Level 1 CFA® Exam:
Legal, Regulatory & Tax Requirements for Bonds
A bond indenture is a contract between the bond issuer and bondholders. The contract describes features of the bond, rights of bondholders and the issuer, as well as obligations of the issuer.
Regarding the bond features, in the contract you will find information about coupon payments and coupon dates, the bond’s maturity and its par value. Also information about embedded options and collaterals is included. Moreover, a bond indenture encompasses bond covenants.
Bond covenants state what the issuer is obliged to do and what the issuer must not do. Thus, we divide bond covenants into:
- affirmative covenants, and
- negative covenants.
An affirmative covenant is a promise to do something. The issuer’s promise to pay all taxes in time is an example of an affirmative covenant. On the other hand, the issuer’s promise not to do something is a negative covenant. So, a promise not to incur additional debt would be an example of a negative covenant.
Note that in the relationship between the bond issuer and bondholders, the bondholder’s interests are represented by a trustee. The trustee makes sure that all obligations of the issuer are met.
Now we proceed to talk about different regulations. We will divide regulations into two groups, namely into:
- legal and regulatory considerations, and
- tax considerations.
Legal & Regulatory Considerations
Legal and regulatory considerations may refer for example to:
- the issuance process,
- required covenants,
- obligations and rights of both the issuer and bondholders,
- the redemption process, and so on.
Legal and regulatory requirements differ depending on the market on which bonds are traded. Generally, the global bond market can be divided into:
- national bond markets and
- the Eurobond market.
As it was the case with legal regulations, tax regulations differ for different countries and different bonds. Some bonds are subject to lower tax rates, whereas some to higher tax rates.
Generally taxes imposed on bonds concern things such as:
- income, that is coupons received by investors,
- capital gains, which result from the difference between the bond’s sale and purchase price, and
- whether a bond was purchased at discount, at par or at premium.
There are also bonds whose coupons are free of tax. We call them tax-exempt bonds. You should remember, that tax regulations may have a great impact on the rates of return earned by investors.
The coupon rate of a tax-exempt bond is equal to 5.5%. What should be the value of the coupon rate of a taxable bond if we assume that both bonds differ only with respect to tax regulations. Assume that the tax rate amounts to 21%.
We can divide bonds according to two criteria:
- the principal repayment criterion, and
- the coupon payment structure criterion.
Principal Repayment Criterion
According to the principal repayment criterion, we distinguish:
- bullet bonds, for which the par value is paid at maturity date,
- fully amortized bonds, for which the par value is repaid in total before the maturity date,
- partially amortized bonds, for which the par value is only partially repaid before the maturity date.
Coupon Payment Structure Criterion
According to the coupon payment structure criterion, we distinguish:
- floating rate notes, whose coupons depend on the reference rate, for example LIBOR,
- step-up coupon bonds, which have fixed or floating coupons that increase in future periods by the specified spread,
- credit-linked coupon bonds with coupons that change when the credit rating of the issuer changes.
- payment-in-kind coupon bonds, for which there is no coupon payment made in cash. Instead, at coupon dates bondholders receive new bonds or stocks issued by the company.
- deferred coupon bonds, which pay no coupon in the first year after the issuance and a couple of consecutive years but pay higher coupons in yet subsequent years,
- index-linked bonds, for which coupons and principal repayment depend on some index, for example inflation. One of the examples of such bonds are Treasury inflation-protected securities (TIPS), which are issued by the U.S. Treasury.
Level 1 CFA Exam Takeaways: Legal, Regulatory & Tax Requirements for Bondsstar content check off when done
- A bond indenture is a contract between the bond issuer and bondholders.
- Bond covenants state what the issuer is obliged to do and what the issuer must not do.
- The trustee makes sure that all obligations of the issuer are met.
- The global bond market can be divided into national bond markets and the Eurobond market.
- The Eurobond market is less regulated than national bond markets and is outside of any country’s jurisdiction.
- There are bonds whose coupons are free of tax. We call them *tax-exempt bonds.
- According to the principal repayment criterion, we distinguish: bullet bonds, fully amortized bonds, and partially amortized bonds.
- According to the coupon payment structure criterion, we distinguish: floating rate notes, step-up coupon bonds, credit-linked coupon bonds, payment-in-kind coupon bonds, deferred coupon bonds, and index-linked bonds.