Chapter 10. Fixed Income Markets. Fixed-Income Securities

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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:

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™ 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.

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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.

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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

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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%).

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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

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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

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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

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

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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

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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.

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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

ƒ Investment grade bond: A bond rated BBB and above by Standard

& Poor’s, or Baa and above by Moody’s.

ƒ 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:

ƒ Coverage ratios: Ratios of company earnings to fixed costs.

For example: Times-interest-earned-ratio = EBIT/interest

ƒ Leverage ratios: Debt/Equity

ƒ Liquidity ratios: Current ratio; Quick ratio

ƒ Profitability ratios: return on assets = EBIT/Total assets

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• 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)

ƒ Text Website: Self-assessment quiz

ƒ End-of-Chapter CFA questions (Page 449)

ƒ Problems: P10.7, 10.9, 10.15

™ Homework (will be collected and graded, due date to be announced)

ƒ Chapter 10: Excel with Spreadsheet (Page 456)

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