume a 0% recovery upon conversion.

The price at which a seller will sell a security.

The disclosure document prepared by the issuer that gives security and financial information about the issuer and the bonds or notes to be issued - currently a required document if the issue is to be sold to the general public in Australia.

Offering details prepared by the issuer disclosing security features, and economic, financial and legal information about the issue. It also contains the pricing information not contained in the initial Information Memorandum (IM).

The price at which members of an underwriting syndicate for a new issue will offer securities to investors.

The overnight cash rate set by the Reserve Bank of Australia (RBA) - used as a monetary policy tool to set market interest rates.

An associate (as defined in section 128F of the Income Tax Assessment Act 1936 (Cth)) of the Issuer that is either

1. a non-resident of Australia which does not hold a security in carrying on a business at or through a permanent establishment in Australia; or
2. a resident of Australia that holds a security in carrying on a business at or through a permanent establishment outside of Australia

A securities market that is conducted by dealers outside the ASX - otherwise known as the unlisted securities market.

Price equal to the face value of a security.

The date that actual principal and interest payments are paid to the registered owner of a security.

An investment's return (usually total return), compared to a benchmark that is comparable to the risk level or investment objectives of the investment.

A perpetual security is an instrument with no maturity date. It can be classified as equity or debt but more often than not people recognise it as quasi equity. Issuers pay distributions/coupons on perpetuals forever and they have no obligation to redeem the capital value.

A floating-rate note with no stated maturity date.

The term used to refer to regularly scheduled payments or prepayments of principal and of interest on securities -Inflation Annuity Bonds are an example of a security available with this style of cashflow.

Long-term interest rates exceed short-term interest rates.

A security that is junior to the issuing entity's debt obligations but senior to common equity in the payment of dividends and the liquidation of assets. The dividend can be fixed or floating and is usually stated as a percentage of par value. Preferred securities usually have no voting rights and frequently have a mandatory or optional redemption provision.

The amount by which the price of a security exceeds its principal amount or issue price excluding accrued interest i.e a security issued at $100 may be now trading in the secondary market at a capital price of $103 , a $3 premium (also see discount).

Bonds priced greater than par.

The partial or complete repayment of the principal amount outstanding on a security before it is due.

The current value of a future payment future stream of payments, given a specified interest rate or yield.

The dollar amount to be paid for a security, stated as a percentage of its face value, or par. Bond prices are best reflected in their yields, which vary inversely with the dollar price. The price you pay for a bond is based on a host of variables, including interest rates, supply and demand, credit quality, maturity ,call features, the size of the transaction and market or economic events.

A document executed by the Issuer in relation to the tranche and expressed to be the Pricing Supplement for that tranche.

The market for new issues of securities.

The face amount of a bond, exclusive of accrued interest and payable at maturity.

Sale and purchase of bonds in which the dealer commits its own capital in effecting the transaction (see 'as principal').

The negotiated offering of new securities directly to investors, without a public underwriting.

A document for the sale of new securities to investors (see offering document )

The adjustment of the interest rate on certain dates on a floating-rate security according to conditions outlined when issued.

Designations used by rating services designed to give relative indications of credit quality.

For an inflation-indexed security, the yield margin above the prevailing inflation rate - also the term referred to as the margin above inflation prevailing on all securities.

The date for determining the owner entitled to the next scheduled payment of principal or interest on a security.

The amount by which the "call" price of a security exceeds its principal, or par value.

Another term for call provisions. Actions taken to pay the principal amount prior to the stated maturity date, in accordance with the provisions for ŇcallÓ stated in the Prospectus or Information Memorandum (see callable bonds).

The repayment of or buying back of a security by the issuer.

For the purposes of calculating the interest rate applicable to a fixed income security, the Reference Banks specified in the applicable Pricing Supplement or, if none are specified, 4 major banks in the relevant financial centre selected by the Issuer.

Sale of a new issue, the proceeds of which are to be used immediately or in the future, to retire an outstanding issue by replacing it with the new issue. Issuers use this financing method make look to save on interest cost, extend the maturity of the debt, relax existing restrictive covenants or issue complying regulatory capital.

The register of holders of a security maintained by the Registrar on behalf of the Issuer in accordance with their conditions.

A bond whose owner is registered with the issuer or its settlement agent .Transfer of ownership can only be accomplished when the securities are properly endorsed by the registered owner. In Australia listed securities are transferred via the CHESS system and OTC or unlisted securities via an independent settlement company such as Austraclear.

Capital standards set out in the Basel Framework administered by APRA that aim (among other things) to ensure that Australian Deposit-taking Institutions (ADIs) maintain adequate capital, on both an individual and group basis, to act as a buffer against the risks associated with their activities, including holding minimum levels and ratios of certain types of capital

A change of law or regulations in Australia that may affect an existing security and it's status in the regulatory capital structure of that company.

The risk that interest income or principal repayments will have to be reinvested at lower rates in a declining interest rate environment.

Comparing the cheapness or expensiveness of a security to another security (usually of comparable credit risk and maturity).

Hybrid and convertible securities offer reset terms where the interest rate or margin over BBSW will change over the next period of the investment.

Any client other than a wholesale client.

A measure of the degree of uncertainty and/or potential for loss inherent in an investment decision (see call risk , credit risk, event risk, market risk).

Risk Weighted Assets (also known as RWA) is a bank's assets weighted according to risk. As a general rule different types of assets have different risk weights associated with them. The calculation of risk weights is dependent on whether the bank has adopted the standardised or internal ratings based (IRB) approach to risk under the Basel framework. In Australia the major banks and Macquarie has been aprroved to use the IRB approach but all other banks have no been approved and must use the standardised approach. This is a contentious issue between the banks as the effective maximum leverage ratios are different making it a uneven playing field for originating mortgages.

In 1988 by the Basel Committee on Banking Supervision (BCBS), which recommends certain standards and regulations for banks, set out a framework for bank regultion called Basel I.  The committee came out with a revised framework known as Basel II in 2004, a subsequent framework in 2010 known as Basel III and more recently the committee has published another revised framework known as "Basel IV". It is up to the individual countrys regulators to implement the revised versions of this regulation.

The ratio of interest to the current market price of the bond, stated as a percentage. For example, a bond with a current market price of $100 that pays $6 per year in interest would have a running yield of 6%. (see also yield to maturity).

When describing yield, investors typically use two measures: the running yield and the yield-to-maturity (yield-to-call). Running yield is calculated by dividing a security’s most recent distribution by its capital price. On the other hand, yield-to-maturity (call) is determined by taking into account all future cashflows such as the present value of all coupon payments and the discount or premium paid on purchase or received at maturity. As a result, the yield-to-maturity (call) is the more accurate measure of a security’s return.

Figure 1. Running Yield  Vs Yield-to-Maturity (Call).

As illustrated above, the yield-to-maturity (call) is calculated by computing the discount rate that equates all cashflows to the current market price. This is known as the time value of money and is essentially the process of earning interest in reverse. For example, if you were to earn 10% interest on $100, you would receive $110 at the end of the investment period and your return would be 10%. From this you can work backwards to find the present value (i.e. $110/(1+interest rate)) of the investment (which is what you begun with, $100). Therefore, the future value is $110, the present value is $100 and the interest rate that allows you to move between these values is 10%.

Although this a simplified example, it demonstrates the same though-process behind the yield-to-maturity (call). The cashflows earnt from a security are discounted back to their present value (which is the market price investors are willing to pay) by the rate of return. This rate of return is the yield-to-maturity (call) and is commonly used as a comparison tool in the security selection process. For the rest of the series, we will refer to the yield-to-maturity (call) as the ‘yield’.

(see Safekeeping).

Holding a customers' securities on their behalf - provided as a service by a bank or institution acting as agent .

Examining the likely performance of an investment under a wide range of possible interest rate environments.

Ongoing market for bonds previously offered or sold in the primary market.

The grouping of securities into a category, based upon similarities that they share such as term or position in the capital structure of a company.

Debt backed by specific assets or revenues of the borrower. In the event of default, secured lenders can force the sale of such assets to meet their claims. These rank ahead of unsecured and subordinated debt holders.

Securitization may be broadly defined as the process of issuing new securities backed by a pool of existing assets such as loans, residential or commercial mortgages, credit card debt, or other assets.

The general term given to an issue of securities.

A selling group includes dealers or brokers who have been asked to join in the offering of a new issue of securities by the Joint Lead Managers.

Refers to a security with an unfavourable outlook.

Semi-Government Bonds (Semis) are issued by the central borrowing authorities of Australian state and territory governments. The central borrowing authorities have an explicit government guarantee from their parent state. Some of these securities also have a Commonwealth Government guarantee (made during the Global Financial Crisis). Issuance of Semi Government Bonds is primarily for budget funding and to support infrastructure investment in major utilities and transport entities.

Semis are primarily fixed rate notes that pay semi-annual interest payments until maturity. However, some central borrowing authority also issue floating rate notes as well. These securities pay a quarterly interest payment equal to a fixed rate margin plus the appropriate benchmark floating rate.

Figure 1. Central Borrowing Authorities.

Figure 2. Market Share of Semi-Government Bond Market.

The securities are released to the public via dealer panels. Each borrowing authority has their own panel of banks known as a dealer panel to support liquidity of their liabilities (semis). These institutions make prices to the market and distribute to the domestic market.

The bulk of state government are known as benchmark bonds. Under these securities, the issuing state treasury corporation commits to maintaining a minimum amount outstanding in the specified bond at any given time. These bonds also allow the borrowing authority to tap the existing line for additional funds instead of pursuing additional new bond issuance.

As state governments do have the ability to print money, they have a marginally higher element of default risk than the Commonwealth of Australia. For this reason, semi government bonds typically have higher yields that their government bond counterparts to compensate for this incremental credit risk.

Bonds and other debt obligations that are considered senior to unsecured and subordinated debt and common equity within an entity's capital structure.

The underwriter who co-ordinates the sale of a securities issue and manages a syndicate or selling group.

Fixed income securities issued in one or more tranches all of which:

1. have identical terms except that the issue date, the Interest Commencement Date and the amount of the first interest may be different in respect of difference tranches of a series.
2. are specified in the applicable Pricing Supplements as having the same series identification number or name

The date for the delivery of securities and payment of funds.

Generally, debt which matures in one year or less or can also be longer dated securities approaching maturity . Also bank bills , term deposits etc...

At any time in respect to the issuer:

1. It is able to pay all its debts when they become due and payable; and
2. Its assets exceed its liabilities, in each case determined on as unconsolidated stand alone basis

(see Wholesale Investor).

Difference in yield or price between the bid and offer on a security.

Securityholder Reference Number for ordinary shares or notes held on the issuer sponsored subregister.

A security that comprises two or more underlying components , neither of which can be traded separately. Some hybrid securities comprise a preference share and an unsecured note.

Securities guaranteed by State governments or Territories in Australia.

An increase to the issue margin at a predetermined date or on the occurrence of a certain event.

A type of debt that places the investor in a lien position behind or subordinated to a company's primary or secured creditors. Securities issued as subordinated debt will pay interest and principal but only after all interest that is due and payable has been paid on any and all senior debt.

A supranational entity is formed by two or more central governments with the purpose of promoting economic development for the member countries. Supranational institutions finance their activities by issuing debt, such as supranational bonds. Examples of supranational institutions include the European Investment Bank and the World Bank. Similarly to the government bonds, the bonds issued by these institutions are considered very safe and have a high credit rating.

Organizations that exists in multiple countries and are most often described as international government or quasi-government organizations.

Where an investor sells one security and simultaneously buys another with the proceeds.

A group of underwriters formed for the purpose of participating jointly in the initial public offering of a new issue of securities. The terms under which a ŇsyndicateÓ is formed and operates are typically set forth in an Ňagreement among underwriters.Ó One or more underwriters will act as manager of the ŇsyndicateÓ and one of the managers will act as lead manager and Ňrun the books.Ó

Refers to taxes, levies, imposts, charges and duties imposed by any authority together with any related interest, penalties, fines and expenses in connection with them. They are calculated in regard to the net income of the holder.

Headline summary of terms and condition of a particular issue of new securities.

In fixed income every security has a predefined period of time (term) that you as the investor is lending your money. Term is generally measured by three different parameters: the call date, the maturity date or no maturity (perpetual).

• At the call date, the bond can be redeemed at the discretion of the issuer before maturity;
• At the maturity date, the principal of bond becomes due and the issuer is legally obliged to repay par value back to the investor;
• If a security has no maturity date, it is classified as perpetual and is typically left outstanding until called by the issuer.

Figure 1. The Relationship Between Term and Certainty of being Redeemed

As callable securities (including perpetual securities) are redeemable at the issuer’s discretion, there is no legal obligation for the issuer to redeem. Therefore, these types of securities are much more uncertain than securities with a fixed maturity date (and obligatory redemption). As a result, when calculating return (yield), an investor must subjectively determine the likelihood of redemption.

Many investors underestimate the size of the fixed income market. Globally, bonds account for nearly twice as much investment as equities while in Australia, the bond market is approximately equal in size to the equity market ($1.5 trillion).

The Australian market is split into wholesale and retail segments.

• The Wholesale (also known as Over-the-counter (OTC)) market can only be accessed by a fixed income dealer or broker as securities in this market are not traded on a public exchange. This market is utilised primarily by institutions and minimum face value investments can range from $10,000 to $500,000. Dealers typically hold inventory of a range of fixed income securities and/or have the ability to source securities that are not held. That being said, brokers attempting to locate securities can be timely and as a result, the OTC market is generally less liquid. However, the OTC market is much larger than the listed market and offers a wider range of fixed income securities meet the various investment needs of individuals.
• The Retail Market main consists of listed securities that be traded on the Australian Securities Exchange (ASX). In contrast to the wholesale market, individuals can invest with a smaller minimum investment amount. The increased transparency allows for better informed investment decisions as prices are readily available. However, it is important to note that the retail market is substantially smaller than the wholesale market and dominated by financial issuers (i.e. major banks). These financial institutions tend offer higher risk fixed income securities (often referred to as hybrids). While the yield offered by hybrids is attractive, investors should understand the features of these types of securities before deploying capital.

Up to the point we have focused on direct fixed income investment but investors can also gain exposure indirectly. There are two primary forms of indirect bond investment: managed funds and exchange traded funds (ETFs).

• Managed funds can be either be unlisted or listed and cover a wide range of investment strategies. The fund can invest in multiple assets or a single asset, invest globally or domestically and cover only bonds or include other credit products in portfolio. We therefore recommend that investors undertake careful due diligence before investing into any of these managed vehicles to ensure that your investment objectives are aligned with the investment objectives of the fund. This includes reviewing the fee structure of the fund.
• As the name suggests, Exchange Traded Funds are listed. The main difference between ETFs and managed funds is their passive investment strategies. ETFs track an underlying index and aim to deliver the same return (before costs and taxes are charged). As a result, ETFs tend to engage in minimal active trading relative to managed funds. They are primarily used as a diversification tool in portfolios as investors can gain large exposure to the fixed income asset class with a small upfront investment. Additionally, ETFs can be sold with ease on the exchange in which they trade which limits any liquidity issues. This is also increases transparency in underlying value.

Before understanding types of fixed income, investors must understand the capital structure. In its simplest form, the capital structure consists of debt and equity. Companies utilise global markets to raise debt and equity to fund growth and maintain the existing operations of the business. In the priority of payments, debt holders are ranked higher than equity holders. This means that in the event of default meaning that if the company is liquidated, debt holders are paid out before equity holders. This is because equity holders are essentially part owners of the company and are entitled to profits and benefit from growth. On the other hand, debt holders receive contractual interest payments and repayment of principal. This means that debtholders are exposed to limited upside while being subject to default risk. Therefore, for protection they are positioned above equity holders within the capital structure.

Although this seems simple, complex capital structures can comprise multiple types of debt with different levels of seniority (refer to ‘Corporate Bonds’ – page 14) and it is important to identify where your potential investment lies in the priority of payments. However, equity always falls behind debt and acts as a buffer for debt holders. Companies that increase equity capital relative to debt capital are essentially shifting value from equity holders to debt holders. But over the long term, this allows companies to reduce the risk of their debt which in turn lowers the interest payments they have to pay on their outstanding securities (as investors’ required returns are less). As a result, these companies are able to lower their cost of funding for future projects and increase profitability which raises shareholder value. This reflects the balancing-act that comes with managing the capital structure as changes to the capital mix are made very regularly. It is therefore important that investors are remain vigilant to the underlying issuer’s funding strategy.

In Australia, there are two main types of capital structures: Financial and Corporate. Financial institutions (i.e. banks, insurance, diversified) are subject to regulation and are required to hold excess amounts of capital to reduce the overall risks of their operations. This is especially prominent in the major banks who adhere to various capital requirements as the safety net to the wider economy. As a result, these institutions issue Tier 2 and Tier 1 securities which are classified as regulatory capital. These securities have different features to traditional subordinated features which will be looked at in more depth later but in terms of the capital structure, Tier 2 and Tier 1 are effectively just two additional layers of debt seniority.

Although many phrases are used when identifying seniority, a key one to look out for is ‘subordinated’. This effectively means that your security is ranked below more senior debt, and is therefore riskier. However, due to this increased risk, these types of investments will generally pay a higher return. It is therefore crucial that investor’s understand the underlying issuer’s capital structure to help justify the risk and return inherent in a potential fixed income investment.

Figure 1. General Bank and Corporate Capital Structures.

Although fixed income is generally less volatile than other asset classes, it is not immune to fluctuations in value. While equities experience a relatively even probability of capital upside and downside, bonds and other debt securities are subject to an asymmetric price structure. This essentially means that fixed income has limited upside and substantial downside. This reiterates the importance of avoiding losers when debt investing.

To help explain this concept we will use two key drivers of bond prices:

1. Interest Rates

When interest rates rise, new issuance of fixed income securities typically offer relatively higher yields to compete with existing securities in the market. As this occurs, these existing securities that offer smaller interest payments (lower coupon rates) become less attractive to investors. As a result, the price of the existing securities will fall (and yields will rise) and trade at a discount to remain competitive with newer bonds with higher coupon rates. On the other hand, if interest rates fall the existing security will be relatively more valuable (as yields drop and prices rise) at a higher coupon rate than other securities being issued at a lower coupon rate. This means that there is an inverse relationship between interest rates and bond prices.

However, investors must consider their upside and downside. In theory the interest rate can range between zero and some infinite value. If we assume a 5% current interest rate then, the price upside is within the 0-5% range while the price downside is in the 5 – 100% range (i.e. default situation with no recovery). This demonstrates the asymmetric nature of bond prices.

To illustrate the interest rate – coupon relationship (also known as interest rate risk), we will use a fixed rate 3-year bond.

Figure 1. Fixed Rate 3-Year Bond Interest-Rate Sensitivity Table

The table above can be summarised as follows:

• If the coupon rate equals the market interest rate, Market Price = Par Value.
• If the coupon rate is less than the market interest rate, Market Price is less than Par Value.
• If the coupon rate is greater than the market interest rate, Market Price is greater than Par Value.

2. Credit Profile

The financial health of the underlying issuer affects the price investors are willing to pay for the bond as it dictates the probability of the company repaying the investor the principal. If the issuer is deemed risky, investors will require a higher return to compensate for the additional risk. If the existing coupon is not adequate, investors will discount the bond price to the point where the return earned on the potential investment is compensatory to the associated risk. In contrast, if the issuer is relatively safe, the specified coupon may be less risky and default risk is less. As a result, investors would require less return for risk compensation and the price of the bond would rise accordingly.

When an issuer is able to improve its credit quality, it does so at a diminishing rate. This means that with each improvement, the credit quality of the issuer improves, but to a lesser extent. In comparison, if the credit quality of the issuer deteriorates, it does so at an increasing rate and worsens as the deterioration continues. As a result, the price upside of the underlying bond is limited by the diminishing returns in credit improvements while price downside can be amplified as deterioration continues. This again reflects the asymmetric payoff structure of bonds.

Figure 2. Exponential Relationship between Credit Quality and Probability of Default

The probability of credit profile deterioration is known as credit risk (or default risk). Migrating up and down the risk curve allows investors to select strong creditworthy issuers from poor creditworthy issuers.

Comprises common Equity Tier 1 (CET1) and Additional Tier 1 capital.

Comprises primarily subordinated debt and other funding sources that rank below deposits and other senior creditors.

Comprises Tier1 & Tier 2 capital.

Investment performance measured over a stated time period which includes coupon interest, interest on interest, and any realized and unrealized gains or losses.

The date that a trade, or sale and purchase, is consummated, with settlement to be made later (see Ňsettlement dateÓ).

The trading margin % or discount margin above a recognised benchmark (such as BBSW). Where a security trades in the secondary market as opposed to the 'new' issue margin.

An issue of fixed income securties all of which are issued on the same issue date and the terms of which are identical in all respects.

A party appointed by an issuer to maintain records of security owners. Treasury Indexed Bonds (TIB's) - Treasury Indexed Bonds are medium to long-term securities issued by the Australian Government for which the Face Value is adjusted for movements in the Consumer Price Index (cpi). Coupon interest payments are made every three months, at a fixed coupon interest rate, on the adjusted capital value (referred to as the Nominal Value of the bond). On Maturity, the last coupon interest payment, plus the higher of either the Nominal Value (the value as adjusted for movement in the CPI over the life of the bond), or the Initial Face Value of the bond is paid to the bond holder. The Australian Government is liable to make these payments.

Under new BASEL 111 guidelines, the terms and conditions of all capital instruments issued by internationally active banks on or after 1 January 2013 which are to be counted towards Additional Tier I or Tier II capital must specify that they are to be either written off or converted to common equity upon the occurrence of certain trigger events (or subject to applicable laws which achieve the same result).

A company designated by the issuer as the custodian of funds and official representative of bondholders. Trustees are appointed to ensure compliance with the bond documents and to represent bondholders in enforcing their contract with the issuer.

Hybrids refer to a broad classification of securities issued by corporations that structurally contain both debt and equity characteristics. In terms of the capital structure, hybrids sit subordinated debt and above equity in the capital structure and tend to offer higher yields than senior bonds. These securities rank behind subordinated debt in the priority of payment while still enjoying the equity buffer. Hybrids are structured in a more complex manner than most other fixed income instruments and generally contain embedded options. These options typically allow the issuer to either redeem the security before its specified maturity or convert the security into ordinary shares.

Figure 1. Hybrid Security Spectrum

Although it is necessary to assess each hybrid on a case-by-case basis, for the purpose of this section we will describe the most common Bank and Non-Bank security structures:

Bank & Insurance Hybrids

Due to Australian regulation enforced by the Australian Prudential Regulation Authority (APRA), the hybrid market is predominantly utilised by banks. Under APRA, Australian banks must adhere to strict capital requirements to ensure future economic stability. As a result, these bank hybrids can either classify as Tier 1 and Tier 2 regulatory capital. These essentially act as two layers of junior debt (with Tier 2 capital ranking above Tier 1 capital and below subordinated debt and Tier 1 capital ranking below Tier 2 capital and above common equity) – refer to page 9 ‘Capital Structure’. The insurance industry also follows the principals of this regulation.

Tier 2 Instruments

• The most common bank Tier 2 security structure is commonly referred to as ‘Subordinated Notes’. This hybrid generally pays a mandatory quarterly floating rate interest payment and typically has an optional call date whereby the issuer can redeem the notes early on that date or any interest payment date thereafter up to the final maturity date.Tier 1 Instruments

Tier 1 Instruments

• The popularity of ‘Capital Notes’ has increased over recent years. These securities primarily distribute a quarterly floating rate interest payment but some pay on a semi-annual basis. However, distributions on these hybrids are discretionary and therefore at the option of the issuer. Additionally, these payments are non-cumulative meaning any missed payments are not owed by the issuer. Capital Notes are classified as a perpetual investment as they have no set maturity date. Instead they are scheduled for mandatory conversion into ordinary shares and subject to optional call date(s) prior to the mandatory conversion date. These securities are primarily issued by the major banks (Westpac, NAB, Commonwealth Bank and ANZ) and Macquarie Group.

• The less commonly used bank Tier 1 security are ‘Preference Shares’. Like capital notes, preference shares are perpetual and have discretionary, non-cumulative interest payments. Preference shares are subject to optional call dates prior to the mandatory conversion date as well. Generally, the major difference between the two main Tier 1 securities is the timing of distributions. Preference Shares tend to pay interest of a semi-annual floating rate basis. 

Regulatory Considerations

A major reason for the push for the Capital Note hybrid has been regulation. Post 2012, new capital instrument eligibility criteria under Basel III was introduced to the Australia Banking System. This included the implementation of loss absorbing terms and conditions known as Capital and Non-Viability Trigger Events. These are common in all new style (after 2012) Tier 1 and Tier 2 hybrids. Upon the occurrence of these events this security will be converted into ordinary shares without the protection of conversion conditions. However, if conversion cannot occur for any reason the notes will be written off and all holders rights terminated.

The Non-Viability Trigger is at the discretion of the regulator, APRA, while the Capital Trigger will occur if the underlying issuer is unable to maintain a Common Equity Tier 1 ratio of 5.125%.

In terms of size, the Tier 1 market is substantially larger than the Tier 2 market.

Figure 2. Major Bank Tier 1 Regulatory Capital

Non-Bank Hybrids

Non-Bank corporations are not subject to same regulatory scrutiny as traditional Australian banks. As a result, hybrid variation is much broader in this market and almost every security is unique in its own right. However, we will outline two general security structures:

• Subordinated Notes are the most common hybrid security issued by Non-Bank corporations. These securities differ between issuers but generally have a fixed maturity date with prior optional call or conversion dates. One of the major differences between these notes and their bank counterparts are that interest payments are discretionary. However, they are cumulative meaning missed interest payments will be made once the issuer is in a position to do so. Some of this types of securities have step-up conditions whereby the coupon will receive a specified increase dependent a particular event. This step-up is typically reversed when the event ends.
• Step-Up Securities are perpetual and interest payments are discretionary but non-cumulative. These securities tend to have an optional redemption date known as the ‘Step-Up Date’. If on the step-up date the issuer chooses not to redeem the securities, the coupon will receive a specified increase until redemption. The issuer is typically able to redeem the securities at any point from the step-up date. It is possible for these securities to have multiple step-up dates. Issuer redemption will be based on the overall cost of funding. If the cost of funding is less than the coupon being paid, the underlying securities will most likely be redeemed.

Securities not listed on an exchange (such as 'over the counter' or unlisted corporate bonds ).

A depositor of the issuer and each creditor of the issuer other than:

1. the holders; and
2. creditors of the issuer under other instruments issued as relevant capital instruments (Tier 1 & Tier 2 instruments)

A statistical measure of the variance of price or yield over time. Volatility is low if the price does not change very much over a short period of time, and high if there is a greater change.

Volume Weighted Average Price of a security during the relevant period. Generally used to aid in setting a new placement of securities.

The fixed income asset class is the broad classification for debt securities that pay a specified distribution over a defined period. A fixed income security is always issued with a specified face value called the principal. Over the life time of the security, an investor will receive periodic interest payments and repayment of face value at maturity. As a result, the investor is effectively lending capital to the issuer in return for interest, similar to a mortgage between a bank and a homeowner.

For example, holders of a 4 year fixed rate security that pays interest semi-annually will receive 8 periodic interest payments over the security’s life time. At the end of the 4-year period the investor will be repaid the principal.

Figure 1. Basic Fixed Income Security Structure

The above example illustrates a fixed income security in its simplest form. However, security structures can vary significantly depending on different features. Features that define the structure of a fixed income security include its type of interest payment (floating, fixed, inflation-linked), the interest payment amount (which is linked to the credit quality of the issuer), its term (perpetual, callable or fixed term) or its position on the capital structure (secured, unsecured or subordinated). Additionally, fixed income is generally defined by the underlying issuer - Government, State Government or Corporations.

Includes institutions, corporations and sophisticated investors (see full Bond Adviser's Terms and Conditions)

1. A court order made for the winding-up of the issuer (and the order is not successfully appealed within 21 days); or
2. An effective resolution passed by shareholders or members for the winding-up of the issuer

The immediate and irrevocable termination of the holder's rights in relation to a interest rate security, including to the payment of interest and face value and the termination of all obligations of the issues in respect to the security. The security will no longer be outstanding and shall be deleted from the register.

The graphical relationship between yield and maturity among debt securities of different maturities and the same credit quality. This line shows the term structure of interest rates (see positive and inverse yield curves). Many regard the shape of the yield curve as a predictor of future rates.

The difference in yield between two bonds or bond indexes.

A yield on a security calculated by assuming that interest payments will be paid until the call date, when the security will be redeemed at the call price.

This is the lowest yield generated, given the potential stated calls prior to maturity.

A yield on a security calculated by assuming that interest payments will be made until the final maturity date, at which point the principal will be repaid by the issuer. Yield to maturity is essentially the discount rate at which the present value of future payments (investment income and return of principal) equals the price of the security.