Fixed Income Securities:

Introduction
Dr. Anna Bayona
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1
Overview of fixed
income securities
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Fixed income
securities
Fixed income securities basics

• A fixed income security is an instrument that allows governments, companies, and

other types of issuers to borrow money from investors. Other names: bonds, debt
securities.
• The promised payments on fixed-income securities are, in general, contractual
obligations of the issuer to the investor. They do not entail ownership rights (cf.
equity).
• Payments of interest and repayment of principal (amount borrowed) are a prior claim on
the company’s earnings and assets compared with the claim of common shareholdings.
They have lower risk than company’s common shares.
• In a portfolio they allow diversification and some degree of “safety” with respect to
income.
• They might offer two sources of return: (1) current income (periodic payments); (2)
capital gains or losses (bond prices are sensitive to interest rates).
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Fixed income
securities
A bond

• A bond is a contractual agreement between the issuer and the bondholder. There are
three important elements to take into account:

• The bond’s features: issuer, maturity, par value, coupon rate and frequency, and currency
denomination. These features determine the bond’s scheduled cash flows and therefore the
investor’s expected and actual return.
• The legal, regulatory and tax considerations that apply to the contractual agreement between
the issuer and the bondholders.
• The contingency provisions that may affect the bond’s scheduled cash flows. These
contingency provisions are options: they give the issuer or the bondholder certain rights
affecting the bond’s disposal or redemption.
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Fixed income
securities
Structure of a
bond’s cashflows
• Typical cash flows for a plain vanilla bond (or bullet bond). Time to maturity at issue:
10 years.

• This bond makes periodic, fixed coupon payments and a lump-sum payment of principal
at maturity. Common for government and corporate bonds.
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Fixed income
securities
Examples of corporate bonds listings

Issuer Symbol Coupon Maturity Moody’ High Low Last Change Yield %
Name s
®/S&P
Amazon AMZN5182954 0.450% May 12.24 /AA 99.913 99.739 99.913 −0.176 0.482282
Com Inc
Source: Hormel HRL5193038 0.650% June 03.24 /A 100.193 99.622 100.122 −0.061 0.491393
Bodie, Foods Corp
Kane and General GM5198643 1.500% June 10 26 /BBB 100.822 99.811 99.903 −0.872 1.520917
Marcus Mtrs Finl Co
(2021) Inc
BP Cap BP4763976 3.790% Feb 06 24 A1/ 107.388 107.34 107.34 −0.116 0.655786
Mkts Amer
Inc
Glaxo GSK4632356 3.375% May 15 23 A2/ 105.279 105.214 105.228 −0.028 0.328114
Smithlinke
Cap Inc
Intel Corp INTC4969549 4.750% Mar 25 50 A1/A+ 134.693 134.275 134.596 0.365 2.933182
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Fixed income
securities Bonds’ features: Issuers
• Many different types of issuers:
• Supranational organizations. E.g., the World Bank
• Sovereign (national) governments. E.g., Japan
• Non-sovereign (local) governments. E.g., state of California.
• Quasi-government entities (agencies that are owned or sponsored by governments). E.g., La
Poste in France
• Companies (corporates). A distinction is often made between financial issuers (e.g., banks and
insurance companies) and non-financial issuers.
• Special legal entities that securitize assets to create asset backed securities (ABS) that are then
sold to investors. This is the structured finance sector.
• Asset backed securities are created from a process called securitization which involves moving
assets from the owner of the assets into a special legal entity. This special legal entity then uses the
securitized assets as guarantees to secure a bond issue, leading to the creation of ABS. Typical assets
to create ABS are mortgage loans, auto loans, student loans, credit card debt, etc.
• The issuer is an important component of the bond’s credit risk.
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Fixed income
securities
Credit quality

• Bond markets can be classified based on the issuers’ creditworthiness at a certain point
in time as judged by credit rating agencies (main ones are Standard and Poor’s (S&P),
Moody’s and Fitch).
• Ratings of BBB- and above (S&P) are investment grade.
• Ratings below BBB- are non-investment grade, high yield, speculative or “junk”.
• Ratings may change if agencies believe there is a change in creditworthiness.
• The distinction between investment grade and speculative rate might be important for
institutional investors (such as regulated banks or insurance companies) because they
might be prohibited or restricted in their investment to lower-quality bonds.
• Global investment grade bonds are more liquid that the equivalent high-yield bonds.
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Fixed income
securities
Credit quality and financial ratios
Aaa Aa A Baa Ba B C
E B I T A/Assets 12.3% 10.5% 11.2% 9.0% 8.8% 6.6% 4.9%
Operating profit margin 24.8% 18.9% 14.3% 12.9% 11.9% 9.6% 4.6%
E B I T A to interest coverage 12.0 19.0 12.2 6.5 3.9 2.0 0.8
(multiple)
Debt/E B I T D A (multiple) 1.9 1.8 2.1 2.8. 3.6 5.1 6.9
Funds from operations/Total debt 40.4% 44.5% 37.7% 28.2% 21.3% 12.5% 5.7%
Retained Cash Flow/Net Debt 32.3% 29.5% 31.2% 26.6% 21.3% 13.0% 6.0%

Source: Bodie, Kane and Marcus (2024)

Note: EBITA is earnings before interest,
Using Moody's Finanicial Metrics, Key Ratios
taxes, and amortization. EBITDA is
by Rating and Industry for Global Non-
earnings before interest, taxes,
Financial Corporations, December 2017.
depreciation, and amortization.
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Fixed income
securities
Bonds’ features: Maturity

• The maturity date of the bond is the date when the issuer is obliged to redeem the
bond by paying the outstanding principal amount.
• The tenor is the time remaining until the bond’s maturity date.
• Maturities generally range from overnight to 30 years or longer.
• Fixed income securities with maturities of one year or less are called money market securities.
Example: Treasury bills, repurchase agreements, Federal funds, commercial paper, certificates of
deposit, etc. Issuers tend to be governments and companies.
• Fixed income securities with maturities of more than one year are called capital market
securities.
• There are some perpetual bonds (rare), such as consols issued by the UK government, which
have no maturity date.
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Fixed income
securities
Bonds’ features: Par value

• The principal amount, principal value, par value, face value, nominal value,
redemption value of a bond is the amount that the issuer agrees to pay to bondholders
on maturity date. Bonds can have any par value.

• In practice, bond prices are quoted as a percentage of their par value. E.g. Assume
that a bond’s par value is $1,000. A quote of 95 means that the bond’s price is $950 (95%
of $1,000).

• Bond’s price and par value

• When the bond is priced at 100% of par, the bond is said to be trading at par.
• If the bond’s price is below 100% of par, the bond is said to be trading at a discount.
• If the bond’s price is above 100% of par, the bond is said to be trading at a premium.
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Fixed income
securities
Bonds’ features:
Coupon rate and frequency
• The coupon rate or nominal rate of a bond is the interest rate that the issuer agrees to
pay each year until the maturity date.
• The annual amount of interest payments made is called the coupon. A bond’s coupon is
determined by multiplying the coupon rate by its par value.
• Coupon payments may be made annually, semi-annual, quarterly or monthly interest
payments. Many mortgage backed securities (ABS backed by mortgages) pay interest
monthly. If a bond has coupon rate of 6% and a par value of $1,000 dollars, the periodic
interest payment will be: $60 if annual frequency; $30 if semi-annual frequency; $15 if
quarterly; $5 if monthly.
• There are various types of coupon structures.
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Fixed income
securities
Legal
considerations
• The bond indenture is the legal contract that describes the form of the bond, the
obligations of the issuer, and the rights of the bondholder. It includes:
• Bond features
• Funding sources for the interest payments and principal repayments, and it specifies:
• Collaterals: Assets or financial guarantees underlying the credit obligation above and beyond the
issuer’s promise to pay. E.g., covered bonds.
• Credit enhancements are provisions that may be used to reduce the credit risk of the bond issue
and can be internal or external. E.g., subordination or bank guarantees.
• Covenants are clauses that specify the rights of the bondholders and any actions that the issuer is
obligated to perform or prohibited from performing.
• Bondholders should pay special attention to their rights in the event of default.
• In addition to the bond features described earlier, an investor should review the following parts of
the indenture:
• Legal entity of the bond issuer and its legal form; the source of repayment proceeds; the asset or
collateral backing; the credit enhancements; covenants.
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Fixed income
securities
Other coupon payment structures
• A floating rate note (FRN) is a bond whose coupon is set based on a reference rate (e.g.,
LIBOR) plus a spread which depends on the creditworthiness of the issuer. FRNs can be
floored, capped or collared.
• An inverse FRN is a bond whose coupon has an inverse relationship to the reference rate.
• Set-up coupons, which pay coupons that increase by specified amounts on specified dates.
• Credit-linked coupons, which change when the issuer’s credit rating changes.
• Bonds with deferred coupons, which pay no coupons in the early years following the issue
but higher coupons thereafter.
• Index-linked bonds (e.g., inflation-linked bond) has a coupon payments and/or principal
repayments that are linked to a price index.
• Zero-coupon bonds pay no coupons and investors by the bond at a discount below the par
value.
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Fixed income
securities
Corporate bonds with contingency
provisions
• A contingency provision is a clause in a legal document that allows for some action if
the event does occur.
• Callable bonds give the issuer the right to buy bonds back prior to maturity, thereby
raising the reinvestment risk for the bond holder. They offer a higher yield and sell at a
lower price than similar non-callable bonds.
• Put bonds give the bondholder the right to sell the bonds back to the issuer prior to
maturity. They offer a lower yield and sell at a higher price than otherwise similar non-
putable bonds.
• Convertible bonds give the bondholder the right to convert the bond into common
shares of the issuing company. Because this option favours the bondholder, convertible
bonds offer a lower yield and sell at higher price than otherwise similar non-convertible
bonds.
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Fixed income
securities
Yield Measures

• There are several yield measures used by market participants.

• Current or running yield is equal to the bond’s annual coupon divided by the price of
the bond, expressed as a percentage. The current yield is a measure that is analogous to
the dividend yield in a common share.
• Yield to maturity (or redemption) is the internal return on a bond’s expected cash flows:
That is the discount rate that equates the present value of the bond’s expected cash flows
with the bond’s price.
• This can be an estimate of the bond’s expected return
• It reflects the annual return that an investor will earn if he buys the bond today and holds it until
maturity
• There is an inverse relationship between the bond’s price and its yield to maturity, all else
being equal. I.e., the higher the bond’s yield to maturity the lower the bond’s price, and vice
versa.
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Fixed income
securities
Risks of investing
in bonds
• Credit risk or default risk. Risk that the issuer will default on interest or principal
payments. Credit ratings may be used to determine the creditworthiness of the issuer.
• Interest rate risk: This is the major cause of price volatility in bonds. When market
interest rates rise, bond prices fall, and vice versa. As interest rates become more volatile,
so do bond prices.
• Liquidity risk. Risk that a bond will be difficult to sell quickly without cutting the price.
• Purchasing power risk related to the unexpected changes in inflation.
• Exchange rate risk if the bond is issued in another currency.
• Call risk. Risk that the bond will be “called” before its scheduled maturity rate. This is
likely when interest rates fall and investors have to replace high-yield bonds with lower-
yield investments.
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Main investors in
Equity securities
market
organization

fixed-income securities
• Main categories are central banks, institutional investors and retail investors. The first
two typically invest directly in fixed-income securities, while retail investors often invest
indirectly through mutual funds or exchange traded funds.
• This is because of the high informational barriers to entry and high minimum
transaction sizes. There are many types and are very diverse.
• Mainly issued and traded over-the counter (OTC) markets. More difficult to access.
• Main types of players:
• Central banks use open market operations to implement monetary policy. Open market operations
are the purchase or sale of bonds, usually sovereign bonds issued by the national government. Buy
buying (selling) bonds, central banks increase (decrease) the monetary base in the economy and
affect interest rates.
• Major types of institutional investors are pension funds, hedge funds, charitable foundations and
endowments, insurance companies, banks, sovereign wealth funds.
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Fixed-income indices
Equity securities
market
organization

• A fixed-income index is a multi-purpose tool used by investors and investment managers to

describe a given bond market or sector as to evaluate the performance of investments and
investment managers.

• Most indices are constructed as portfolios of securities that reflect a particular bond market
or sector. The index construction varies, and index weighting is typically market capitalization.

• Popular indices: Bloomberg Barclays Global Aggregate Bond Index is a broad measure of
the global investment-grade fixed-rate bond index; J.P.Morgan Emerging Markets Bond Index
is an important one for emerging markets; FTSE Global Bond Index Series.
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Fixed-income indexing
• Similar to stock market indexing.

• Create a portfolio that mirrors the composition of an index that measures the broad
market.

• Challenges in construction:
• Very difficult to purchase each security in the index in proportion to its market value.
• Many bonds are very thinly traded.
• Difficult rebalancing problems.
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Fixed income
securities
Central banks’ interest rates
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Fixed income
securities
10 year government bond yields

Statista, June 2024

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Fixed income
securities 15 year corporate bond yield:
historical

Source: S&P
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Corporate bond yields by maturity

Equity securities
market
organization

Source: S&P
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Innovation in bonds
• Inverse floaters are like floating-rate bonds, except coupon rate falls when the general level of interest
rates rises.

• Asset-backed bonds use income from a specified group of assets to service the debt.

• Catastrophe bonds’ final payment depends on whether there has been a specified catastrophe.
• Indexed bonds make payments that are tied to a general price index or the price of a commodity.
• Treasury Inflation Protected Securities (T I P S).

• Green bonds are a type of sustainable debt investment that are financing eco-friendly projects.
Fixed Income Securities:
Introduction
Dr. Anna Bayona