Fixed-Income

Securities

Fixed-Income Securities
Learning Goals
1. Explain the basic investment attributes of bonds
and their use as investments.
2. Describe the essential features of a bond, note
the role that bond ratings play in the market,
and distinguish among different types of call,
refunding, and sinking-fund provisions.
3. Explain how bonds are priced in the market and
why some bonds are more volatile than others.

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Fixed-Income Securities
Learning Goals (contd)
4. Identify the different types of bonds and the
kinds of investment objectives these securities
can fulfill.
5. Discuss the global nature of the bond market
and the difference between dollar-denominated
and nondollar-denominated foreign bonds.
6. Describe the basic features and characteristics
of convertible securities, and measure the value
of a convertible.

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What Are Bonds?

Liabilities, or publicly traded IOUs
Also called fixed income securities since
payments tend to be fixed amounts
Borrower agrees to pay a fixed amount of
interest over a specified period of time
Borrower agrees to repay a fixed amount of
principal at a predetermined maturity date

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Why Invest in Bonds?

They can provide current income for
conservative investors
At times, they can provide capital gains (or
losses) for more aggressive investors
Some bonds can provide tax-free income
They can be used for preservation and longterm accumulation of capital

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Interest Rates and Bonds

The behavior of interest rates is the single most important
force in the bond market
Interest rates and bond prices move in opposite directions
When interest rates rise, bond prices fall
When interest rates drop, bond prices move up
Bond markets are bullish when interest rates are low
or falling
Bond markets are bearish when interest rates are high
or rising

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Figure 10.1 Behavior of Interest

Rates Over Time (19622011)

(Source: Aswath Damodaran, The Data Page, http://pages.stern.nyu.edu/~adamodar/.)

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Bonds Versus Stocks

Compared to stocks, bonds offer lower
returns
Main benefits of bonds in portfolio:
Lower risk and level of stability
High levels of current income
Diversification

Bonds add an element of stability to a

portfolio

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Figure 10.2 Comparative Performance of

Stocks and Bonds (1992-2011)

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Bonds and Risk

Interest Rate Risk is the chance that changes in
interest rates will affect the bonds value
Purchasing Power Risk is the chance that bond
yields will lag behind inflation rates
Business/Financial Risk is the chance the issuer
of the bond will default on interest and/or principal
payments
Liquidity Risk is the risk that a bond will be
difficult to sell at a reasonable price
Call Risk is the risk that a bond will be called
(retired) before its scheduled maturity date

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Essential Features of a Bond

Coupon is the amount of annual interest income
Current Yield is a measure of the annual interest income a
bond provides relative to its current market price
Principal (par value) is the amount of capital that must be
repaid at maturity
Maturity Date is the date when a bond matures and the
principal must be repaid
Term Bond is a bond that has a single maturity date
Serial Bond is a bond that has a series of different maturity
dates
Note is a debt security originally issued with a maturity from
2 to 10 years

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Principles of Bond Price

Behavior
Price of a bond is a function of its coupon rate, its maturity,
and market movements in interest rates
Longer maturities move more with changes in interest rates
Premium bond has a market value that is above par value
Occur when market interest rates are below bonds coupon rate

Discount bond has a market value that is below par value

Occur when market interest rates are above bonds coupon rate

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Figure 10.3 The Price Behavior of a

Bond

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Essential Features of a Bond (contd)

Call feature allows the issuer to repurchase the bonds
before the maturity date
Freely callable
Noncallable
Deferred call

Call premium is the amount added to bonds par value and

paid upon call to compensate bondholders
Call price is the bonds par value plus call premium
Refunding provision prohibits the premature retirement of
an issue from proceeds of a lower-coupon refunding bond

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Essential Features of a Bond (contd)

Sinking fund stipulates how a bond will be
paid off over time
Applies only to term bonds
Issuer is obligated to pay off the bond
systematically over time

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Types of Secured Debt

Secured debt is backed by pledged collateral
Senior bonds are backed by legal claim to
specific assets
Mortgage bonds are backed by real estate.
Collateral trust bonds are backed by securities
(stocks, bonds) held in trust by a third party
Equipment trust certificates are backed by specific
pieces of equipment, such as railcars or airplanes

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Types of Unsecured Debt

Unsecured debt is backed only by the promise
of the company to pay
Junior bonds are backed only by promise and good
faith of the issuer to pay
Debenture is an unsecured (junior) bond
Subordinated debentures are unsecured bonds
whose claim is secondary to other claims
Income bond requires interest to be paid only after
a specific amount of income has been earned

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Bond Ratings
Bond ratings are letter grades that designate investment
quality
Private bond rating agencies assign ratings based upon
financial analysis of the bond issuer
Investment grade ratings are received by financially
strong companies
Junk bond ratings are received by companies making
payments, but default risk is high
Split ratings occur when a bond issue is given different
ratings by major rating agencies
Higher rated bonds have less default risk and pay lower
interest rates

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Table 10.2 Bond Ratings

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The Market for Debt Securities

Bonds are traded mainly over the counter
Bond price activity is remarkably stable
compared to stock market
Bond market is larger than the U.S. stock
market
Bond market is growing rapidly

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Treasury Bonds
Considered risk freeno risk of default
Interest is exempt from state and local taxes
Sold in $1,000 denominations
Types of Treasury Bonds
Treasury notes: maturities of 2, 3, 5, 7, and 10 years
Treasury bonds: mature in 30 years

Treasury Inflation-Indexed Obligations (TIPS)

Protect against inflation by adjusting investor returns
Interest rates are very low
Maturities of 5, 10, and 20 years

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Agency Bonds
Issued by U.S. government agencies
Federal Home Loan Bank
Federal National Mortgage Association
Small Business Administration

High quality securities with almost no risk of

default
Interest rates usually higher than Treasury
issues

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Municipal Bonds
Issued by states, counties, cities and any
other political subdivision
Issued to fund public projects
Two basic types
General obligation bonds are paid from general
fund of the issuer
Revenue bonds are paid from revenues from the
project being financed

Often guaranteed by private insurers to

lower risk and interest rates
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Municipal Bonds
Interest is tax-exempt for Federal taxes

Interest can be tax-exempt from state taxes if you

live in the state where the bond was issued

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Corporate Bonds
Issued by corporations from four major
segments

Industrials
Public utilities
Rail and transportation bonds
Financial issues

Provide higher returns than government

bonds due to higher risk of default
Wide variety of bond quality and bond types
available
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Zero-Coupon Bonds
Do not pay interest
Sold at deep discount from par value
Value increases over time
Subject to tremendous price volatility as interest
rates fluctuate
Interest must be reported as it is accrued for tax
purposes, even though no interest is actually
received.
Treasury strips are zero-coupon bonds created
from U.S. Treasury securities.
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Mortgage-Backed Securities
Bond backed by pool of residential mortgages
Principal and interest are paid monthly
Governmental agencies are major issuers:
Government National Mortgage Association (GNMA)
Federal Home Loan Mortgage Corporation (FHLMC)
Federal National Mortgage Association (FNMA)

Self-liquidating investment since portion of

principal is received each month

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Collateralized Mortgage Securities

Mortgage-back bond pool that is divided
into tranches, or classes of investors
All principal payments go first to the
shortest tranche until it is fully retired, then
the next in sequence is paid
Allows investors to choose short-term,
medium-term or long-term investment
Potentially complex; interest rate
fluctuations may have significant impact
upon bond prices
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Asset-Backed Securities
Issued by corporations and backed by pools
of loans
Auto loans
Credit card loans
Home equity loans

Provide relatively high yields

Short maturities, typically 3 to 5 years
Interest and principal payments are monthly
High credit quality

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Junk Bonds (High-Yield Bonds)

Highly speculative, usually subordinated
debentures
Have low, sub-investment grade ratings
Typically offer very high yields
Prices tend to behave more like stocks
than bonds

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Global Bonds
Potentially higher returns than U.S. bonds
Offer broader diversification opportunities
Interest rate trends in other countries may
not follow U.S. rates
Currency exchange rate fluctuations can
impact returns in U.S. dollars

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Dollar-Denominated Bonds
Bonds issued by foreign governments or
corporations and denominated in dollars
Based on U.S. dollars
Yankee bonds are registered with the SEC
and issued and traded in U.S.
Eurodollar bonds are not registered with
the SEC and are issued and traded outside
of the U.S.
No currency exchange rate risk since bonds
are in U.S. dollars
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Foreign-Pay Bonds
Bonds issued by foreign governments
or corporations
Based on currency other than U.S. dollars
Not registered with the SEC and issued and
traded outside of the U.S.
Subject to currency exchange rate risk

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Convertible Securities
Fixed-income security that allows holder to convert
the security into a specified number of shares of
the issuing companys common stock
Two major types of convertible securities:
Convertible bonds
Convertible preferred stock

Equity kicker: another name for the conversion

feature that allows holder to convert the security
into a specified number of shares of common stock
Forced conversion: calling in of convertible bonds
by the issuing firm

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Convertible Securities (contd)

Conversion privilege: the conditions and specific
nature of the conversion feature on convertible
securities
Conversion period: the time period during which
a convertible issue can be converted
Conversion ratio: the number of shares of
common stock into which a convertible issue can
be converted
Conversion price: the stated price per share at
which common stock will be delivered to the
investor in exchange for a convertible issue

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Special Types of Convertible

Securities (contd)
LYON (Liquid Yield Option Note)
Zero coupon bond with both a conversion
feature and a put option
No current income, but no limit on potential
capital appreciation
Put option allows security to be sold back to
issuer at prespecified prices, providing downside
protection

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Sources of Value
Value of convertibles is based in both the stock and
the bond dimensions of the security
Convertibles trade much like common stock as the
market price of the stock starts getting close to (or
exceeds) the stated conversion price
Convertibles trade much like a bond when the
market price of the stock is well below the
conversion price
Bond price sets a price floor in case the stock price goes
into a freefall

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Measuring the Value of a Convertible

Conversion Value: indication of what a
convertible issue would trade for if it were
priced to sell on the basis of its stock value

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Measuring the Value of a

Convertible (contd)
Conversion Equivalent: the price at which
the common stock would have to sell in
order to make the convertible security
worth its present market price

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Measuring the Value of a

Convertible (contd)
Conversion Premium: amount above the
conversion value that investors are willing to pay;
typically due to the higher current income provided
by convertibles over common stock

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Measuring the Value of a

Convertible (contd)
Payback Period: the length of time it takes
for the buyer of a convertible to recover the
conversion premium from the extra current
income earned on the convertible

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Table 10.1 Historical Annual Yields and Total

Rates of Return for Treasury Bonds

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