Structured & Hybrid Bonds

Structured bonds/notes: Debt products whose payoffs are linked to other assets or indices (e.g., equity, credit events, rates). They are created by combining basic building blocks like a zero-coupon bond and one or more options.

Hybrid bonds: Instruments that blend debt and equity characteristics (e.g., convertibles, CoCos, perpetuals). They sit between pure bonds and equity on the risk/return spectrum.

Key Pricing Concepts

Common interview topics include: Yield to Maturity (YTM), Yield to Worst (YTW), Option-Adjusted Spread (OAS), duration & convexity, and the implied option value embedded in the structure.

Definition & Purpose

A convertible bond pays fixed coupons but gives the holder the option to convert into a pre-set number of issuer shares (conversion ratio) — offering downside protection (coupon) with upside equity participation.

Mechanics

• Face value (usually $1,000).
• Conversion ratio = number of shares per bond (or conversion price = face value ÷ ratio).
• Coupon paid until conversion or maturity.
• Conversion window and any call/put provisions specified in indenture.

Valuation Basics

Convertible Value ≈ Straight Bond Value + Value of Embedded Equity Call Option. Valued via models that combine interest-rate models and equity volatility (often a hybrid binomial or Monte Carlo).

Important Metrics

• Parity value: conversion ratio × stock price.
• Conversion premium: (Bond price − Parity) ÷ Parity.
• Delta (equity sensitivity): Convertibles have an option-like “delta”, often less than 1.

Worked Example

Face value = $1,000; coupon = 4%; maturity = 5 years. Conversion ratio = 25 shares (conversion price = $40). Current stock price = $50.

1. Parity value: 25 shares × $50/share = $1,250.
2. If the bond trades at $1,300, the Conversion Premium is ($1,300 - $1,250) / $1,250 = 4%.

Key Risks

• Equity risk (if stock falls) — but coupon cushions losses.
• Credit risk of issuer.
• Liquidity (some convertibles thinly traded).
• Dilution (if many convert).

Q: How do you decide whether to convert?
A: Convert when the parity value is greater than the bond's market value. Also consider tax implications and transaction costs.

Definition

Like convertibles, but convertible into shares of a different company (usually a subsidiary or another listed entity).

Why Issue?

A parent company can monetize its stake in a subsidiary without an immediate sale, while the investor gets equity participation in that other company.

Mechanics & Example

A bond with a face value of $1,000 is exchangeable into 40 shares of Subsidiary S. If the stock price of S is $30, the parity value is 40 × $30 = $1,200. The valuation mechanics are the same as for convertibles.

Risks / Interview Note

Understand the counterparty/corporate structure and potential strategic reasons for issuance (tax, regulatory, market impact).

Definition

CoCos are bank-issued bonds that convert into equity or are written down when a pre-specified trigger (usually a regulatory capital ratio like CET1) is breached. They are used to absorb losses and bolster bank capital.

Mechanics & Trigger Types

• Conversion to equity at a fixed conversion ratio or at a market price.
• Write-down (partial or full) of principal.
• Trigger: CET1 ratio falls below a specified percentage (e.g., 7%). Triggers are publicized in the prospectus.

Key Valuation Features

• High coupon (compensates for risk).
• Valuation uses credit models plus jump-to-default and regulatory-trigger modeling (complex).
• Market prices are highly sensitive to the bank’s CET1 trajectory and credit spreads.

Key Risks

• Trigger Risk: The bond can convert or be written down at a time of stress, often at regulatory discretion.
• Coupon Cancellation: Issuers can often cancel coupons without it being an event of default.
• High Loss Severity: Bondholders can lose their entire principal.

Q: Why do CoCos pay high coupons?
A: Because investors are compensated for taking on the significant risk of principal loss upon a trigger event and the risk of coupon cancellation. It's a credit and equity-like risk premium.

Definition

Perpetual bonds have no maturity date. They pay coupons indefinitely until the issuer calls them. They are often used by banks as regulatory capital.

Mechanics

• The coupon may be fixed or floating, and the bond is often callable at set dates (e.g., after 5 years).
• Perpetuals often include non-cumulative features or deferrable coupons.

Valuation Note

For a perpetual with a constant coupon (C) and a discount rate (r), the theoretical present value is C/r. However, real-world valuation must include call options and credit risk.

Q: How does yield behave for perps vs long-dated fixed bonds?
A: Perps usually yield more due to no maturity and higher credit/call risk.

Definition

These are bonds where the coupon changes at predetermined dates. A step-up bond increases its coupon, while a step-down bond decreases it.

Mechanics & Example

Example: A bond pays 5.0% for the first 5 years, then steps up to 7.0% thereafter until maturity. It is often combined with a call option at the first step-up date.

Why Used?

Step-up features are often used to compensate investors for call risk and to incentivize the issuer to call the bond before the coupon rate increases.

Definition

A structured note that pays a high coupon, but at maturity, the issuer may repay in cash or deliver a predetermined number of shares of an underlying stock if that stock has fallen below a certain barrier.

Mechanics

• The underlying can be a single stock or a basket of stocks.
• A barrier or knock-in level is set (e.g., 70% of the initial price).
• If the underlying finishes above the barrier, the investor receives the par value in cash plus coupons.
• If it finishes below, the investor receives a specified number of shares (or cash equivalent, potentially at a loss).

Worked Example

An investor buys a reverse convertible for $1,000 with a 10% coupon. The underlying stock is at $50 and the barrier is $35. If the stock finishes below $35, the investor receives 20 shares. If the stock ends at $30, the investor gets shares worth $600 (20 x $30), resulting in a capital loss.

Risks

• Equity downside risk (loss can be large).
• Counterparty risk (issuer default).
• Not principal protected despite high coupon.

Definition

A CLN is a debt instrument with a payoff that is contingent on a credit event of a separate reference entity. The investor receives a higher coupon for taking on the credit risk of that third party.

Mechanics

• It is structured as a bond plus a short position in a Credit Default Swap (CDS) on a reference entity.
• If no credit event occurs, the investor receives coupons plus principal at maturity.
• If a credit event occurs, the note principal is reduced or used to pay the defaulted exposure.

Worked Example

Face value $1,000, coupon 6% (vs similar non-linked instrument at 3%). Reference is Company X. If Company X defaults, principal is reduced to its recovery value (e.g., 40%), so the investor receives $400 instead of $1,000.

Autocallable Note

Pays coupons periodically if an underlying asset stays above a barrier. Can be redeemed early ("autocalled") if the underlying is at or above a certain level on observation dates. If not called, the final payoff may be linked to shares and could incur losses.

Range Accruals

A note where the coupon only accrues for the days that a reference rate or index stays within a specified range. Payoffs are highly path-dependent.

Definition

Notes where principal protection is achieved by combining a zero-coupon bond (to guarantee principal at maturity) with options (to provide upside). The principal protection is only valid if the issuer remains solvent.

Mechanics & Example

Example composition: An investor's principal is used to buy a zero-coupon bond that will pay $1,000 at maturity. The remaining funds are used to buy call options on an equity index to provide upside potential.

Risk

The principal protection is dependent on the issuer's solvency. The investor still bears the counterparty risk of the issuer.

Definition

Securitizations pool loans or other assets and issue tranches (slices) of debt ranked by seniority. Each tranche has a different level of credit risk and yield.

Mechanics & Key Concepts

• Tranches: Senior tranches have the highest priority and lowest yield. Mezzanine and equity tranches absorb losses first but offer higher potential returns.
• Waterfall: The priority order in which cash flows are distributed to the tranches.
• Credit Enhancement: Mechanisms like subordination, reserve accounts, and overcollateralization protect senior tranches.
• REMIC: A structure for mortgage passthrough securities with favorable tax treatment.

• Yield to Maturity (YTM): The single discount rate that equates the bond's price to the present value of its cash flows.
• Yield to Worst (YTW): The lowest possible yield an investor can receive among all possible scenarios (e.g., maturity, various call dates).
• Option-Adjusted Spread (OAS): The spread over a benchmark curve after removing the value of any embedded options.
• Duration & Convexity: Measures of interest-rate sensitivity. For bonds with options, use "effective" (option-adjusted) duration and convexity.
• Delta / Equity Sensitivity: For convertibles, this measures the bond's price sensitivity to changes in the underlying stock price.

• Credit / Counterparty Risk: Issuer solvency.
• Market Risk: Changes in rates, equities, FX.
• Model Risk: Valuation depends on complex models and assumptions.
• Liquidity Risk: Many structured products are illiquid.
• Event / Trigger Risk: For CoCos, CLNs, etc.
• Regulatory Risk: Changes in capital rules affecting CoCos/perps.

Case A — CoCo Conversion Event

A CoCo has a $1,000 face value and a conversion ratio of 50 shares (implying a $20 conversion price). The trigger is CET1 < 7%. If the trigger occurs when the stock price is $8, the holder receives 50 shares worth only $400 (50 x $8). This demonstrates a 60% principal loss.

Case B — Reverse Convertible Payoff

A reverse convertible has a $1,000 face value and is linked to 20 shares of a stock (initial price $50). The barrier is $35 (70% of initial). If the final stock price is $30 (below the barrier), the investor receives 20 shares valued at $600 (20 x $30). The total return is the coupons received plus the $600, representing a significant capital loss versus the initial principal.

• Always state who bears which risk (issuer, investor, reference entity, counterparty).
• Use numeric examples, even simple ones, to demonstrate your understanding.
• Mention key valuation drivers: interest rates, implied volatility, credit spreads, and correlation.
• Highlight the importance of legal documents (prospectus, indenture) for defining triggers and terms.
• Practice explaining OAS and YTW, as these are commonly tested concepts.