CHAPTER THREE

FIXED INCOME SECURITIES

 INTRODUCTION

 Fixed-income securities(FISs) comprises the money

market securities, long-term debt securities and
preferred shares.
 Debt securities are often called fixed-income
securities (FIS) because they either promise:
 a fixed stream of income or
 determined according to a specified formula.
 A FIS is a debt instrument issued by a government,
corporation or other entity to finance and expand their
operations.
Cont’d

 FIS provide investors a return in the form of fixed

periodic payments and eventual return of principal at
maturity.
 FISs differ from equity, as they do not entail
an ownership interest in a company, but they
confer a seniority of claim, as compared to
equity interests, in cases of bankruptcy or
default.
Advantage of Fixed-income Securities

 It is relatively easy to understand.

 Its uncertainty about their cash flows is
minimal.
 They can provide current income for
conservative investors, particularly for
retirees, fixed-income investments are a
secure, low-risk way to generate a steady
flow of income.
Cont…

 It can be an important part of a well-diversified

portfolio.
 Some bonds can provide tax-free income.
 They can be used for preservation and long-
term accumulation of capital.
Money Market Securities

 Money market securities often considered as

a good place to invest funds that are needed
in a shorter time period—usually one year or
less.
 Money market instruments include certificates
of deposit, commercial paper, T-bills, and
bankers' acceptances.
Certificates of Deposit (CD)

 CD is a product issued by commercial banks

and thrift institutions such as credit unions
that provides an interest rate premium in
exchange for the customer agreeing to leave
a lump-sum deposit untouched for a
predetermined period of time.
 CDs are large-denomination, negotiable time
deposits.
Commercial Paper

 Commercial paper takes the form of short-term,

unsecured promissory notes issued by both financial
and non-financial corporations, typically for the
financing of accounts payable and inventories.
 Maturities on commercial paper rarely range longer
than 270 days.
 Commercial paper is usually issued at a discount
from face value and reflects prevailing market
interest rates.
Treasury Bills (T-bills)

 T-bills are the safest type of short-term debt

instrument issued by a federal government.
 Ideal for investors seeking a 1- to 12- month
investment period, T-bills are highly liquid and
very secure.
Banker’s Acceptances (BAs)

 BAs are short-term promissory notes issued

by a corporation, bearing the unconditional
guarantee (acceptance) of a major Chartered
Bank.
 BAs are typically used to finance international
transactions in goods and services.
 BAs offer yields superior to T-bills, and a
higher quality and liquidity than most
commercial paper issues.
Preferred Stock

 It is considered to be equity.
 It is also included in the fixed-income
universe.
 Dividends are paid in perpetuity.
 Nonpayment of dividends does not mean
bankruptcy.
 Preferred dividends are paid before common.
Long-term Debt Securities

 The bond market includes treasury bonds and

notes, municipal bonds, corporate bonds,
mortgage securities, etc.
Bonds Characteristics

 Bonds are debt instruments

 A bond is a loan made by an investor to an issuer
(e.g. a government or a company).
 In turn, the issuer promises to repay the principal (or
face value) of the bond on a fixed maturity date and
to make regularly scheduled interest payments
(usually every six months).
 The major issuers of bonds are governments and
corporations.
Cont…

 The bond indenture is the contract between

the issuer and the bondholder that sets forth
the promises of a corporate bond issuer and
the rights of investors.
 Issuers are borrowers and holders are
creditors.
 The indenture gives the coupon rate, maturity
date, and par value.
Terms

 Coupon is the amount of annual interest income.

 Current Yield is a measure of the annual interest income a
bond provides relative to its current market price.
 Principal (par value or face value) is the amount of capital
that must be repaid at maturity.
 Maturity Date is the date when a bond matures and the
principal must be repaid.
 Term Bond is a bond that has a single maturity date
 Serial Bond is a bond that has a series of different maturity
dates.
Cont…

Face or par value is typically $1,000

The coupon rate determines the interest
payment:
 Interest is usually paid semiannually.
 The coupon rate can be zero.
 Interest payments are called “coupon payments”.
Example: Bond Indenture

• To illustrate, assume a bond with par value of

$1,000 paying coupon annually for 30 years at rate
of 8% might be sold to a buyer for $1,000.
• The bondholder is then entitled to a payment of 8%
of $1,000, or $80 per year, for the stated life of the
bond, 30 years.
• The $80 payment typically comes in two semiannual
installments of $40 each.
• At the end of the 30-year life of the bond, the issuer
also pays the $1,000 par value to the bondholder.
Treasury Bonds and Treasury
Notes
 Treasury note maturity is 1-10 years
 Treasury bond maturity is 10-30 years
 Bonds and notes may be purchased directly
from the Treasury.
 Denomination can be as small as $100, but
$1,000 is more common.
 Both make semiannual coupon payments.
Municipal Bonds

 They are issued by state and local governments.

 They are similar to Treasury and corporate bonds,
except their interest income is exempt from federal
income taxation.
 The interest also is exempt from state and local
taxation in the issuing state.
 Capital gains tax, however, must be paid if the
bonds mature or are sold for more than the
investor’s purchase price.
Corporate Bonds

 Like the government, corporations borrow

money by issuing bonds.
 They are the means by which private firms
borrow money directly from the public.
 These bonds are much like structured like
treasury issues in that they typically require
semiannual coupons over their lives and
return the face value to the bond holder at
maturity.
Cont…

 However, they differ most importantly from treasury

bonds in risk.
 Default risk is a real consideration in the purchase of
corporate bonds.
 Corporate bonds can be classified in to secured and
unsecured bonds.
 Secured bonds have specific collateral backing them
in the event of firm bankruptcy where as unsecured
bonds, also called debentures, have no collateral.
Cont…

 Corporate bonds sometimes come with options

attached such as callable, puttable, convertible and
floating rate bonds.
 Callable bonds: can be repurchased bond at a
specified call price before the maturity date.
 For example, if a company issues a bond with a high
coupon rate when market interest rates are high,
and interest rates later fall, the firm might like to
retire the high-coupon debt and issue new bonds at
a lower coupon rate to reduce interest payments.
Cont…

 Puttable bonds: give the bondholder the

option to retire or extend the bond.
 If the bond’s coupon rate less than current
market yields, for instance, the bondholder will
choose to retire the bond.
 Convertible bonds: can be exchanged for
shares of the firm’s common stock.
 Floating rate bonds: have an adjustable
coupon rate.
Foreign Bonds

 Foreign bonds are issued by a borrower from a

country other than the one in which the bond is sold.
For example:
 Dollar denominated foreign bonds sold in the US by non-US issuers are called Yankee
bonds.
 Yen-denominated foreign bonds sold in Japan by non-Japanese issuers are called
Samurai bonds.
 British pound-denominated foreign bonds sold in the United Kingdom are called bulldog
bonds.
 Canadian dollar denominated foreign bonds sold in the Canada by non-Canadian
issuers are called Maple bonds.
 Australian dollar denominated foreign bonds sold in the Australia by non-Australian
issuers are called Matilda/Kangaroo bonds.
Eurobonds

 Eurobonds are bonds denominated in currency

of the issuer, but sold in other national markets.
For example:
Eurodollar bonds are dollar-denominated bonds selling
outside the United States.
Euroyen bonds are yen-denominated bonds selling
outside Japan.
Eurosterling bonds are pound-denominated Eurobonds
selling outside the United Kingdom.
Accrued Interest and Quoted
Bond Prices
 The bond prices that you see quoted in the
financial pages are not actually the prices that
investors pay for the bond.
 This is because the quoted price does not
include the interest that accrues between
coupon payment dates.
Cont…

 If a bond is purchased between coupon

payments, the buyer must pay the seller for
accrued interest, the prorated share of the
upcoming semiannual coupon.
 The formula for the amount of accrued
interest between two dates is:
AnnualCouponPayment DaysSinceLastCouponPayment
AccruedInterest  
2 DaysInCouponPeriod
Example: Accrued Interest

 Assume 30 days have passed since the last

coupon payment, and there are 182 days in
the semiannual coupon period. Suppose that
the coupon rate is 8% and the quoted price of
the bond is $990. Calculate the accrued
interest and determine the invoice price.
$80 30
AccruedInterest    $6.59
2 182
Cont…

 Based on the formula the accrued interest on

the bond is $40 x (30/182) = $6.59.
 The sale, or invoice, price of the bond would
equal the quoted price (sometimes called the
stated price or flat price) plus the accrued
interest.
 The invoice price will be $990 + $6.59 =
$996.59.
Cont…

 In contrast to bonds, stocks do not trade at flat

prices with adjustments for “accrued dividends.”
 Whoever owns the stock when it goes “ex-dividend”
receives the entire dividend payment, and the stock
price reflects the value of the upcoming dividend.
 The price therefore typically falls by about the
amount of the dividend on the “ex-day.”
 There is no need to differentiate between reported
and invoice prices for stocks.
Bond Pricing (Bond Valuation)

T Coupon ( C ) ParValue
Bond Pr ice ( PB )   t 
t 1 (1 r )t (1 r )T

Bond Pr ice ( PB )  Coupon 

1 1 1   ParValue  1
r  (1 r )T  (1 r )T

• Where:
• PB = Price of the bond
• Ct = Interest or coupon payments
• T = Number of periods to maturity
• r = Semi-annual discount rate or the semi-annual yield to maturity, semi-
annual required rate of return, semi-annual market interest rate.
Cont…

• What is the price of 30-year, 8% coupon bond

with par value of $1,000 paying
semiannually? Suppose that the (market)
interest rate is 10% annually.

Bond Pr ice ( PB )  $40 

1 1 1   $1, 000  1
 $810.71
0.05  (1 0.05 )60  (1 0.05 ) 60
Bond Prices and Yields

• Prices and yields (required rates of return)

have an inverse relationship.
• Therefore, bond prices fall as market interest
rates rise.
• The longer the maturity, the more sensitive
the bond’s price to changes in market interest
rates.
Yield to Maturity (YTM)

• YTM is an interest rate that makes the PV of

the value of the bond’s payments equal to its
price.
• Solve the bond formula for r:
T Coupon ( C ) ParValue
PB   t 
t 1 (1 r )t (1 r )T

PB  Coupon 
1 1 1   ParValue  1
r  (1 r )T  (1 r )T
Example: YTM

• Suppose an 8% coupon, 30 year bond is

selling for $1,276.76. What is its average rate
of return?

$1, 276.76  $40 

1 1 1   $1, 000  1
r  (1 r )60  (1 r ) 60

• r = 0.03 = 3% per half year

Cont…

• Bond equivalent yield = 6%

• Effective annual yield (interest rate) =
(1+0.03)2 – 1 = 6.09%
• Current Yield = bond’s annual coupon
payment divided by the bond price =
$80/$1,276.76 = 0.0627 = 6.27% per year
YTM vs. Current Yield

YTM Current Yield

•It is the bond’s internal rate of •The current yield is the
return. bond’s annual coupon
•It is the interest rate that payment divided by the bond
price.
makes the PV of a bond’s
payments equal to its price. •For bonds selling at a
•It assumes that all bond premium, coupon rate >
current yield>YTM.
coupons can be reinvested at
the YTM rate. •For discount bonds,
relationships are reversed.
Yield to Call

• If interest rates fall, price of straight bond can

rise considerably.
• The price of the callable bond is flat over a
range of low interest rates because the risk of
repurchase or call is high.
• When interest rates are high, the risk of call is
negligible and the values of the straight and
the callable bond converge.
Cont…

• Suppose the 8% coupon, 30-year maturity bond

sells for $1,150 and is callable in 10 years at a call
price of $1,100. What is its yield to maturity and
yield to call?
1  1  1
$1,150  $40  1  $1,100 
r  (1 r ) 20 
  (1 r ) 20

• r = 0.0332 = 3.32% per half year

• Bond equivalent yield = 6.64%
• Effective annual interest rate = (1+0.0332)2 – 1 =
6.75%
Cont…

1 1   $1, 000  1

$1,150  $40 
1
 (1 r )60 
r (1 r ) 60

• r = 0.0341 = 3.41% per half year

• Bond equivalent yield = 6.82%
• Effective annual interest rate = (1+0.0341)2 –
1 = 6.936%
YTM vs. HPR

YTM HPR
•YTM is the average •HPR is the rate of return
return if the bond is held over a particular
to maturity investment period
•YTM depends on coupon •HPR depends on the
rate, maturity, and par bond’s price at the end of
value the holding period, an
•All of these are readily unknown future value
observable in the market •HPR can only be
forecasted
Risks in Bond

• Investing in debt securities is generally

considered less risky than investing in equity
securities, but bondholders still face a number
of risks.
• A change in a bond’s risk will affect its
required rate of return and its price.
• Riskier bonds typically have higher yields to
maturity, reflecting the higher required rate of
return.
Types of Risks

• Interest Rate Risk is the chance that changes in interest

rates will affect the bond’s value.
• Purchasing Power Risk is the chance that bond yields will
lag behind inflation rates.
• Business/Financial Risk is the chance the issuer of the
bond will default on interest and/or principal payments.
• Liquidity Risk is the risk that a bond will be difficult to sell at
a reasonable price.
• Call Risk is the risk that a bond will be “called” (retired)
before its scheduled maturity date.
Ratings of Bonds

• Bond ratings are critical to a company's ability

to issue debt at an acceptable interest rate.
• The credit rating agency evaluates the credit
worthiness of a company or an individual
considering a variety of factors like their
assets, liabilities, past history etc.
Default Risk and Bond Pricing

• Rating companies:
Moody’s Investor Service, Standard & Poor’s,
Fitch, DBRS (Canada)
• Rating Categories
Highest rating is AAA or Aaa
Investment grade bonds are rated BBB or Baa
and above
Speculative grade/junk bonds have ratings below
BBB or Baa
Factors Used by Rating
Companies
• Coverage ratios (EBIT/IntExp)
• Leverage ratios (D/E)
• Liquidity ratios (CA/CL)
• Profitability ratios (ROA, ROE)
• Cash flow to debt (CF/Outst.Debt)
Protection Against Default

• Sinking funds – a way to call bonds early

• Subordination of future debt– restrict additional
borrowing (i/creditor agreement)
• Dividend restrictions– force firm to retain assets
rather than paying them out to shareholders
• Collateral – a particular asset bondholders
receive if the firm defaults.
• Distinguishes secured vs unsecured debt.
End of Chapter Three

• Questions???