Fixed Income Analysis

Lecture 1&2 Main Features of Fixed Income Securities

 Organisation of the course

- Lectures – 2 hour/week
- Seminar – 2 hour/week (last 3 weeks)

Teaching Resources – weekly lecture notes, tutorials (self study), any

other info

Reading – core reading is essential…but read out with material

Last week set aside for revision depending on how lectures go

 Schedule

Weeks 1-10: Topics

Week 11: Review for exam
Bring your questions
Mock exam
 How to Contact me

[email protected]

2.02 Business School

Meeting: by appointment (Book office hour via email)

 Assessment

Group Presentation: 30% Including 20% WebPA

Final Exam (closed book- in-person): 70%
 Lecture Objectives

After this lecture you will understand

● the fundamental features of bonds

● the types of issuers

● the importance of the term to maturity of a bond

● the types of risks faced by fixed-income investors

● how to calculate the price of a bond

● that to price a bond it is necessary to estimate the expected cash flows and
determine the appropriate yield at which to discount the expected cash flows
● why the price of a bond changes in the direction opposite to the change in required
yield
 Recommended reading

Fabozi, J. F. (2013) Chapter 1, 2, 3

Graham, J.R. & Harvey, C.R. (2001). The theory and practice of corporate finance: Evidence from the field.
Journal of Financial Economics, 60(2-3), 187- 243.

Löffler, G. (2004). An anatomy of rating through the cycle. Journal of Banking & Finance, 28(3), 695-720.

Kisgen, D. J. (2006). Credit ratings and capital structure. Journal of Finance, 61(3), 1035-1072.

Gredil, O. R., Kapadia, N., & Lee, J. H. (2022). On the information content of credit ratings and market-based
measures of default risk. Journal of Financial Economics, 146(1), 172-204.

EU Credit Ratings market 2023, ESMA

ESMA50-165-2477 EU Credit Ratings market 2023 (europa.eu)

Default, Transition, and Recovery: 2022 Annual Global Corporate Default And Rating Transition Study
Default, Transition, and Recovery: 2022 Annual Global Corporate Default And Rating Transition Study | S&P
Global Ratings (spglobal.com)
 You will be surprised but……
The bond market is much larger than the stock market
Ranked: the world’s top bond markets
 Investment Returns by Asset Class

Source: Investment Returns by Asset Class (1985 to 2022) (themeasureofaplan.com)

Source: Investment Returns by Asset Class (1985 to 2022) (themeasureofaplan.com)
Correlations Between Investment Returns by Asset Class
 Introduction

❑ Judged by total market value, fixed income securities constitute the

most prevalent means of raising capital globally.

❑ A fixed income security is an instrument that allows governments,

companies and other types of issuers to borrow money from
investors.

❑ Any borrowing of money is debt.

❑ A promised payments on fixed-income securities are contractual

obligations of the issuer to the investors.
 Overview of Bond Features

1) Type of Issuer
2) Term to Maturity
3) Principal and Coupon Rate
4) Amortization Feature
5) Embedded Options
6) Describing a Bond Issue
 Overview of Bond Features

1) Type of Issuer – there are three issuers of bonds

✓ the federal government and its agencies
✓ municipal governments
✓ corporations (domestic and foreign)

2) Term to Maturity – refers to the date that the issuer will redeem the bond by
paying the principal
▪ Typically range from overnight to 30 years or longer.
▪ There may be provisions in the indenture that allow either the issuer or
bondholder to alter a bond’s term to maturity.
▪ Fixed-income securities with maturities at issuance (original maturity) of one
year or less are known as money market securities.
▪ longer than one year are called capital market securities
▪ perpetual bonds , such as the consols issued by the sovereign government
in the UK, have no stated maturity date
 Overview of Bond Features

3) Principal and Coupon Rate

✓ Principal Value – amount that the issuer agrees to repay the

bondholder at the maturity date.
▪ bond prices are quoted as a percentage of their par value.
✓ Zero-Coupon Bond – interest is paid at the maturity with the
exact amount being the difference between the principal value and
the price paid for the bond
✓ Coupon Rate – the nominal or interest rate that the issuer agrees
to pay each year; the annual amount of the interest payment is
called the coupon.
 Overview of Bond Features

✓ Floating-rate bonds – issues where the coupon rate resets

periodically (the coupon reset date) based on the coupon reset
formula given by:

reference rate + quoted margin

✓ Linkers – bonds whose interest rate is tied to the rate of inflation

✓ Inverse-floating-rate bonds – coupon interest rate moves in the
opposite direction from the change in intere.st rates
 Overview of Bond Features

4) Amortization Feature – the principal repayment of a bond issue can call for either
the total principal to be repaid at maturity or the principal repaid over the life of the
bond.

✓ In the latter case, there is a schedule of principal repayments called an

amortization schedule.

✓ For amortizing securities, a measure called the weighted average life or simply
average life of a security is computed.
 Overview of Bond Features

5) Embedded Options – it is common for a bond issue to include a provision in

the indenture that gives either the bondholder and/or the issuer an option to
take some action against the other party.

✓ Call provision - grants the issuer the right to retire the debt, fully or
partially, before the scheduled maturity date

✓ Put provision - gives the bondholder the right to sell the issue back to the
issuer at par value on designated dates

✓ Convertible bond - provides the bondholder the right to exchange the

bond for shares of common stock

✓ Exchangeable bond - allows the bondholder to exchange the issue for a

specified number of common stock shares of a corporation different from
the issuer of the bond
 Overview of bond Features

6) Describing a Bond Issue –most securities are identified by a nine character

CUSIP number

✓ CUSIP stands for Committee on Uniform Security Identification

Procedures
✓ First six characters of CUSIP identify the issuer
✓ The next two characters identify whether the issue is debt or equity and
the issuer of the issue
✓ The last character is a check character that allows for accuracy checking
Risk associated with investing in Bonds

1) Interest-rate Risk
2) Reinvestment Risk
3) Call Risk
4) Credit Risk
5) Inflation Risk
6) Exchange Rate Risk
7) Liquidity Risk
8) Volatility Risk
9) Risk Risk
 Risks Associated with Investing
in Bonds (continued)

Interest-rate risk
❑ interest-rate risk or market risk refers to an investor having to
sell a bond prior to the maturity date.
❑ an increase in interest rates will mean the realization of a
capital loss because the bond sells below the purchase price.
❑ interest-rate risk is by far the major risk faced by an investor in
the bond market.
 (continued)

Reinvestment risk
❑ reinvestment risk is the risk that the interest rate at which
interim cash flows can be reinvested will fall.
❑ reinvestment risk is greater for longer holding periods, as well
as for bonds with large, early, cash flows, such as high-coupon
bonds.
❑ it should be noted that interest-rate risk and reinvestment risk
have offsetting effects.
 (continued)

Call Risk
❑ Call risk is the risk that a callable bond will be called when
interest rates fall.
❑ Many bonds include a provision that allows the issuer to retire or
“call” all or part of the issue before the maturity date; for
investors, there are three disadvantages to call provisions:
a) cash flow pattern cannot be known with certainty
b) investor is exposed to reinvestment risk
c) bond’s capital appreciation potential will be reduced
 (continued)

Credit Risk
❑ Credit risk is the default risk that the bond issuer will fail to
satisfy the terms of the obligation with respect to the timely
payment of interest and principal.
❑ Credit spread is the part of the risk premium or spread
attributable to default risk.
❑ Credit spread risk is the risk that a bond price will decline due
to an increase in the credit spread.
 (continued)

Inflation Risk
❑ Inflation risk arises because of the variation in the value of cash
flows from a security due to reduction in purchasing power.
❑ If investors purchase a bond on which they can realize a
coupon rate of 7% but the rate of inflation is 8%, the purchasing
power of the cash flow falls.
❑ For all but floating-rate bonds, an investor is exposed to
inflation risk because the interest rate the issuer promises to
make is fixed for the life of the issue.
 (continued)

Exchange-Rate Risk
❑ Exchange-rate risk refers to the unexpected change in one
currency compared to another currency.
▪ From the perspective of a U.S. investor, a non-dollar-
denominated bond (i.e., a bond whose payments occur in a
foreign currency) has unknown U.S. dollar cash flows.
▪ The dollar cash flows are dependent on the exchange rate
at the time the payments are received.
▪ The risk of the exchange rate causing smaller cash flows is
the exchange rate risk or currency risk.
 (continued)

Liquidity Risk
❑ Liquidity risk or marketability risk depends on the ease with
which an issue can be sold at or near its value.
▪ The primary measure of liquidity is the size of the spread between
the bid price and the ask price quoted by a dealer.
▪ The wider the dealer spread, the more the liquidity risk.
 (continued)

Volatility Risk
❑ Volatility risk is the risk that a change in volatility will adversely affect the price
of a bond.
❑ The value of an option rises when expected interest-rate volatility increases.
▪ For example, consider the case of a callable bond where the borrower
has an embedded option, the price of the bond falls when interest rates
fall due to increased downward volatility in interest rates.
 (continued)

Risk Risk
❑ Risk risk refers to not knowing the risk of a security.
❑ Two ways to mitigate or eliminate risk risk are:
1) Keep up with the literature on the state-of-the-art methodologies for
analyzing securities
2) Avoid securities that are not clearly understood
 Bond Pricing

Time value of money

Review of time value of money
Review of Time value of money
 FV of Annuity…

If you invest $10,000 each year for the next two years at 11% starting
in one year, how much will you have at the end of the two years?
1+𝑟 𝑁−1
FV𝑁 = 𝐴
𝑟
 PV of Annuity…

If you expect to receive $10,000 each year for two years starting in one

year, and your opportunity cost is 11%, how much is it worth today?
1
1− 𝑁
1+𝑟
PV0 = 𝐴
𝑟
 Pricing a Bond

❑ Determining the price of any financial instrument requires an

estimate of
1) the expected cash flows
2) the appropriate required yield
3) the required yield reflects the yield for financial instruments
with comparable risk, or alternative investments
❑ The cash flows for a bond that the issuer cannot retire prior to
its stated maturity date consist of
1) periodic coupon interest payments to the maturity date
2) the par (or maturity) value at maturity
 Pricing a Bond

In general, the price of a bond (P) can be computed using the following
formula:

P = price (in dollars)

n = number of periods (number of years times 2)
t = time period when the payment is to be received
C = semiannual coupon payment (in dollars)
r = periodic interest rate (required annual yield divided by 2)
M = maturity value
 Example

Computing the Value of a Bond: An Example

❖ Consider a 20-year 10% coupon bond with a par value of $1,000 and a required
yield of 11%.
❖ Given C = 0.1($1,000) / 2 = $50, n = 2(20) = 40 and r = 0.11 / 2 = 0.055, the
present value of the coupon payments (P) is:

1 − 1/ (1 + r ) n 
P =C 
 r 
1 − 1/ (1 + 0.055 ) 40 
P = $50  
 0.055 
P = $50 [16.046131] = $802.31
 Pricing a Bond (continued)
Computing the value of a bond: an example
❖ the present value of the par or maturity value of $1,000 is:

 M   $1, 000 
(1 + r ) n  =  1 + 0.055 40  = $117.46
  ( ) 

Continuing the computation from the previous slide:

the price of the bond (p) =
present value coupon payments + present value maturity value =
$802.31 + $117.46 = $919.77.
 Pricing a Bond (continued)
• For zero-coupon bonds, the investor realizes interest as the
difference between the maturity value and the purchase price. the
equation is:
Mt
P= n
(1 + r )
P = price (in dollars)
M = maturity value
r = periodic interest rate (required annual yield divided by 2)
n = number of periods (number of years times 2)
 Pricing a Bond (continued)

❖ Zero-Coupon Bond Example

Consider the price of a zero-coupon bond (p) that matures 15
years from now, if the maturity value is $1,000 and the required
yield is 9.4%. Given M = $1,000, r = 0.094 / 2 = 0.047, and n =
2(15) = 30, what is P ?

Mt $ 1, 0 0 0
P = n = 30 = $ 252 . 12
(1 + r ) (1 + 0 . 0 4 7 )
 Pricing a Bond (continued)

❖ Price-Yield Relationship

➢ A fundamental property of a bond is that its price changes in the

opposite direction from the change in the required yield.
➢ The reason is that the price of the bond is the present value of
the cash flows.
➢ If we graph the price-yield relationship for any option-free bond,
we will find that it has the “bowed” shape.
 Table 1
Price-Yield Relationship for a
20-Year 10% Coupon Bond

Yield Price ($) Yield Price ($) Yield Price ($)

0.050 1,627.57 0.085 1,143.08 0.120 849.54

0.055 1,541.76 0.090 1,092.01 0.125 817.70
0.060 1,462.30 0.095 1,044.41 0.130 787.82
0.065 1,388.65 0.100 1,000.00 0.135 759.75
0.070 1,320.33 0.105 $958.53 0.140 733.37
0.075 1,256.89 0.110 $919.77 0.145 708.53
0.080 1,197.93 0.115 883.50 0.150 685.14
 Bond Pricing

It is clear that:-
▪ When the required return (or yield) INCREASES, bond prices FALL
▪ When the required return (or yield) DECREASES, bond prices RISE
▪ Why does this occur?
 Figure 1
Shape of Price-Yield Relationship for an
Option-Free Bond

Maximum
Price
Price

Yield
 Pricing a Bond (continued)

❖ Relationship Between Coupon Rate, Required Yield, and

Price

➢ When yields in the marketplace rise above the coupon rate at a given point
in time, the price of the bond falls so that an investor buying the bond can
realizes capital appreciation.
➢ The appreciation represents a form of interest to a new investor to
compensate for a coupon rate that is lower than the required yield.
➢ When a bond sells below its par value, it is said to be selling at a discount.
➢ A bond whose price is above its par value is said to be selling at a premium.
 Pricing a Bond (continued)

❖ Relationship Between Bond Price and Time if Interest Rates

Are Unchanged
➢ For a bond selling at par value, the coupon rate equals the
required yield.
➢ As the bond moves closer to maturity, the bond continues to
sell at par .
➢ Its price will remain constant as the bond moves toward the
maturity date.
➢ The price of a bond will not remain constant for a bond selling
at a premium or a discount.
 Table 2
Time Path for the Price of a 20-Year 10% Bond Selling at a Discount and Premium as It
Approaches Maturity

Price of Price of ➢ Table 2 shows the time path of a 20-

Year
Discount Bond Premium Bond year 10% coupon bond selling at a
Selling to Yield Selling to Yield discount and the same bond selling
12% 7.8% at a premium as it approaches
maturity.
20.0 $ 849.54 $1,221.00
16.0 859.16 1,199.14 ✓ The discount bond increases in
price as it approaches maturity,
12.0 874.50 1,169.45 assuming that the required yield
10.0 does not change.
885.30 1,150.83
✓ For a premium bond, the
8.0 898.94 1,129.13 opposite occurs.
4.0 937.90 1,074.37 ✓ For both bonds, the price will
equal par value at the maturity
0.0 1,000.00 1,000.00 date.
 Example

1. Compute the price of a 4-year 10% coupon bond if the

discount rate is
a) 10%
b) 12%
c) 8%
2. Assuming the discount rate remains constant in each of the
three scenarios above, graph how the bond’s price will move
towards maturity.
 Example 3 (solution)

Time to maturity Premium bond Discount bond Par bond

Par value 100 4.0 106.73 93.79 100.00
Maturity 4 years 3.5 106.00 94.42 100.00
Coupon rate 10% semi-annual 3.0 105.24 95.08 100.00
Discount rate of premium bond 8% 2.5 104.45 95.79 100.00
Discount rate of discount bond 12% 2.0 103.63 96.53 100.00
Discount rate of par bond 10% 1.5 102.78 97.33 100.00
1.0 101.89 98.17 100.00
0.5 100.96 99.06 100.00
0.0 100.00 100.00 100.00
 Pricing a Bond (cont.)

❖ Reasons for the Change in the Price of a Bond

The price of a bond can change for three reasons:
1) there is a change in the required yield owing to changes in the
credit quality of the issuer
2) there is a change in the price of the bond selling at a premium or a
discount, without any change in the required yield, simply because
the bond is moving toward maturity
3) there is a change in the required yield owing to a change in the
yield on comparable bonds (i.e., a change in the yield required by
the market)
 Complications

❖ The framework for pricing a bond assumes the following:

1) the next coupon payment is exactly six months away
2) the cash flows are known
3) the appropriate required yield can be determined
4) one rate is used to discount all cash flows
 Complications

❖ The next coupon payment is exactly six months away

When an investor purchases a bond whose next coupon payment is due in
less than six months, the accepted method for computing the price of
the bond is as follows:

n C M
P = t −1 +
t=1
v
(1 + r ) (1 + r ) (1 + r )v (1 + r )t −1

where v = (days between settlement and next coupon) /(days in six-month

period)
 Complications

❖ Cash Flows May Not Be Known

➢ For most bonds, the cash flows are not known with certainty.
➢ This is because an issuer may call a bond before the maturity date.

❖ Determining the Appropriate Required Yield

➢ All required yields are benchmarked off yields offered by Treasury
securities.
➢ From there, we must still decompose the required yield for a bond into its
component parts.

❖ One Discount Rate Applicable to All Cash Flows

➢ A bond can be viewed as a package of zero-coupon bonds, in which case a
unique discount rate should be used to determine the present value of each
cash flow.
 Rating Agencies

Credit rating agencies (CRAs)

are seen as the experts
when it comes to analyzing
the credit status of a
borrower, i.e., the likelihood
of a borrower to meet their
contractual obligations.
2022 global corporate default

Source: S&P Global 2023

Leverage loan default will rise- low economic growth in 2024
 Credit Rating Agencies: Analysing Credit Risk

While each CRA has its own unique (and proprietary) approach,
the main issues that are being analyzed are:
▪ Legal protections
▪ Covenants analysis
▪ Collateral analysis
▪ Ability to pay
▪ Sector / business risks
▪ Operating cash flow variation
▪ Corporate governance risks
▪ Agency problem
▪ Financial risk
▪ Interest coverage ratio
Empirical Evidence on the Importance of Credit Rating Agencies

Credit Ratings and Capital Structure

• There is anecdotal evidence that firms may target specific credit ratings rather than
a specific capital structure. In their survey of CFOs, Graham and Harvey (2001) find
that credit ratings are the second most important factor when it comes to a firm's
capital structure decisions and/or debt policy (after financial flexibility).
• Kisgen (2006) examines the impact of credit ratings on firms' capital structure
decisions in an empirical setting and finds robust evidence that credit ratings
directly affect capital structure decisions by managers.

Information value of credit rating

• Gredil et al. (2022) directly compare the informational value of credit ratings
and market-based measures on default risk.

• There main findings can be summarized as follow:

• Market-based default measures are better at predicting default
probability in the short-term than credit ratings, up to 1 year.
• Credit ratings, in contrast, are better in the long-run. More importantly,
credit ratings are less affected by purely transitory shocks to credit
risks.
On the Timeliness of Credit Rating Changes
• In the wake of the large corporate bankruptcies of Enron and Worldcom, CRAs
faced increasing pressure from investors as well as regulators regarding the
timeliness of their rating changes. Two issues that CARs potentially face when
trying to improve timeliness is lower accuracy and increased rating volatility (i.e.,
more rating changes over a short period of time).

• Another contentious point is the CRAs proclaimed ability to "rate through the
cycle." This means that CRAs focus on permanent shocks to the creditworthiness
of a borrower rather than on transitory shocks.

• Löffler (2004) is one of the first to look at this in detail and finds evidence that
CRAs indeed appear to try to rate through the cycle. This may come at the cost of
short term accuracy, but should lead to better long-term stability of ratings.
 Next Week

Bond Price Volatility, Duration and Convexity

63
 Practice Questions

Consider a 5-year 8% coupon bond rate with a par value of

$1,000. The required return on this bond is 10%.
a) What is the price of the bond today?
b) What is the price of the bond today if the required return
suddenly increases to 11%?
c) What is the price of the bond today if the required return
suddenly decreases to 9%?
d) What is the price of the bond today if the required return
suddenly decreases to 8%?
e) What is the price of the bond exactly one year from now if
the required return remains at 10%?
f) What are the quoted prices for a, b, c, d, e?
Which bond prices don’t seem right?

Issue Coupon (%) Yield (%) Price

A 7.25 6 113.65
B 6.75 7 99.14
C 0 5 103.5
D 5.5 5.25 102.85
E 6.5 6.5 100
F 4.5 4 96.5
G 7.375 7.375 101.86