Chapter 10
Fixed-Income Securities
Bond characteristics
Bond sectors
Bond risks
Bond ratings and quotations
Fixed Income Markets
Bond: Tradable security that promises to
make a pre-specified series of payments over time.
• Straight bond makes fixed coupon and principal payment.
• Bonds are traded mainly over-the-counter.
Historical Bond Yields:
Compared to stocks, bonds offer lower returns
Main benefits of bonds in portfolio:
• Lower risk
• High levels of current income
• Diversification
Comparative Performance of Stocks and Bonds:
Definitions:
Face Value (or Par Value): Principal amount or denomination that the issuer agrees to pay back to the bondholder, exclusive of interest
Coupon Rate: The interest rate that the issuer agrees to pay each year.
Market Value: Price at which bond trades, expressed in percent of principal.
Maturity: Date that the debt will cease to exist
• Term Bond is a bond that has a single maturity date
• Serial Bond is a bond that has a series of different maturity dates
Floating-rate Bond.
• Coupon rate is reset periodically according to a predetermined benchmark.
• Benchmark is usually a financial index.
Fixed Income Markets
Definitions:
Premium Bond.
• Bond price higher than its par value.
• Bond trades at a premium whenever market interest rates drop below its coupon rate
Discount Bond.
• Bond price lower than its par value.
• Bond trades at a discount whenever market interest rates move above its coupon rate
Current Yield: measures of the annual interest income relative to its current market price.
price Bond
interest coupon
Annual eld
Current Yi =
Example: If an 8% coupon bond with a par of $1,000 current trades at $875, its current yield is:
80/875 = 9.14%
Bond Price Behavior
Price of a bond is a function of its coupon rate, its maturity, and market movements in interest rates.
Bonds with longer maturities move more with changes in interest rates.
Bonds with lower coupon rate move more with changes in interest rates.
The Treasury Market:
General obligations of the federal government: no default risk.
Treasury Notes and Bonds
• Pay semiannual coupons
• Sold in $1,000 denominations
• Maturities up to 30 years (bonds), 10 years (notes).
• Bullet bonds, generally not callable
Strips: Zero-coupon bonds
Treasury Inflation-Indexed Obligations (TIPS)
• Protect against inflation by adjusting investor returns
• Interest rates are very low
The Agency Market:
Issued by government agencies
Federally related agencies:
• Exlm Bank, GNMA, SBA, TVA
• Guaranteed by US government
Federally sponsored agencies:
• e.g., Fannie Mae, FHLB, Freddie Mac which provide credit to the housing sector
• Not guaranteed by US government and thus subject to slight default risk
• Trade at yield spread relative to Treasuries
Fixed Income Markets
The Municipal Bond Market:
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
Tax exemption:
• Interest on municipal bonds is not taxable at federal level
• Trade at much lower yields than Treasuries
Fixed Income Markets
The Municipal Bond Market:
rate tax Federal -
1
bond municipal on
Yield t Yield
Equivalen
Taxable =
Example:
A municipal bond offers a yield of 6.5%. For an individual with a marginal tax bracket of 35%, what is the taxable equivalent yield of this bond?
Taxable equivalent yield = 1 35%
% 5 . 6
− = 10%.
In other words, for this individual, holding this muni is equivalent to holding a taxable bond with a yield of 10%.
For this reason, municipal bonds are most attractive to individual in higher federal tax brackets (28% to 35%).
The Corporate Bond Market:
Issued by private corporations
Subject to credit risk:
• Failure to pay timely interest or principal constitutes default
• Bondholders incur a loss upon default
• As compensation, bonds sell at higher yields than Treasuries
Debenture bonds are unsecured general obligations
Mortgage bonds give bondholders a lien against specific property
Corporate bonds have special provisions:
• Many bonds are callable by issuer
• Many bonds have sinking fund provision
The Corporate Bond Market:
• 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 bond’s par value and paid upon call to compensate
bondholders
• Call price is the bond’s par value plus call premium
• 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
Fixed Income Markets
The Mortgage Market:
Mortgages are loans to purchase real estate
Securitization: S&Ls created securities out of bundled mortgage obligations
• Mortgage Pass-Throughs are such securities
• Mortgage-Backed Securities are guaranteed as to payment by
o Government National Mortgage Association (GNMA) o Federal Home Loan Mortgage Corporation (FHLMC) o Federal National Mortgage Association (FNMA)
Homeowner has the right to call the mortgage if he/she moves, or if rates fall.
• The homeowner is long a complex call option
The bondholder is short this option:
• If interest rate rise, the bond will lose value
• If interest rate fall, the homeowner will refinance and repay the bond
• The bondholder will require a payment, or higher yield, to offset this option
Fixed Income Markets
The Mortgage Market:
Collaterized Mortgage Obligations are repackaged MBS securities with different payment streams.
• 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
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
Global 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
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 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
Fixed Income Markets
Junk 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 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.
Bond Characteristics
Embedded Options:
Callable Bond
• Issuer can retire the debt, fully or partially, before the scheduled maturity date
• Mortgage loans are all callable
Putable Bond
• Bond holder can sell the bond back to the issuer at a fixed price schedule
Convertible Bond.
• Gives the bondholder the right to exchange the bond for a specified number of shares of common stock
Bond Risks:
Interest rate risk (Market risk).
• The major risk faced by a bond investor
• A typical bond's price changes in the opposite direction from a change in interest rate
• Bond sold before maturity may therefore realize a capital loss
• Degree of price sensitivity to interest rate change depends on bond characteristics
Reinvestment risk.
• When market interest rate fall, interim cash flow has to be reinvested at a lower interest rate.
• Reinvestment risk is greater for high coupon bonds
Offsetting effects: Interest rate risk is the risk that interest rate will rise, while reinvestment risk is the risk that interest rate will fall.
Bond Risks:
Call risk
• Cash flow of a callable bond is not known with certainty.
• Issuer will call the bond when interest rate drops, exposing investors to reinvestment risk.
Default risk
• The risk that bond issuer may not be able to make timely principal and interest payment.
• Bond with default risk has a lower price than comparable US Treasury securities, which are considered free of default risk.
Inflation risk
• When inflation increases, bond with fixed coupon will realize lower returns, as measured by
purchasing power.
• Floating-rate bonds have lower inflation risk.
Bond Characteristics
Bond Risks:
Exchange rate risk
• A US investor holding non-dollar-denominated bond will face exchange rate risk.
• An investor holding British Pound denominated bond will lose money when USD/GBP falls.
Liquidity risk
• The risk that bond cannot be sold at or near its market value before maturity.
• Measured by the bid-ask spread
Volatility risk
• The risk that a change in volatility will affect the price of a bond adversely
• Bonds with embedded options have volatility risk because the value of option is affected by
volatility.
Bond Ratings
Bond Ratings:
Bond Ratings Very High
Quality
High
Quality Speculative Very Poor Standard & Poor’s AAA AA A BBB BB B CCC D
Moody’s Aaa Aa A Baa Ba B Caa C
Investment grade bond: A bond rated BBB and above by Standard
& Poor’s, or Baa and above by Moody’s.
Speculative grade or junk bond: A bond rated BB or lower by Standard & Poor’s, Ba or lower by Moody’s, or an unrated bond.
Determinants of Bond Safety:
Coverage ratios: Ratios of company earnings to fixed costs.
For example: Times-interest-earned-ratio = EBIT/interest
Leverage ratios: Debt/Equity
Liquidity ratios: Current ratio; Quick ratio
Profitability ratios: return on assets = EBIT/Total assets
• Bond quotes are stated as percentage of par value
• 97 means 97% of par value
• Treasuries are quoted in 32nds.
• A $1,000 par value bond price at 97 would sell for $970
• 100 means bond trades at par value
Readings: Chapter 10
Exercises: Chapter 10 (will NOT be collected)
Text Website: Self-assessment quiz
End-of-Chapter CFA questions (Page 449)
Problems: P10.7, 10.9, 10.15
Homework (will be collected and graded, due date to be announced)
Chapter 10: Excel with Spreadsheet (Page 456)
