Global Edition

Chapter 1
Introduction
 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 this option on cash
flow
 Learning Objectives (continued)

After reading this chapter, you will understand

 the various types of embedded options
 the types of risks faced by fixed-income
investors
What is a Bond?

• A bond is a debt instrument

representing the obligations of the
borrower (issuer/debtor) to make
periodic interest payments and to pay
back the borrowed amount to the
bondholder (lender/investor) over a
specified period of time.

• The term “fixed income securities” is

often used interchangeably with bonds.
Sectors of the U.S. Bond Market
(continued)
1. Treasury sector – securities issued by the
U.S. government

2. Agency sector – securities issued by

federally related institutions and
government-sponsored enterprises

3. Municipal sector – securities issued by state

and local governments bonds
Sectors of the U.S. Bond Market
(continued)
4. Corporate sector – securities issued in the
U.S. by U.S. corporations and foreign
corporations

5. Asset-backed sector – securities backed by

a pool of assets

6. Mortgage sector – securities backed by

mortgage loans
 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
 The 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
 There may be provisions in the indenture that
allow either the issuer or bondholder to alter a
bond’s term to maturity.
 Why the Maturity of a Bond is
Important?
• It defines the period over which the
interest and principal payments will be
received by the bondholder.

• The return (yield) earned by the

bondholder will be affected by the
maturity.

• The fluctuation in the price of the bond

(price volatility) will depend to a large
extent on the maturity of the bond.
 The Bond Features (continued)

3. Principal and Coupon Rate

 Principal Value – amount that the issuer agrees to
repay the bondholder at the maturity date
 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
 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
 The Bond Features (continued)

3. Principal and Coupon Rate

 LIBOR (London Interbank Offered Rate) – rate at
which the highest credit quality banks borrow from each
other in the London interbank market. The rate is
reported in 10 currencies
 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
interest rates
Coupon rate = constant rate (K) – L x reference rate
 The Bond Features (continued)

4. Amortization Feature – the principal

repayment of a bond issue can call for either
i. the total principal to be repaid at maturity or
ii. 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.
 The Bond Features (continued)

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
 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
 The Bond Features (continued)

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
 The CUSIP International Numbering System (CINS)
identifies foreign securities and includes 12 characters
Bond Features and Variations

Features 5-Year Treasury Note Variations

Principal Non-amortizing Amortizing

Term to Maturity Fixed Callable / Putable / Perpetual

Redemption Par Call price / Put price / Index-

linked
Coupon Rate Fixed Zero / Floating / Inverse floating
/ Variable / Step-up
Coupon Frequency Semi-annual Annual / Quarterly

Embedded Options None Callable / Putable / Convertible

Risks Associated with Investing
in Bonds (continued)
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)
1. 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.
 Risks Associated with Investing
in Bonds (continued)
2. 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.
 Risks Associated with Investing
in Bonds (continued)
3. 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:
i. cash flow pattern cannot be known with certainty
ii. investor is exposed to reinvestment risk
iii. bond’s capital appreciation potential will be
reduced
 Risks Associated with Investing
in Bonds (continued)
4. 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.
 Risks Associated with Investing
in Bonds (continued)
5. Inflation Risk
 Inflation risk arises because of the variation in the
value of cash flows from a security due to rises 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.
 Risks Associated with Investing
in Bonds (continued)
6. 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.
 Risks Associated with Investing
in Bonds (continued)
7. 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.
 Risks Associated with Investing
in Bonds (continued)
8. 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.
 Risks Associated with Investing
in Bonds (continued)
9. Risk Risk
 Risk risk refers to not knowing the risk of a
security.

 Two ways to mitigate or eliminate risk risk are:

i. Keep up with the literature on the state-of-the-art
methodologies for analyzing securities
ii. avoid securities that are not clearly understood
Risks of 10-Year U.S. Treasury Note

Dimension of Risk Level of Risk Present in the Security

Future Cash Flows Known in advance

Credit Risk Not present
Interest Rate Risk High
Reinvestment Risk High
Liquidity Risk Generally very liquid, bid-offer spreads are narrow
Call Risk No uncertainty of timing of cash flows
Exchange Rate Risk None for domestic investor
Inflation Risk Present
Volatility Risk Not present