SAMPLE WORK
TOPIC 1
OVERVIEW OF FIXED INCOME SECURITIES
QUESTION 1
August 2025 Question One B
Evaluate THREE types of fixed income securities available to investors in your country.
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Answers
Treasury Bills (T-Bills)
Nature and Return: Treasury Bills are short-term instruments issued by the Kenyan government, usually with maturities of 91, 182, or 364 days. They are issued at a discount and do not pay periodic interest; instead, the investor earns a return from the difference between the purchase price and the face value received at maturity.
Risk Profile and Suitability: These securities carry very low risk since they are backed by the government. They are well-suited for investors focused on preserving capital and managing short-term funds due to their safety and short duration.
Treasury Bonds (T-Bonds)
Nature and Return: Treasury Bonds are longer-term government securities with maturities ranging from one year up to 30 years. They provide regular interest payments, typically on a semi-annual basis, along with repayment of the principal at maturity.
Risk Profile and Suitability: Like T-Bills, they are considered very low risk because they are government-backed. They are appropriate for investors seeking stable, predictable income over the medium to long term with minimal credit risk.
Corporate Bonds
Nature and Return: Corporate Bonds are long-term debt instruments issued by companies listed on the Nairobi Securities Exchange to raise funds. They offer periodic interest payments, which are generally higher than those of comparable government securities.
Risk Profile and Suitability: These bonds involve higher credit risk since repayment depends on the issuing company’s financial strength. They are better suited for investors with a moderate risk tolerance who are willing to accept increased risk in pursuit of higher returns.
QUESTION 2
August 2025 Question Two A
Discuss THREE contingency provisions that might affect the time of cash flows of fixed income securities.
Answers
Contingency provisions, also known as embedded options, are terms included in a bond contract that give either the issuer or the investor the right—but not the obligation—to take certain actions. These actions can change the timing of cash flows and the bond’s effective maturity.
Call Provision (Issuer’s option):
- This allows the issuer to repay the bond before its maturity at a specified call price.
- It is beneficial when interest rates decline, as the issuer can refinance debt at a lower cost.
- For investors, it reduces the expected maturity and cuts off future coupon payments, creating reinvestment risk.
Put Provision (Investor’s option):
- This enables the investor to sell the bond back to the issuer at a predetermined price before maturity.
- It becomes advantageous when interest rates rise or the issuer’s creditworthiness weakens.
- It shortens the bond’s life since the investor can demand early repayment and reinvest at better rates.
Conversion Provision (Investor’s option):
- Common in convertible bonds, this allows investors to exchange bonds for a fixed number of company shares.
- If the company’s share price rises significantly, investors may choose to convert.
- Once exercised, all remaining fixed payments stop as the bond is converted into equity.
QUESTION 3
April 2025 Question One A
Explain the following coupon payment structures:
- Floating rate notes.
- Step-up coupon bonds.
- Credit-linked coupon bonds.
- Deferred coupon bonds.
- Payment-in-kind coupon bonds.
Answers
i) Floating Rate Notes (FRNs): These have variable coupon rates that adjust periodically based on a benchmark rate plus a fixed margin, transferring interest rate risk to investors.
ii) Step-Up Coupon Bonds: The interest rate increases at predetermined times, often encouraging investors to hold the bond beyond potential call dates.
iii) Credit-Linked Coupon Bonds: Coupon payments vary with the issuer’s credit rating—rising if the rating worsens and falling if it improves.
iv) Deferred Coupon Bonds: No interest is paid initially; payments begin later, which suits issuers expecting delayed cash inflows.
v) Payment-in-Kind (PIK) Bonds: Issuers may pay interest by issuing additional bonds instead of cash, offering flexibility but increasing investor risk exposure.
QUESTION 4
December 2024 Question One A
Assess THREE legal, regulatory and tax factors that might influence the issuance and trading of fixed income securities.
Answers
- Legal and regulatory systems: Rules governing bond issuance, including disclosure and registration requirements, shape how and where issuers raise funds. Strict regulations may push issuers to alternative markets.
- Tax treatment: Taxes on interest income and capital gains affect investor demand and borrowing costs. Tax-exempt bonds allow issuers to borrow more cheaply, while capital gains taxes influence investment decisions.
- Jurisdictional differences: Variations across countries create separate bond markets (e.g., domestic, foreign, Eurobond markets), affecting issuer choices and investor participation.
QUESTION 5
August 2024 Question Four B
In relation to bond covenant, explain the following clauses:
- Negative pledge.
- Cross-default.
- Equal footing.
Answers
- Negative pledge: Prevents issuers from pledging assets as collateral for new debt unless existing bondholders receive equal protection.
- Cross-default: A default on one obligation triggers default on others, preventing selective repayment.
- Equal footing (pari passu): Ensures all bondholders of the same class are treated equally and prevents new creditors from gaining priority.
QUESTION 6
April 2024 Question One A
Describe TWO reasons why investors might be concerned with the term to maturity of a bond.
Answers
- Interest rate risk: Longer-term bonds are more sensitive to interest rate changes, leading to greater price volatility.
- Liquidity risk: Short-term bonds are usually easier to sell, while long-term bonds may be harder to trade without price concessions.
QUESTION 7
April 2024 Question Four A
Describe THREE features of fixed income securities.
Answers
- Predictable cash flows: Investors receive regular, predetermined interest payments.
- Return of principal: The issuer repays the bond’s face value at maturity.
- Priority in liquidation: Bondholders have a higher claim on assets than shareholders if the issuer becomes insolvent.
QUESTION 8
August 2023 Question One A
In relation to currency denomination, explain the following types of bonds:
- Dual currency bonds.
- Currency options bond
Answers
i) Dual Currency Bonds: These bonds involve two currencies—one for denomination and another for payments—at a fixed exchange rate.
ii) Currency Option Bonds: These give investors the choice to convert payments into another currency at a specified rate, offering flexibility and a hedge against currency risk.
QUESTION 9
April 2023 Question Five A&B
With reference to fixed income contracts, distinguish between the following terms:
- “Maintenance covenants” and “incurrence covenants”.
- “Affirmative covenants” and “negative covenants”.
Highlight THREE factors that might be considered when negotiating financial covenants to ensure that monitoring and testing of such covenants for compliance is not a problem.
Answers
i) Maintenance vs. Incurrence Covenants:
- Maintenance covenants require borrowers to continuously meet financial ratio thresholds.
- Incurrence covenants restrict certain actions (e.g., taking on more debt) and are only tested when such actions are attempted.
ii) Affirmative vs. Negative Covenants:
- Affirmative covenants require borrowers to perform specific actions (e.g., provide reports, maintain insurance).
- Negative covenants restrict actions that could harm the lender’s position (e.g., excessive borrowing, asset sales).
Factors for effective covenant design and monitoring
- Clarity: Terms and calculations should be clearly defined to avoid confusion.
- Relevance: Covenants should reflect meaningful indicators of financial performance.
- Flexibility: They should accommodate realistic business conditions and market changes.
- Benchmarking: Align covenants with industry standards for fairness and practicality.
- Testing frequency: Balance between too frequent (burdensome) and too infrequent (risk of oversight) monitoring.
- Early warning systems: Include triggers that prompt discussions before breaches occur, allowing proactive solutions.
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