1. Chapter 10
Fixed-Income Securities

2. Fixed-Income Securities
Learning Goals
Explain the basic investment attributes of bonds and their use as investment vehicles.
Describe the essential features of a bond, note the role that bond ratings play in the market, and distinguish among different types of call, refunding, and sinking-fund provisions.
Explain how bonds are priced in the market, and why some bonds are more volatile than others.
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3. Fixed-Income Securities
Learning Goals (cont’d)
Identify the different types of bonds and the kinds of investment objectives these securities can fulfill.
Discuss the global nature of the bond market and the difference between dollar-denominated and non-dollar denominated foreign bonds.
Describe the basic features and characteristics of convertible securities, and measure the value of a convertible.
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4. What Are Bonds? Liabilities, or “publicly traded IOUs”
Also called “fixed income securities” since payments are fixed amounts
Borrower agrees to repay a fixed amount of principal at a predetermined maturity date
Borrower agrees to pay a fixed amount of interest over a specified period of time
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5. Why Invest in Bonds?
They can provide current income for conservative investors
At times, they can provide capital gains (or losses) for more aggressive investors
Some bonds can provide tax-free income
They can be used for preservation and long-term accumulation of capital
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6. Interest Rates and Bonds
The behavior of interest rates is the single most important force in the bond market
Interest rates and bond prices move in opposite directions
When interest rates rise, bond prices fall
When interest rates drop, bond prices move up
Bond markets are bullish when interest rates are low or falling
Bond markets are bearish when interest rates are high or rising
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7. Figure 10.1 Behavior of Interest Rates Over Time—1961–2005
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8. Bonds Versus Stocks Compared to stocks, bonds offer lower returns
Main benefits of bonds in portfolio:
Lower risk and level of stability
High levels of current income
Diversification
Bonds add an element of stability to a portfolio
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9. Figure 10.2 Performance of Stocks and Bonds—1996 Through 2005
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10. Bonds and Risk
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
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11. Essential Features of a Bond
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) 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
Note is a debt security originally issued with a maturity from 2 to 10 years
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12. Principles of Bond Price Behavior
Price of a bond is a function of its coupon rate, its maturity, and market movements in interest rates
Longer maturities move more with changes in interest rates
Premium bond has a market value that is above par value
Occur when market interest rates are below bond’s coupon rate
Discount bond has a market value that is below par value
Occur when market interest rates are above bond’s coupon rate
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13. Figure 10.3 The Price Behavior of a Bond
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14. Essential Features of a Bond (cont’d)
Call feature allows the issuer to repurchase the bonds before the maturity date
Freely callable
Noncallable
Deferred call
Call premium is the amount added to bond’s par value and paid upon call to compensate bondholders
Call price is the bond’s par value plus call premium
Refunding provision prohibits the premature retirement of an issue from proceeds of a lower-coupon refunding bond
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15. Essential Features of a Bond (cont’d)
Sinking fund stipulates how a bond will be paid off over time
Applies only to term bonds
Issuer is obligated to pay off the bond systematically over time
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16. Types of Secured Debt Secured debt is backed by pledged collateral
Senior bonds are backed by legal claim to specific assets
Mortgage bonds are backed by real estate.
Collateral trust bonds are backed by securities (stocks, bonds) held in trust by a third party
Equipment trust certificates are backed by specific pieces of equipment, such as railcars or airplanes
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17. Types of Unsecured Debt
Unsecured debt is backed only by the promise of the company to pay
Junior bonds are backed only by promise and good faith of the issuer to pay
Debenture is an unsecured (junior) bond
Subordinated debentures are unsecured bonds whose claim is secondary to other claims
Income bond requires interest to be paid only after a specific amount of income has been earned
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18. Bond Ratings
Bond ratings are letter grades that designate investment quality
Private bond rating agencies assign ratings based upon financial analysis of the bond issuer
Investment grade ratings are received by financially strong companies
Junk bond ratings are received by companies making payments, but default risk is high
Split ratings occur when a bond issue is given different ratings by major rating agencies
Higher rated bonds have less default risk and pay lower interest rates
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19. Table Bond Ratings
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20. The Market for Debt Securities
Bonds are traded mainly over-the-counter
Bond price activity is remarkably stable compared to stock market
Bond market is larger than the U.S. stock market
Bond market is growing rapidly
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21. Treasury Bonds Considered risk free—no risk of default
Interest is exempt from state and local taxes
Sold in $1,000 denominations
Types of Treasury Bonds
Treasury notes: mature in 2 to 10 years
Treasury bills: mature in 20 and 30 years
Treasury Inflation-Indexed Obligations (TIPS)
Protect against inflation by adjusting investor returns
Interest rates are very low
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22. Agency Bonds Issued by U.S. government agencies
Federal Home Loan Bank
Federal National Mortgage Association
Small Business Administration
High quality securities with almost no risk of default
Interest rates usually higher than Treasury issues
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23. Municipal Bonds
Issued by states, counties, cities and any other political subdivision
Issued to fund public projects
Two basic types
General obligation bonds are paid from general fund of the issuer
Revenue bonds are paid from revenues from the project being financed
Often guaranteed by private insurers to lower risk and interest rates
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24. Municipal Bonds Interest is tax-exempt for Federal taxes
Interest can be tax-exempt from state taxes if you live in the state where the bond was issued
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25. Corporate Bonds Issued by corporations from four major segments
Industrials
Public utilities
Rail and transportation bonds
Financial issues
Provide higher returns than government bonds due to higher risk of default
Wide variety of bond quality and bond types available
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26. Zero-Coupon Bonds Do not pay interest
Sold at deep discount from par value
Value increases over time
Subject to tremendous price volatility as interest rates fluctuate
Interest must be reported as it is accrued for tax purposes, even though no interest is actually received.
Treasury strips are zero-coupon bonds created from U.S. Treasury securities.
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27. Mortgage-Backed Securities
Bond backed by pool of residential mortgages
Principal and interest are paid monthly
Governmental agencies are major issuers:
Government National Mortgage Association (GNMA)
Federal Home Loan Mortgage Corporation (FHLMC)
Federal National Mortgage Association (FNMA)
Self-liquidating investment since portion of principal is received each month
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28. Collateralized Mortgage Securities
Mortgage-back bond pool that is divided into “tranches,” or classes of investors
All principal payments go first to the shortest tranche until it is fully retired, then the next in sequence is paid
Allows investors to choose short-term, medium-term or long-term investment
Potentially complex; interest rate fluctuations may have significant impact upon bond prices
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29. Asset-Backed Securities
Issued by corporations and backed by pools of loans
Auto loans
Credit card loans
Home equity loans
Provide relatively high yields
Short maturities, typically 3 to 5 years
Interest and principal payments are monthly
High credit quality
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30. Junk Bonds (High-Yield Bonds)
Highly speculative, usually subordinated debentures
Have low, sub-investment grade ratings
Typically offer very high yields
Prices tend to behave more like stocks than bonds
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31. Global Bonds Potentially higher returns than U.S. bonds
Offer broader diversification opportunities
Interest rate trends in other countries may not follow U.S. rates
Currency exchange rate fluctuations can impact returns in U.S. dollars
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32. Dollar-Denominated Bonds
Bonds issued by foreign governments or corporations and denominated in dollars
Based on U.S. dollars
Yankee bonds are registered with the SEC and issued and traded in U.S.
Eurodollar bonds are not registered with the SEC and are issued and traded outside of the U.S.
No currency exchange rate risk since bonds are in U.S. dollars
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33. Foreign-Pay Bonds Bonds issued by foreign governments or corporations
Based on currency other than U.S. dollars
Not registered with the SEC and issued and traded outside of the U.S.
Subject to currency exchange rate risk
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34. Convertible Securities
Fixed-income security that allows holder to convert the security into a specified number of shares of the issuing company’s common stock
Two major types of convertible securities:
Convertible bonds
Convertible preferred stock
“Equity kicker”: another name for the conversion feature that allows holder to convert the security into a specified number of shares of common stock
Forced conversion: calling in of convertible bonds by the issuing firm
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35. Convertible Securities (cont’d)
Conversion privilege: the conditions and specific nature of the conversion feature on convertible securities
Conversion period: the time period during which a convertible issue can be converted
Conversion ratio: the number of shares of common stock into which a convertible issue can be converted
Conversion price: the stated price per share at which common stock will be delivered to the investor in exchange for a convertible issue
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36. Special Types of Convertible Securities (cont’d)
LYON (Liquid Yield Option Note)
Zero coupon bond with both a conversion feature and a put option
No current income, but no limit on potential capital appreciation
Put option allows security to be sold back to issuer at prespecified prices, providing downside protection
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37. Sources of Value
Value of convertibles is based in both the stock and the bond dimensions of the security
Convertibles trade much like common stock as the market price of the stock starts getting close to (or exceeds) the stated conversion price
Convertibles trade much like a bond when the market price of the stock is well below the conversion price
Bond price sets a “price floor” in case the stock price goes into a freefall
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38. Measuring the Value of a Convertible
Conversion Value: indication of what a convertible issue would trade for if it were priced to sell on the basis of its stock value
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39. Measuring the Value of a Convertible (cont’d)
Conversion Equivalent: the price at which the common stock would have to sell in order to make the convertible security worth its present market price
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40. Measuring the Value of a Convertible (cont’d)
Conversion Premium: amount above the conversion value that investors are willing to pay; typically due to the higher current income provided by convertibles over common stock
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41. Measuring the Value of a Convertible (cont’d)
Payback Period: the length of time it takes for the buyer of a convertible to recover the conversion premium from the extra current income earned on the convertible
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42. Chapter 10 Review Learning Goals
Explain the basic investment attributes of bonds and their use as investment vehicles.
Describe the essential features of a bond, note the role that bond ratings play in the market, and distinguish among different types of call, refunding, and sinking-fund provisions.
Explain how bonds are priced in the market, and why some bonds are more volatile than others.
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43. Chapter 10 Review (cont’d)
Learning Goals (cont’d)
Identify the different types of bonds and the kinds of investment objectives these securities can fulfill.
Discuss the global nature of the bond market and the difference between dollar-denominated and non-dollar denominated foreign bonds.
Describe the basic features and characteristics of convertible securities, and measure the value of a convertible.
Copyright © 2008 Pearson Addison-Wesley. All rights reserved.

44. Chapter 10
Additional Chapter Art

45. Table 10.1 Historical Annual Yields and Returns in the Bond Market, 1961–2005* (Yields and returns based on performance of high-grade corporate bonds)
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46. Figure 10.4 Auction Results—The Return of the 30-Year Treasury Bond
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47. Table 10.3 Characteristics of Some Popular Agency Issues
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48. Table 10.4 Taxable Equivalent Yields for Various Tax-Exempt Returns
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