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B o n d M arkets , A nalysis ,
and S trategies
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 Ninth Edition

B o n d M arkets , A nalysis ,
and S trategies

FRANK J. FABOZZI, CFA

Professor of Finance
EDHEC Business School

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Library of Congress Cataloging-in-Publication Data

Fabozzi, Frank J.
Bond markets, analysis, and strategies/Frank J. Fabozzi.—Ninth edition.
  pages cm
Includes index.
ISBN 978-0-13-379677-3—ISBN 0-13-379677-9 1. Bonds. 2. Investment analysis. 3. Portfolio management. 4. Bond market.
I. Title.
HG4651.F28 2016
332.63’23—dc23
2014033129
10 9 8 7 6 5 4 3 2 1

ISBN 10:    0-13-379677-9

ISBN 13: 978-0-13-379677-3
To the memory of my parents, Josephine and Alfonso Fabozzi.
Contents
Preface x Benchmark Spread 93
Term Structure of Interest Rates 99
1 Introduction 1 Swap Rate Yield Curve 119
Learning Objectives 1 Key Points 120 Questions 122
Sectors of the U.S. Bond Market 2
Overview of Bond Features 3 6 Treasury and Federal Agency Securities 125
Risks Associated with Investing in Bonds 8 Learning Objectives 125
Overview of the Book 11 Treasury Securities 125
Questions 12 Stripped Treasury Securities 133
Federal Agency Securities 134
2 Pricing of Bonds 14 Key Points 137 Questions 138
Learning Objectives 14
Review of Time Value of Money 14 7 Corporate Debt Instruments 140
Pricing a Bond 20 Learning Objectives 140
Complications 26 Seniority of Debt in a Corporation’s
Pricing Floating-Rate and Capital Structure 141
Inverse-Floating-Rate Securities 28 Bankruptcy and Creditor Rights 142
Price Quotes and Accrued Interest 30 Corporate Debt Ratings 144
Key Points 31 Questions 32 Corporate Bonds 146
Medium-Term Notes 153
3 Measuring Yield 34 Commercial Paper 156
Learning Objectives 34 Bank Loans 158
Computing the Yield or Internal Rate Default Risk for Corporate Debt Instruments 163
of Return on any Investment 35 Corporate Downgrade Risk 166
Conventional Yield Measures 38 Corporate Credit Spread Risk 167
Potential Sources of a Bond’s Dollar Return 46 Key Points 168 Questions 169
Total Return 49
Applications of the Total Return 8 Municipal Securities 172
(Horizon Analysis) 54 Learning Objectives 172
Calculating Yield Changes 54 Types and Features of Municipal Securities 173
Key Points 55 Questions 55 Municipal Money Market Products 178
Floaters/Inverse Floaters 179
4 Bond Price Volatility 58 Credit Risk 180
Learning Objectives 58 Risks Associated with Investing
Review of the Price–Yield Relationship in Municipal Securities 182
for Option-Free Bonds 59 Yields on Municipal Bonds 183
Price-Volatility Characteristics Municipal Bond Market 184
of Option-Free Bonds 60 The Taxable Municipal Bond Market 186
Measures of Bond Price Volatility 62 Key Points 186 Questions 187
Convexity 73
Additional Concerns When Using Duration 82 9 International Bonds 189
Do Not Think of Duration as a Measure of Time 82 Learning Objectives 189
Approximating a Bond’s Duration and Classification of Global Bond Markets 190
Convexity Measure 83 Non-U.S. Bond Issuers and Bond Structures 191
Measuring a Bond Portfolio’s Responsiveness Foreign Exchange Risk and Bond Returns 193
to Nonparallel Changes in Interest Rates 85 Bonds Issued by Non-U.S. Entities 194
Key Points 89 Questions 90 Key Points 206 Questions 207
5 Factors Affecting Bond Yields and the Term 10 Residential Mortgage Loans 209
Structure of Interest Rates 92 Learning Objectives 209
Learning Objectives 92 Origination of Residential Mortgage Loans 210
Base Interest Rate 93 Types of Residential Mortgage Loans 211

vi
 Contents vii

Conforming Loans 219 Collateralized Debt Obligations 335

Risks Associated with Investing Key Points 337 Questions 338
in Mortgage Loans 220
16 Pooled Investment Vehicles
Key Points 221 Questions 221
for Fixed-Income Investors 340
11 Agency Mortgage Pass-Through Learning Objectives 340
Securities 223 Investing in Pooled Investment Vehicles 341
Learning Objectives 223 Investment Company Shares 342
Sectors of the Residential Mortgage-Backed Exchange-Traded Funds 346
Security Market 224 Hedge Funds 352
General Description of an Agency Mortgage Real Estate Investment Mortgage Trusts 354
Pass-Through Security 225 Key Points 356 Questions 357
Issuers of Agency Pass-Through Securities 227
17 Interest-Rate Models 358
Prepayment Conventions and Cash Flow 228
Learning Objectives 358
Factors Affecting Prepayments
Mathematical Description of
and Prepayment Modeling 235
One-Factor Interest-Rate Models 359
Cash Flow Yield 240
Arbitrage-Free versus Equilibrium Models 362
Prepayment Risk and Asset/Liability
Empirical Evidence on Interest-Rate Changes 364
Management 242
Selecting an Interest-Rate Model 366
Secondary Market Trading 243
Estimating Interest-Rate Volatility
Key Points 244 Questions 245
Using Historical Data 367
12 Agency Collateralized Mortgage Obligations Key Points 370 Questions 371
and Stripped Mortgage-Backed Securities 248
18 Analysis of Bonds with Embedded Options 372
Learning Objectives 248
Learning Objectives 372
Agency Collateralized Mortgage Obligations 249
Drawbacks of Traditional Yield Spread Analysis 373
Agency Stripped Mortgage-Backed Securities 282
Static Spread: An Alternative to Yield Spread 373
Key Points 284 Questions 285
Callable Bonds and their Investment
13 Nonagency Residential Characteristics 378
Mortgage-Backed Securities 288 Components of a Bond with an
Learning Objectives 288 Embedded Option 380
Collateral Types 290 Valuation Model 382
Credit Enhancement 290 Option-Adjusted Spread 395
Cash Flow for Nonagency Effective Duration and Convexity 395
Mortgage-Backed Securities 296 Key Points 397 Questions 398
Key Points 301 Questions 302
19 Analysis of Residential Mortgage–Backed
14 Commercial Mortgage Loans and Securities 400
Commercial Mortgage–Backed Securities 304 Learning Objectives 400
Learning Objectives 304 Static Cash Flow Yield Methodology 401
Commercial Mortgage Loans 305 Monte Carlo Simulation Methodology 409
Commercial Mortgage-Backed Securities 307 Total Return Analysis 423
Types of Deals 312 Key Points 424 Questions 425
Key Points 314 Questions 315
20 Analysis of Convertible Bonds 428
15 Asset-Backed Securities 317 Learning Objectives 428
Learning Objectives 317 Convertible Bond Provisions 429
Creation of an Asset-Backed Security 318 Categorization of Convertible Securities 430
Collateral Type and Securitization Structure 323 Basic Analytics and Concepts for Convertible
Credit Risks Associated with Investing Bond Analysis 432
in Asset-Backed Securities 324 Option Measures 436
Review of Several Major Types Profile of a Convertible Bond 438
of Asset-Backed Securities 327 Pros and Cons of Investing in a
Dodd-Frank Wall Street Reform and Convertible Bond 438
Consumer Protection Act 334 Convertible Bond Arbitrage 440
viii Contents

Options Approach to Valuation 442 25 Bond Portfolio Construction 550

Key Points 443 Questions 444 Learning Objectives 550
Brief Review of Portfolio Theory
21 Measuring Credit Spread Exposures and Risk Decomposition 551
of Corporate Bonds 446 Application of Portfolio Theory to Bond
Learning Objectives 446 Portfolio Construction 552
Measuring Changes in Credit Spreads 447 Tracking Error 554
Measuring Credit Spread Sensitivity 447 Cell-Based Approach to Bond
Empirical Duration for Corporate Bonds 451 Portfolio Construction 558
Key Points 458 Questions 459 Portfolio Construction with
22 Corporate Bond Credit Analysis 462 Multi-Factor Models 560
Learning Objectives 462 Key Points 575 Questions 575
Overview of Corporate Bond Credit Analysis 463 26 Considerations in Corporate Bond
Analysis of Business Risk 464 Portfolio Management 580
Corporate Governance Risk 466 Learning Objectives 580
Financial Risk 468 Risk–Return for Corporate Bonds
The Investment Decision 471 versus Equities 581
Corporate Bond Credit Analysis Corporate Bond Benchmarks 583
and Equity Analysis 472 Credit Relative Value Strategies 588
Case Study: Credit Analysis of Sirius Constraint-Tolerant Investing 592
XM Holdings Inc. 472 Using Credit Risk Modeling to Construct
Case Study: Sino-Forest Corporation 482 Corporate Bond Portfolios 595
Key Points 488 Questions 488 Liquidity Management for Corporate
23 Credit Risk Modeling 490 Bond Portfolios 598
Learning Objectives 490 Key Points 604 Questions 605
Difficulties in Credit Risk Modeling 491 27 Liability-Driven Investing for Defined
Overview of Credit Risk Modeling 492 Benefit Pension Plans 607
Credit Ratings versus Credit Risk Models 493 Learning Objectives 607
Structural Models 493 Historical Background 608
Estimating Portfolio Credit Risk: Default Understanding the Liabilities
Correlation and Copulas 498 of DB Pension Plan Liabilities 608
Reduced-Form Models 499 LDI Strategies 611
Empirical Evidence: Credit Ratings, Structural De-Risking Solutions to Mitigate Risk 614
Models, and Reduced-Form Models 502 Strategies for Hedging Interest-Rate Risk 615
An Application of Credit Risk Modeling 503 Key Points 623 Questions 624
Incomplete-Information Models 507
Key Points 508 Questions 509 28 Bond Performance Measurement
and Evaluation 626
24 Bond Portfolio Management Strategies 510 Learning Objectives 626
Learning Objectives 510 Requirements for a Bond Performance
The Asset Allocation Decision 511 and Attribution Analysis Process 627
Portfolio Management Team 512 Performance Measurement 627
Spectrum of Bond Portfolio Strategies 513 Performance Attribution Analysis 633
Bond Benchmarks 515 Key Points 638 Questions 639
The Primary Risk Factors 521
Top-Down versus Bottom-Up Portfolio 29 Interest-Rate Futures Contracts 641
Construction and Management 522 Learning Objectives 641
Active Portfolio Strategies 523 Mechanics of Futures Trading 642
Smart Beta Bond Strategies 537 Futures versus Forward Contracts 644
The Use of Leverage 539 Risk and Return Characteristics
Key Points 545 Questions 546 of Futures Contracts 644
 Contents ix

Interest-Rate Futures Contracts 645 Hedge Strategies 712

Pricing and Arbitrage in the Interest-Rate Key Points 718 Questions 719
Futures Market 651
Bond Portfolio Management Applications 658 31 Interest-Rate Swaps, Caps, and Floors 721
Key Points 676 Questions 677 Learning Objectives 721
Interest-Rate Swaps 722
30 Interest-Rate Options 679 Interest-Rate Caps and Floors 744
Learning Objectives 679 Key Points 750 Questions 751
Options Defined 680
Differences Between an Option 32 Credit Default Swaps 754
and a Futures Contract 680 Learning Objectives 754
Types of Interest-Rate Options 680 Credit Events 755
Intrinsic Value and Time Value of an Option 683 Single-Name CDS 758
Profit and Loss Profiles for Simple Naked Index CDS 764
Option Strategies 684 Economic Interpretation of a CDS
Put–Call Parity Relationship and and an Index CDS 766
Equivalent Positions 696 Using CDSs for Controlling Credit Risk 768
Option Price 698 Key Points 769 Questions 770
Models for Pricing Options 699
Sensitivity of Option Price to Change in Factors 708 Index 773
Preface
The objective of the first edition of Bond Markets, Analysis, and Strategies published in
1989 was to provide coverage of the products, analytical techniques for valuing bonds and
quantifying their exposure to changes in interest rates, and portfolio strategies for achiev-
ing a client’s objectives. In the seven editions subsequently published and in the current
edition, the coverage of each of these areas has been substantially updated. Throughout
this book there are practical applications of principles as provided by third-party com-
mercial vendors.
Each edition has benefited from the feedback of readers and instructors using the
book at universities and training programs. I benefited from many discussions with chief
investment officers, portfolio managers, analysts, traders, and regulators, as well as my
experiences serving on the board of directors of two BlackRock fund complexes and
consulting engagements.
I am confident that the ninth edition continues the tradition of providing up-to-date
information about the bond market and the tools for managing bond portfolios.

Chapters New to the Ninth Edition

Chapter 16: Pooled Investment Vehicles for Fixed-Income Investors
The chapters prior to this chapter in the book focus on individual debt instruments. This
new chapter describes investment vehicles that represent pooled investments and are also
referred to as collective investment vehicles. They include investment company shares,
exchange-traded shares, hedge funds, and real estate investment trusts. We discuss them
from two perspectives: their investment characteristics and their use as part of a bond
portfolio strategy.

Chapter 21: Measuring Credit Spread Exposures of Corporate Bonds

Earlier chapters in the book explain how to quantify the interest-rate sensitivity of a bond
and a bond portfolio to a change in the level of Treasury rates. In this new chapter, the
focus is on how to best model credit spread behavior and how to measure exposure to
credit spread risk when Treasury rates change.

Chapter 26: Considerations in Corporate Bond Portfolio Management

Whereas earlier chapters in the book describe bond portfolio strategies and management
in general, this new chapter covers issues associated specifically with the management of
corporate bond portfolios. Coverage includes the stability of the investment characteristics
of bond market indexes, credit relative value trades, constraint-tolerating investing, and
how to quantify liquidity risk for corporate bonds.

Chapter 27: Liability-Driven Investing for Defined Benefit Pension Plans

The eighth edition of the book had a chapter entitled “Liability-Driven Strategies,” which
just described immunization and cash flow matching strategies. That chapter (Chapter 24)
is replaced with this new chapter that focuses on liability-driven investing for defined

x
 Preface xi

benefit pension plans. The chapter begins with a description of how historically pension
plan sponsors incorrectly formulated investment policy by focusing solely on the asset side.
After covering measures used to describe the health of a defined benefit pension plan, liability-
driven investing strategies are described that take into account their liability obligations.

Significantly Revised Chapters

Chapter 22: Corporate Bond Credit Analysis (Chapter 19
in the previous edition)
Expanded coverage and the addition of two cases—credit analysis and covenant analysis
of Sirius XM Holdings Inc. and credit analysis of Sino-Forest Corporation (a commercial
forestry company in China)—are provided.

Chapter 24: Bond Portfolio Management Strategies (Chapter 22

in the previous edition)
New material on selection of bond benchmarks, problems with market-capitalization-
weighted bond indexes, customized indexes, alternative bond benchmarks, and smart beta
strategies are provided.

Other Noteworthy Changes to Chapters

Chapter 19: Analysis of Residential Mortgage-Backed Securities
(Chapter 18 in the previous edition)
Two real-world illustrations provided by FactSet are included.

Chapter 23: Credit Risk Modeling (Chapter 21 in the previous edition)

An illustration of how to use risk models in relative value analysis provided by Kamakura
Corporation is presented.

Instructor Supplements
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Instructor’s Resource Center—Register.Redeem.Login

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faculty member, you can log in directly to download resource files, and receive immediate
access and instructions for installing Course Management content on your campus server.
Need help? Our dedicated Technical Support team is ready to assist instructors with ques-
tions about the media supplements that accompany this text. Visit http://247pearsoned
.custhelp.com/ for answers to frequently asked questions and toll-free user support phone
numbers. The following supplements are available to adopting instructors. Detailed descrip-
tions of the following supplements are provided on the Instructor’s Resource Center.
xii Preface

Electronic Instructor’s Manual with Solutions

Prepared by Dr. Rob Hull of Washburn University School of Business, the Instructor’s
Manual contains chapter summaries and suggested answers to all end-of-chapter
questions.

PowerPoint Presentation
Prepared by Dr. Rob Hull of Washburn University School of Business, the PowerPoint
slides provide the instructor with individual lecture outlines to accompany the text. The
slides include all of the figures and tables from the text. These lecture notes can be used as
is or professors can easily modify them to reflect specific presentation needs.

Acknowledgments
I am grateful to the following individuals who assisted in different ways as identified below:
• Cenk Ural (Barclays Capital) for the extensive illustrations used in Chapters 4, 25,
and 26.
• Karthik Ramanathan (Fidelity Management and Research Company/Pyramis Global
Advisors) for feedback on Chapter 9.
• William Berliner (Consultant) for feedback on Chapter 10.
• Anand Bhattacharya (Arizona State University) for feedback on Chapter 10.
• Alex Levin (Andrew Davidson & Co.) for reviewing and commenting on Chapter 19.
• Andrew Davidson (Andrew Davidson & Co.) for reviewing and commenting on
Chapter 19.
• Bill McCoy (FactSet) for providing the two illustrations in Chapter 19.
• Oren Cheyette (Loomis Sayles) for reviewing and commenting on Chapter 19.
• Jay Hyman (Barclays Capital) for reviewing and commenting on Chapter 21.
• Lev Dynkin (Barclays Capital) for feedback on Chapters 21 and 26.
• Jie Liu (Sentry Investments), who made several important contributions to Chapter 22,
including the two Sirius XM Holdings cases and the Sino Forest case.
• Jane Howe for allowing me to use some of our joint work in Chapter 22.
• Donald van Deventer (Kamakura Corporation) for allowing me to use his case “Bank of
America Corporation: Default Probabilities and Relative Value Update” in Chapter 23
as well as providing feedback on the chapter.
• Tim Backshall for reviewing and commenting on Chapter 23.
• Bruce Phelps (Barclays Capital) for reviewing and commenting on Chapter 26.
• Peter Ru for preparing the hedging illustrations in Chapters 29 and 30.
• Donald Smith (Boston University) for providing the correct methodology for valuing
interest-rate caps and floors in Chapter 31.
• Mark Paltrowitz (BlackRock Financial Management) for the illustrations in Chapters 29
and 31.
• Harry Kim (Korea Fixed-Income Investment Advisory Co., Ltd) for providing me with a
list of errors in the eighth edition.
I am indebted to the following individuals who shared with me their views on various
topics covered in this book:
Sylvan Feldstein (Guardian Life), Michael Ferri, Sergio Focardi (Stony Brook, SUNY).
Laurie Goodman, David He, Claire Jahns, Frank Jones (San Jose State University), Andrew
Kalotay (Andrew Kalotay Associates), Martin Leibowitz (Morgan Stanley), Jack Malvey
 Preface xiii

(BNY Mellon), Steven Mann (University of South Carolina), Lionel Martellini (EDHEC
Business School), Wesley Phoa (The Capital Group Companies), Philippe Priaulet (Natexis
Banques Populaires and University of Evry Val d’Essonne), Scott Richard (Wharton), Ron
Ryan (Ryan ALM), Richard Wilson, David Yuen (Franklin Advisors), and Yu Zhu (China
Europe International Business School).
I also received extremely helpful comments from a number of colleagues using the text
in an academic setting as well as reviewers of earlier editions of the book. I am sincerely
appreciative of their suggestions. They are:
Şxenay Ağca, George Washington University
Michael J. Alderson, St. Louis University
David Brown, University of Florida
John Edmunds, Babson College
R. Philip Giles, Columbia University
Martin Haugh, Columbia University
Ghassem Homaifar, Middle Tennessee State University
Tao-Hsien Dolly King, University of North Carolina at Charlotte
Deborah Lucas, MIT
Davinder K. Malhotra, Philadelphia University
Peter Ritchken, Case Western Reserve University
Jeffrey A. Schultz, Christian Brothers University
Shahzeb Shaikh, Umea University
John H. Spitzer, University of Iowa
Michael Stutzer, University of Colorado at Boulder
Joel M. Vanden, Dartmouth College
Ying Wang, University at Albany
Russell R. Wermers, University of Colorado at Boulder
Berry K. Wilson, Pace University
Xiaoqing Eleanor Xu, Seton Hall University
This page intentionally left blank
B o n d M arkets , A nalysis ,
and S trategies
This page intentionally left blank
 Introduction
1
Learning Objectives
After reading this chapter, you will understand
• the fundamental features of bonds
• the types of issuers
• the importance of the term to maturity of a bond
• floating-rate and inverse-floating-rate securities
• what is meant by a bond with an embedded option and the effect of an embedded
option on a bond’s cash flow
• the various types of embedded options
• convertible bonds
• the types of risks faced by investors in fixed-income securities
• the secondary market for bonds

A bond is a debt instrument requiring the issuer (also called the debtor or borrower) to
repay to the lender/investor the amount borrowed plus interest over a specified ­period
of time. A typical (“plain vanilla”) bond issued in the United States specifies (1) a fixed date
when the amount borrowed (the principal) is due, and (2) the contractual amount of inter-
est, which typically is paid every six months. The date on which the principal is required to
be repaid is called the maturity date. Assuming that the issuer does not default or redeem
the issue prior to the maturity date, an investor holding a bond until the maturity date is
assured of a known cash flow pattern.
For a variety of reasons to be discussed later in this chapter, since the early 1980s a
wide range of bond structures has been introduced into the bond market. In the residential
mortgage market particularly, new types of mortgage designs were introduced. The practice

1
2       Chapter 1    Introduction

of pooling individual mortgages to form mortgage pass-through securities grew dramatically.

Using the basic instruments in the mortgage market (mortgages and mortgage pass-through
securities), issuers created derivative mortgage instruments such as collateralized mortgage
obligations and stripped mortgage-backed securities that met the specific investment needs
of a broadening range of institutional investors.

Sectors of the U.S. Bond Market

The U.S. bond market is the largest bond market in the world. The market is divided into six
sectors: U.S. Treasury sector, agency sector,1 municipal sector, corporate sector, ­asset-backed
securities sector, and mortgage sector. The Treasury sector includes securities ­issued by the U.S.
government. These securities include Treasury bills, notes, and bonds. This sector plays a key
role in the valuation of securities and the determination of interest rates throughout the world.
The agency sector includes securities issued by federally related institutions and
government-sponsored enterprises. The distinction between these issuers is described in
Chapter 6. The securities issued are not backed by any collateral and are referred to as
agency debenture securities. This sector is the smallest sector of the bond market.
The municipal sector is where state and local governments and their authorities raise
funds. This sector is divided into two subsectors based on how the interest received by
­investors is taxed at the federal income tax level. The tax-exempt market is the largest ­sector
where interest received by investors is exempt from federal income taxes. Historically, the
taxable sector was a small sector of the municipal bond market. The municipal bond market
includes two types of structures: (1) tax-backed bonds and (2) revenue bonds.
The corporate sector includes securities issued by U.S. corporations and securities issued
in the United States by non–U.S. corporations. Issuers in the corporate sector issue bonds,
­medium-term notes, structured notes, and commercial paper. In addition to their issuance
of these securities, corporations borrow funds from banks. At one time commercial banks
that made these loans held them in their loan portfolio. Today, certain commercial loans
are traded in the market. The corporate sector is divided into the investment-grade and
­noninvestment-grade sectors. The classification is based on the assignment of a credit rating
determined by a third-party commercial entity. We will discuss credit ratings in Chapter 7.
An alternative to the corporate sector where a corporation can raise funds is the
­asset-backed securities sector. In this sector, a corporation pools loans or receivables and
uses the pool of assets as collateral for the issuance of a security. Captive finance companies,
that is, subsidiaries of operating companies that provide funding for loans to customers of
the parent company to buy the product manufactured, are typically issuers of asset-backed
securities. Harley-Davidson Financial Services, Ford Motor Credit Company, and Caterpillar
Financial Services Corporation are just a few examples. Probably the most well-known asset-
backed securities (although a very tiny part of the market) are those issued by performing
artists such as David Bowie, Ashford & Simpson, and James Brown, backed by music royalty
future receivables.2 The various types of asset-backed securities are described in Chapter 15.

1
In later chapters, we will see how organizations that create bond market indexes provide a more detailed
breakdown of the sectors.
2
David Bowie was the first recording artist to issue these bonds, in 1997, and hence these bonds are popularly
referred to as “Bowie bonds.” The bond issue, a $55 million, 10-year issue, was purchased by Prudential and was
backed by future royalties from a substantial portion of Bowie’s music catalogue.
 Chapter 1    Introduction       3

The mortgage sector is the sector where the securities issued are backed by mortgage
loans. These are loans obtained by borrowers in order to purchase residential property or
to purchase commercial property (i.e., income-producing property). The mortgage sector is
thus divided into the residential mortgage sector and the commercial mortgage sector. The
residential mortgage sector, which includes loans for one- to four-family homes, is covered
in Chapters 10 through 13. The commercial mortgage sector, backed by commercial loans
for income-producing property such as apartment buildings, office buildings, industrial
properties, shopping centers, hotels, and health care facilities, is the subject of Chapter 14.
Chapter 10 discusses the different types of residential mortgage loans and the classification
of mortgage loans in terms of the credit quality of the borrower: prime loans and subprime
loans. The latter loans are loans to borrowers with impaired credit ratings. Also, loans are clas-
sified as to whether or not they conform to the underwriting standards of a federal agency or
government-sponsored enterprise that packages residential loans to create residential mortgage-
backed securities. Residential mortgage-backed securities issued by a federal agency (the
Government National Mortgage Association, or Ginnie Mae) or Fannie Mae or Freddie Mac
(two ­government-sponsored enterprises) are referred to as agency mortgage-backed securities.
Chapter 11 is devoted to the basic type of such security, an agency mortgage pass-through secu-
rity, while Chapter 12 covers securities created from agency mortgage pass-through securities:
collateralized mortgage obligations and stripped mortgage-backed securities.
Residential mortgage-backed securities not issued by Ginnie Mae, Fannie Mae, or
Freddie Mac are called nonagency mortgage-backed securities and are the subject of
Chapter 13. This sector is divided into securities backed by prime loans and those backed
by subprime loans. The securities in the latter sector, referred to as subprime mortgage-
backed securities, have had major difficulties due to ­defaults. The turmoil in the financial
market caused by the defaults in this sector is referred to as “the subprime mortgage crisis.”
Non-U.S. bond markets include the Eurobond market and other national bond
­markets. We discuss these markets in Chapter 9.
Bond investors—retail investors and institutional investors—have an opportunity to
invest in a pooled investment vehicle in lieu of constructing their own portfolio to obtain
exposure to the broad bond market and/or specific sectors of the bond market. For retail
investors, the benefits of investing in pooled funds rather than the direct purchase of individ-
ual bonds to create a portfolio are (1) better diversification in obtaining the desired exposure,
(2) better liquidity, and (3) professional management. These investment instruments, re-
ferred to as collective investment vehicles and the subject of Chapter 16, include investment
company shares, exchange-traded shares, hedge funds, and real estate investment trusts.

Overview of Bond Features

In this section, we provide an overview of some important features of bonds. A more
­detailed treatment of these features is presented in later chapters.

Type of Issuer
A key feature of a bond is the nature of the issuer. There are three issuers of bonds: the
federal government and its agencies, municipal governments, and corporations (domestic
and foreign). Within the municipal and corporate bond markets, there is a wide range of
issuers, each with different abilities to satisfy their contractual obligation to lenders.
4       Chapter 1    Introduction

Term to Maturity
The term to maturity of a bond is the number of years over which the issuer has promised
to meet the conditions of the obligation. The maturity of a bond refers to the date that
the debt will cease to exist, at which time the issuer will redeem the bond by paying the
outstanding principal. The practice in the bond market, however, is to refer to the term to
maturity of a bond as simply its maturity or term. As we explain subsequently, there may
be provisions in the indenture that allow either the issuer or bondholder to alter a bond’s
term to maturity.
Generally, bonds with a maturity of between one and five years are considered short-
term. Bonds with a maturity between 5 and 12 years are viewed as intermediate-term,
and long-term bonds are those with a maturity of more than 12 years.
The term to maturity of a bond is important for three reasons. The most obvious is
that it indicates the time period over which the holder of the bond can expect to receive
the coupon payments and the number of years before the principal will be paid in full. The
second reason that term to maturity is important is that the yield on a bond ­depends on it.
As explained in Chapter 5, the shape of the yield curve determines how term to maturity
affects the yield. Finally, the price of a bond will fluctuate over its life as yields in the mar-
ket change. As demonstrated in Chapter 4, the volatility of a bond’s price is dependent on
its maturity. More specifically, with all other factors constant, the longer the maturity of a
bond, the greater the price volatility resulting from a change in market yields.

Principal and Coupon Rate

The principal value (or simply principal) of a bond is the amount that the issuer agrees to
repay the bondholder at the maturity date. This amount is also referred to as the redemp-
tion value, maturity value, par value, or face value.
The coupon rate, also called the nominal rate, is the interest rate that the issuer agrees to
pay each year. The annual amount of the interest payment made to owners during the term
of the bond is called the coupon.3 The coupon rate multiplied by the principal of the bond
provides the dollar amount of the coupon. For example, a bond with an 8% coupon rate and
a principal of $1,000 will pay annual interest of $80. In the United States and Japan, the usual
practice is for the issuer to pay the coupon in two semiannual installments. For bonds issued
in certain European bond markets, coupon payments are made only once per year.
Note that all bonds make periodic coupon payments, except for one type that makes
none. The holder of a zero-coupon bond realizes interest by buying the bond substantially
below its principal value. Interest is then paid at the maturity date, with the exact amount
being the difference between the principal value and the price paid for the bond.
Floating-rate bonds are issues where the coupon rate resets periodically (the coupon
reset date) based on a formula. The formula, referred to as the coupon reset formula, has
the following general form:
reference rate 1 quoted margin

3
Here is the reason why the interest paid on a bond is called its “coupon.” At one time, the bondholder received
a physical bond, and the bond had coupons attached to it that represented the interest amount owed and when
it was due. The coupons would then be deposited in a bank by the bondholder to obtain the interest payment.
Although in the United States most bonds are registered bonds and, therefore, there are no physical “coupons,”
the term coupon interest or coupon rate is still used.
 Chapter 1    Introduction       5

The quoted margin is the additional amount that the issuer agrees to pay above the
r­ eference rate. For example, suppose that the reference rate is the 1-month London inter-
bank offered rate (LIBOR), an interest rate that we discuss in later chapters. Suppose that
the quoted margin is 150 basis points. Then the coupon reset formula is
1-month LIBOR 1 150 basis points
So, if 1-month LIBOR on the coupon reset date is 3.5%, the coupon rate is reset for that
period at 5.0% (3.5% plus 150 basis points).
The reference rate for most floating-rate securities is an interest rate or an interest-
rate index. The mostly widely used reference rate throughout the world is the London
Interbank Offered Rate and referred to as LIBOR. This interest rate is the rate at which
the highest credit quality banks borrow from each other in the London interbank ­market.
LIBOR is calculated by the British Bankers Association (BBA) in conjunction with Reuters
based on interest rates it receives from at least eight banks with the information released
every day around 11 a.m. Hence, often in debt agreements LIBOR is referred to as BBA
LIBOR. The rate is reported for 10 currencies:4 U.S. dollar (USD), UK pound sterling
(GBP), Japanese yen (JPY), Swiss franc (CHF), Canadian dollar (CAD), Australian dollar
(AUD), euro (EUR), New Zealand dollar (NZD), Swedish krona (SEK), and Danish krona
(DKK). So, for example, the AUD BBA LIBOR is the rate for a LIBOR loan denominated in
Australian dollars as computed by the British Bankers Association.
There are floating-rating securities where the reference rate is some financial index
such as the return on the Standard & Poor’s 500 or a nonfinancial index such as the price
of a commodity. An important non-interest-rate index that has been used with increasing
frequency is the rate of inflation. Bonds whose interest rate is tied to the rate of inflation
are referred to generically as linkers. As we will see in Chapter 6, the U.S. Treasury issues
linkers, and they are referred to as Treasury Inflation Protection Securities (TIPS).
Although the coupon on floating-rate bonds benchmarked off an interest rate bench-
mark typically rises as the benchmark rises and falls as the benchmark falls, there are issues
whose coupon interest rate moves in the opposite direction from the change in interest
rates. Such issues are called inverse-floating-rate bonds (or simply, inverse floaters) or
reverse floaters.
In the 1980s, new structures in the high-yield (junk-bond) sector of the corporate bond
market provided variations in the way in which coupon payments are made. One reason is
that a leveraged buyout (LBO) or a recapitalization financed with high-yield bonds, with
consequent heavy interest payment burdens, placed severe cash flow constraints on the
corporation. To reduce this burden, firms involved in LBOs and recapitalizations issued
deferred-coupon bonds that let the issuer avoid using cash to make interest payments for a
specified number of years. There are three types of deferred-coupon structures: (1) deferred-
interest bonds, (2) step-up bonds, and (3) payment-in-kind bonds. Another high-yield bond
structure requires that the issuer reset the coupon rate so that the bond will trade at a prede-
termined price. High-yield bond structures are discussed in Chapter 7.
In addition to indicating the coupon payments that the investor should expect to
­receive over the term of the bond, the coupon rate also indicates the degree to which the

4
The symbol in parentheses following each currency is the International Organization for Standardization
three-letter code used to define a currency.
6       Chapter 1    Introduction

bond’s price will be affected by changes in interest rates. As illustrated in Chapter 4, all
other factors constant, the higher the coupon rate, the less the price will change in response
to a change in market yields.

Amortization Feature
The principal repayment of a bond issue can call for either (1) the total principal to be
repaid at maturity, or (2) the principal repaid over the life of the bond. In the latter case,
there is a schedule of principal repayments. This schedule is called an amortization schedule.
Loans that have this feature are automobile loans and home mortgage loans.
As we will see in later chapters, there are securities that are created from loans that have
an amortization schedule. These securities will then have a schedule of periodic principal
repayments. Such securities are referred to as amortizing securities. Securities that do not
have a schedule of periodic principal repayment are called nonamortizing securities.
For amortizing securities, investors do not talk in terms of a bond’s maturity. This is
because the stated maturity of such securities only identifies when the final principal pay-
ment will be made. The repayment of the principal is being made over time. For amortizing
securities, a measure called the weighted average life or simply average life of a security is
computed. This calculation will be explained later in this book when we cover the two ma-
jor types of amortizing securities—mortgage-backed securities and asset-backed securities.

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. The
most common type of option embedded in a bond is a call provision. This provision grants
the issuer the right to retire the debt, fully or partially, before the scheduled maturity date.
Inclusion of a call feature benefits bond issuers by allowing them to replace an outstand-
ing bond issue with a new bond issue that has a lower coupon rate than the outstanding
bond issue because market interest rates have declined. A call provision effectively allows
the issuer to alter the maturity of a bond. For reasons explained in the next section, a call
provision is detrimental to the bondholder’s interests.
The right to call an obligation is also included in most loans and therefore in all securi-
ties created from such loans. This is because the borrower typically has the right to pay off a
loan at any time, in whole or in part, prior to the stated maturity date of the loan. That is, the
borrower has the right to alter the amortization schedule for amortizing securities.
An issue may also include a provision that allows the bondholder to change the
­maturity of a bond. An issue with a put provision included in the indenture grants the
bondholder the right to sell the issue back to the issuer at par value on designated dates.
Here the advantage to the investor is that if market interest rates rise after the issuance
date, thereby reducing the bond’s price, the investor can force the issuer to redeem the
bond at the principal value.
A convertible bond is an issue giving the bondholder the right to exchange the bond
for a specified number of shares of common stock. Such a feature allows the bondholder
to take advantage of favorable movements in the price of the issuer’s common stock. An
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. These bonds
are discussed and analyzed in Chapter 20.
 Chapter 1    Introduction       7

Some issues allow either the issuer or the bondholder the right to select the currency
in which a cash flow will be paid. This option effectively gives the party with the right to
choose the currency the opportunity to benefit from a favorable exchange-rate movement.
Such issues are described in Chapter 9.
The presence of embedded options makes the valuation of bonds complex. It requires
investors to have an understanding of the basic principles of options, a topic covered in
Chapter 18 for callable and putable bonds and Chapter 19 for mortgage-backed securities
and asset-backed securities. The valuation of bonds with embedded options frequently is
complicated further by the presence of several options within a given issue. For example,
an issue may include a call provision, a put provision, and a conversion provision, all of
which have varying significance in different situations.

Describing a Bond Issue

There are hundreds of thousands of bond issues. Most securities are identified by a nine-
character (letters and numbers) CUSIP number. CUSIP stands for Committee on Uniform
Security Identification Procedures. The CUSIP International Numbering System (CINS)
is used to identify foreign securities and includes 12 characters. The CUSIP numbering
system is owned by the American Bankers Association and operated by Standard & Poor’s.
CUSIP numbers are important for a well-functioning securities market because they aid
market participants in properly identifying securities that are the subject of a trade and in
the clearing/settlement process.
The CUSIP number is not determined randomly but is assigned in such a way so
as to identify an issue’s key differentiating characteristics within a common structure.
Specifically, the first six characters identify the issuer: the corporation, government
agency, or municipality. The next two characters identify whether the issue is debt or
equity and the issuer of the issue. The last character is simply a check character that ­allows
for accuracy checking and is sometimes truncated or ignored; that is, only the first char-
acters are listed.
The debt instruments covered are
• asset-backed securities
• banker acceptances
• certificates of deposits
• collateralized debt obligations
• commercial paper
• corporate bonds
• medium-term notes
• mortgage-backed securities
• municipal bonds
• structured products
• U.S. federal government agencies
• U.S. Treasury securities: bonds, bills, and notes
Interest-rate derivatives and credit derivatives are also covered.
In general, when bonds are cited in a trade or listed as holdings in a portfolio, the
particular issue is cited by issuer, coupon rate, and maturity date. For example, three
bonds issued by Alcoa Inc. and how they would be referred to are shown in the following
table.
8       Chapter 1    Introduction

Coupon Maturity
5.95% Feb. 1, 2037 Alcoa, 5.95%, due 2/1/2037 or Alcoa,
5.95s 2/1/2037
6.15% Aug. 15, 2020 Alcoa, 6.15%, due 8/15/2020 or Alcoa,
6.15s 8/15/2020
6.75% July 15, 2018 Alcoa, 6.75%, due 7/15/2018 or Alcoa,
6.75s 7/15/2018

Risks Associated with Investing in Bonds

Bonds may expose an investor to one or more of the following risks: (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, and (9) risk risk. Although each of these risks is dis-
cussed further in later chapters, we describe them briefly in the following sections. In later
­chapters, other risks, such as yield curve risk, event risk, and tax risk, are also introduced.
What is critical in constructing and controlling the risk of a portfolio is the ability to quan-
tify as many of these risks as possible. We will see this in later chapters, particularly in our
coverage of factor models in Chapter 25.

Interest-Rate Risk
The price of a typical bond will change in the opposite direction from a change in interest
rates: As interest rates rise, the price of a bond will fall; as interest rates fall, the price of a
bond will rise. This property is illustrated in Chapter 2. If an investor has to sell a bond
prior to the maturity date, an increase in interest rates will mean the realization of a capital
loss (i.e., selling the bond below the purchase price). This risk is referred to as interest-rate
risk or market risk.
As noted earlier, the actual degree of sensitivity of a bond’s price to changes in market
interest rates depends on various characteristics of the issue, such as coupon and maturity.
It will also depend on any options embedded in the issue (e.g., call and put provisions),
­because, as we explain in later chapters, the value of these options is also affected by interest-
rate movements.

Reinvestment Income or Reinvestment Risk

As explained in Chapter 3, calculation of the yield of a bond assumes that the cash flows
received are reinvested. The additional income from such reinvestment, sometimes called
interest-on-interest, depends on the prevailing interest-rate levels at the time of reinvest-
ment, as well as on the reinvestment strategy. Variability in the reinvestment rate of a given
strategy because of changes in market interest rates is called reinvestment risk. This risk is
that the prevailing market 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. This risk is analyzed in more detail in Chapter 3.
It should be noted that interest-rate risk and reinvestment risk have offsetting effects.
That is, interest-rate risk is the risk that interest rates will rise, thereby reducing a bond’s
price. In contrast, reinvestment risk is the risk that interest rates will fall. A strategy based
on these offsetting effects is called immunization, a topic covered in Chapter 27.
 Chapter 1    Introduction       9

Call Risk
As explained earlier, bonds may include a provision that allows the issuer to retire or “call” all or
part of the issue before the maturity date. The issuer usually retains this right in order to have flex-
ibility to refinance the bond in the future if the market interest rate drops below the coupon rate.
From the investor’s perspective, there are three disadvantages to call provisions. First, the
cash flow pattern of a callable bond is not known with certainty. Second, because the issuer will
call the bonds when interest rates have dropped, the investor is exposed to reinvestment risk
(i.e., the investor will have to reinvest the proceeds when the bond is called at relatively lower
interest rates). Finally, the capital appreciation potential of a bond will be reduced because the
price of a callable bond may not rise much above the price at which the issuer will call the bond.5
Even though the investor is usually compensated for taking call risk by means of a
lower price or a higher yield, it is not easy to determine if this compensation is sufficient.
In any case the return or price performance of a bond with call risk can be dramatically
­different from those obtainable from an otherwise comparable noncallable bond. The
magnitude of this risk depends on various parameters of the call provision, as well as on
market ­conditions. Techniques for analyzing callable bonds are explained in Chapter 18.

Credit Risk
It is common to define credit risk as the risk that the issuer of a bond will fail to satisfy the
terms of the obligation with respect to the timely payment of interest and repayment of
the amount borrowed. This form of credit risk is called default risk. Market participants
gauge the default risk of an issue by looking at the credit rating assigned to a bond issue by
one of the three rating companies—Standard & Poor’s, Moody’s, and Fitch. We will ­discuss
the rating systems used by these rating companies (also referred to as rating agencies) in
Chapter 7 and the factors that they consider in assigning ratings in Chapter 22.
Risks are associated with investing in bonds other than default that are also components
of credit risk. Even in the absence of default, an investor is concerned that the market value
of a bond issue will decline in value and/or that the relative price performance of a bond issue
will be worse than that of other bond issues, which the investor is compared against. The yield
on a bond issue is made up of two components: (1) the yield on a similar maturity Treasury
issue, and (2) a premium to compensate for the risks associated with the bond issue that do
not exist in a Treasury issue—referred to as a spread. The part of the risk premium or spread
attributable to default risk is called the credit spread. An entire chapter, Chapter 21, is de-
voted to the measurement of credit spread, and in Chapter 26 we explain how the measures
can be used in portfolio management of corporate bond portfolios.
The price performance of a non-Treasury debt obligation and its return over some invest-
ment horizon will depend on how the credit spread of a bond issue changes. If the credit spread
increases—investors say that the spread has “widened”—the market price of the bond issue will
decline. The risk that a bond issue will decline due to an increase in the credit spread is called
credit spread risk. This risk exists for an individual bond issue, bond issues in a particular indus-
try or economic sector, and for all bond issues in the economy not issued by the U.S. Treasury.
Once a credit rating is assigned to a bond issue, a rating agency monitors the credit
quality of the issuer and can change a credit rating. An improvement in the credit quality
of an issue or issuer is rewarded with a better credit rating, referred to as an upgrade; a
5
The reason for this is explained in Chapter 18.
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*** START OF THE PROJECT GUTENBERG EBOOK THE TIME OF

COLD ***
THE TIME OF COLD
 BY MARY CARLSON

Queer creatures! They fled the life-giving

sun and hid where even tin froze solid!

[Transcriber's Note: This etext was produced from

Worlds of If Science Fiction, September 1963.
Extensive research did not uncover any evidence that
the U.S. copyright on this publication was renewed.]
Curt felt the airship going out of control as he passed over a rock
spattered stretch of sand. Automatically he looked for a smooth
place to land and steered the bucking ship for it. The jolt of the
landing triggered the ejector seat and in a second he was hurtling
through the air away from the explosion of the damaged vehicle.
Just before he blacked out, he thought—almost calmly—"a good
hundred and fifty miles from the colony."
When he regained consciousness, night was passing and the first of
the three suns was peeking over the horizon. Curt lay still for a
while, afraid to find out what might be wrong with him. And the
rescue ship could take anything from an hour to a week to find him.
He moved his head to discover if there might be anything left of his
ship; he saw nothing but pieces.
"Well," he said aloud, "so much for that." He reached back gingerly
and undid the seat straps. Carefully, he sat up and began to ease his
weight onto his feet. A sharp twinge of pain in his knee dropped him
back to a sitting position. He probed at the knee but found no
broken bones.
"Well," he said again, quietly. The colony leaders had had very little
to offer in the way of survival. Rule number 1: Mark the crash site
and your direction of travel. Number 2: Get into shade before the
combined heat of the three suns boils your blood. Number 3: Carry
your pistol for protection against liquid scorpions, and always save
the last pellet for yourself.
Curt glanced about nervously at the thought of the liquid scorpions—
the one form of animal life the colonist had found on this mineral-
rich planet. Liquid scorpions were enormous masses of clear, jellyish
liquid that oozed forward across the rock and sand with remarkable
speed. A liquid scorpion changed shape constantly, its mass shooting
out legs wherever they were needed. Only the eyes, fixed in a bulge
over the center of its mass, and the almost-solid, curved stinger that
arched over its back remained the same.
The first landing party had stood transfixed while one of the crew
was attacked and absorbed before their eyes. Clear, the scorpion had
been almost invisible to them until it flowed about the navigator's
legs and paralyzed him with the swaying stinger. When his frantic
struggles had ceased, the creature flowed over his body and
absorbed it. As the party watched, the clearness slowly became a
thin, dark red, and the body could no longer be seen.
Avengers had poured out of the ship after the giant scorpion, which
reared back, tripling its height and halving its width. At the apex, the
two protruding eyes bulged at them and the stinger swayed back
and forth, reaching out and retreating. Explosive pellets fired into its
flesh were absorbed with a slurping sound. The captain in the end,
had knelt and taken careful aim at the right eye, behind which was
the only unreddened sector of the mass. When the right eye
disappeared, the clear area spurted out of the hole and drained over
the jelly-like surface. Slowly, silently, the first of the liquid scorpions
died.
Curt counted the pellets in his belt—an even hundred. Enough ... if
he managed to keep out of sight and had good enough aim. He
surveyed the surrounding countryside. Farther along the valley were
shaded caves where he could find protection once he had marked
his course.
If he could walk that far.

Xen came sluggishly awake, feeling the warmth penetrate his mass.
The time of heat had come again, the time to search for what would
halt the hunger that ached through every inch of him.
Slowly, his cold-stiffened mass flowed forward from its hiding place
in the warmth-holding sand. The heat melted the stiffness out of
him and he began to slide across the sand, his alert senses
functioning again. Sense of touch led him across rocks and over
ridges easily. The touchy sense of vibration waited apprehensively
for movement that would shake the ground. And the third sense, the
one that could be called only "sense" or "sense of knowing,"
functioned as always without his understanding. Today, this third
sense told Xen, was different from other days.
Extra-cautious, Xen oozed over rocky barriers in the direction that
his "sense" told him held food. Once he felt a slight tremor, and in
terror flooded out over the rock into thin, transparent nothing. He
waited several degrees of heat, but no further movement touched
the sensitive receivers in his mass.
A falling rock, he decided, collecting himself and starting forward
again. He slithered down rocky walls, pouring almost like water
when the drop was long and drawing together at the bottom. When
his feeling of touch warned him of the shade whose coolness might
solidify him and leave him helpless in the open, he drew hurriedly
away and changed direction.
Finally, he reached an open spot that was likely to contain food. His
mass ached for something to consume, but he flooded himself thin
again and waited, feeling. There was no vibration through the
surface, nor did his "sense" tell him of anything other than the
possibility of nourishment. Xen hesitated only a degree of heat
before bubbling excitedly into the open space.
Touch found him something edible almost immediately—he flowed
around and over it, absorbing it hungrily. His mass dissolved it
almost immediately and ached for more. He slid thin, reaching out in
every direction until contact was made, then absorbing the food
instantly and moving on.

Curt, lying in meager shade that would be gone in half an hour

when the third and largest sun rose, first saw the movement when it
was on the rocks. His already frayed nerves gave a frightened leap.
He lay perfectly still. Where he had seen the movement on the rocky
shelf there was now nothing.
The nothing moved forward.
Curt shivered. He was certain he was seeing nothing, and yet his
eyes were trying to tell him there was movement. When it reached
the flat place and flowed swiftly forward, he realized that it was a
liquid animal and was suddenly pointedly conscious of the weight of
the pistol against his hip.
He watched carefully for the eyes and the stinger, but saw none.
That frightened him. If he could not find the brain, he had no mark
to shoot at. As he watched, the liquid creature flowed against one of
the hardy, sun-browned plants and jerked in reaction. Instantly, it
flowed over the plant and absorbed it. The liquid turned momentarily
a thin brownish green and then cleared again.
Curt watched it with narrowed eyes. It was just possible that this
creature ate only plant life. The colonists had realized that the liquid
scorpions had fed upon something else before they arrived, but no
one had been able to discover what that something was.

Xen was in the process of absorbing a plant when the vibration

sense alerted him. Terror shot through him and he spread thinly
across thirty feet of ground and lay motionless, his "sense" telling
him frantically that a Sting was hunting nearby.
He lay for many degrees of heat, waiting. Sense of vibration and
knowing both told him that the Sting was approaching, but
uncertainly, searching. Then both senses reacted startledly to a new
danger on the other side. New movement! A new feeling that his
"sense" could not understand.
The Sting was approaching at an angle that would inevitably bring it
in contact with Xen. Absorption was the penalty for being caught.
Xen was resigned to death, for he could not possibly escape the
Sting. And now there was this new sensation on the other side of
him. Whatever it was, he had no idea; but likely it was as voracious
as the Sting.
Now the new thing vibrated jerkily around him and stopped between
him and the Sting. The vibrations from the eager Sting accelerated
rapidly, eagerly, as it flowed over the ground. Then, for no reason
except that the new creature had moved slightly, the Sting recoiled.
The jerks were plainly recorded through the earth to Xen; and as he
felt the heavy jar, his "sense" told him that the danger from the
Sting was past. The Sting was dead.
Xen drew himself together and considered that.
The new thing vibrated jerkily the place from which Xen had first felt
it move. It must be solid as the rocks to move so jerkily, Xen
thought. The Sting-killer drew itself back under the enormous rock
and ceased to move.
Curiosity drew Xen forward, fear dragged him back. He spread thin
and drew together with uncertainty. At last, he oozed forward
carefully until he reached the rock. The Sting-killer was pressed back
under the rock, where touch told Xen a tiny amount of the cold-
carrying shade remained. Xen puzzled at that. Why should this
creature hide from the life-giving suns?
He reached out and absorbed a plant thoughtfully. This thing was
different from the liquid structures he had always known. If it was
solid where they were liquid, perhaps then it was also opposite in its
needs. Maybe this Sting-killer needed cold instead of heat.
While Xen was considering this difficult thought, the Sting-killer
began to move again.
Curt gasped. The shade was gone. The third sun was reaching long
rays under the rock to sear his already-burned flesh. He had to find
more shade.
Movements were very painful. His lips were cracking and his face
had blackened. The injured knee had swollen inside the protective
suit; it throbbed and ached. Dazedly, he pulled himself to his feet.
On the rock beside him, spread an inch thick, was the almost-
invisible creature he had been forced to circle in order to stop the
liquid scorpion. He wondered tiredly if it was dangerous. It lay
completely motionless, just as it had when the liquid scorpion had
approached. So it was probably more afraid of him than he was of it.
He turned away. There appeared to be shade down the valley—
perhaps a mile, perhaps three. Too much for him, he knew, but he
set out, feeling the sun beat cruelly at him, crying out when the pain
in his knee forced him to catch his balance against the sun-heated
rock.
He knew without turning that the liquid creature was following him,
stopping when he stopped, starting when he started. When he knew
he could go no farther and felt his knee give weakly to his weight,
he saw it ooze forward and began to flow over his legs. He tried to
reach his pistol, but it seemed so far away.

Xen, following the Sting-killer curiously, put together all that he had
learned. This creature was different from himself. It needed shade.
It had killed his enemy, which was possibly also its own enemy. Now
it was trying to reach the shade, but its progress grew steadily
slower.
He considered that progress. The only thing he could liken it to was
one of his own kind, caught out in the time of cold, trying to reach
the heat-retaining sands, slowly congealing into a solid mass and
dying. This, then, was the reverse process. Perhaps the Sting-killer
would become liquid after a certain degree of heat.
Xen's sense of knowing warned him gently about too much
wandering in the open, where countless Stings could be hiding. He
drew back, unwilling to stop following this interesting creature. The
Sting-killer vibrated the ground and lay still suddenly. Xen waited for
a "sense" of death but none came. This might be for the new thing a
stage similar to that when one of Xen's own kind became unable to
move from the cold, but still lived and feared.
Caught between his own fear and a very strange sensation that he
could not interpret, Xen waited a degree of heat. Then he oozed
forward and spread himself over the still shape, until it floated within
him. When he flowed over one part, the thing struggled pitiably. Xen
drew back startedly and the movement ceased. Carefully, he
retraced his course, leaving the part free. This time there was no
struggling.
Spurred by fear of Stings, Xen began to flow across the land, letting
his "Sense" guide him to the coldness. He slithered up slopes,
poured over steep drops, always collecting himself in time to catch
his burden.
He found a place that would stay cold until the next time of heat and
halted in front of it, his anxiety evident in the way he spread and
collected himself, back and forth. At last he inched forward, feeling
the agony of the cold bite into every cell. Bunching himself behind
the Sting-killer, he made it flow along him until it broke free and lay
upon the shaded rock. Xen drew back as hurriedly as his already-
sluggish mass would allow. He spread thin across the earth and let
the heat liquefy his body again....

It was when the time of cold was only a few degrees away that Xen
felt the heavy vibration which nearly made him dissolve with fear. It
lasted for a few degrees and then weakened and made only a small
tremor. Now many smaller vibrations reached him, like many
creatures moving about. The tremors spread out, moving slowly
toward the rocky valley.
Xen lay still trying to identify the vibrations. They were not those of
Stings. As they approached, he recognized them as resembling in
great numbers the creature he had put upon the rock.

Curt imagined he heard voices, an incoherent babble of them. He

struggled to sit up, but there was an incredible weight on his chest.
"Lie still," a voice said clearly, and his mind echoed, "Still ... still ...
still...."
He struggled again. "Liquid," he croaked painfully, "liquid animal ...
liquid...." The weight was still there. He heard one last voice say,
"Poor guy, he must have run into scorpions."
Then he was lifted and it seemed as though the lifting would never
cease.

Xen waited until the small tremor was gone and the great vibration
had roared and disappeared. He knew by the sense of emptiness
that the Sting-killer had gone back to his own kind. For a moment he
felt very alone, though he knew the sand was full of Xens.
Slowly, he drew himself together. For the time of cold was but a few
degrees away, and he must seek the warm sands.
*** END OF THE PROJECT GUTENBERG EBOOK THE TIME OF COLD
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