CHAPTER 4 FIXED INCOME SECURITIES (1)

CHAPTER 4 – FIXED INCOME SECURITIES
Main contents
4.1. Introduction
4.2. Bond characteristics
4.3. Bond price and Yields
4.4. Risks in bond and Bond Rating
4.1. Introduction
 What Are Bonds?
 Long-term, fixed-obligation debt securities packaged in convenient and affordable

denominations
 Also called “fixed income securities” since payments tend to be fixed amounts
 Borrower agrees to pay a fixed amount of interest over a specified period of time
 Borrower agrees to repay a fixed amount of principal at a predetermined maturity
date
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, e.g. TBs and Munis
 They can be used for preservation and long-term accumulation of capital
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
1
 Bonds add an element of stability to a portfolio
4.2. Bond characteristics
 A bond can be characterized based on:

1. its intrinsic features,
2. its type,
3. its indenture provisions, or
4. the features that affect its cash flows and/or its maturity.
1. Intrinsic Features: Includes,

 coupon – is what the bond investor will receive over the life (or holding
period) of the issue. This is known as interest income, coupon income, or
nominal yield.
 term to maturity – the date or number of years before a bond matures
(expires), and may be a term bond or serial obligation bond
 Principal (par value) – represents original value of obligation
 Ownership – a bearer bond and registered bond
 With a bearer bond – the holder (bearer) is the owner, so the issuer keeps no
record of ownership, and interest is obtained byclipping coupons attached to the
bonds and sending them to the issuer for payment.
 With registered bonds, the issuermaintain records of owners and pay the interest
directly to them.
2. Types of Issues:
 Bonds can have different types of collateral and be either;

 Secured (senior) – backed by a legal claim on some specified property of the
issuer in case of default, e.g. mortgage bond
2
 Unsecured (debentures) - backed only by the promise of issuer to pay interest
and principal on a timely basis, i.e. secured by the general credit of the issuer.
 Subordinated (junior) – possess a claim on income and assets that is s ubordinated
to other debentures
3. Indenture Provisions:
 it is the contract b/n issuer and bondholder specifying the issuer’s legal
requirements.
 dictate a bond’s features, its type and maturity.
4. Features Affecting Bond’s Maturity:

 three alternative option features (provisions)that affect maturity.
a. freely callable– that allows the issuer to retire the bond at any time with a typical
notification period of 30 to 60 days.
b. deferred call– the issue cannot be called for a certain period of time after the date
of issue (e.g., 5 to 10 years).
c. noncallable– the issuer cannot retire the bond prior to its maturity.
 Call premium – amount above par value that the issuer must pay to bondholder
for prematurely retiring the bond, and declines with years of the bond’s issue date.
 Sinking fund– specifies that a bond must be paid off systematically over its life
4.3. Bond price and Yields
 Price of a bond is a function of its coupon rate, maturity, and market movements
in interest rates
 Longer maturities move more with changes in interest rates

 Interest rates and bond prices move in opposite directions –bond prices fall when
interest rates rise, and vice versa.
 Bond markets;
 are bullish when interest rates are low or falling, and
3
 are bearish when interest rates are high or rising
 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
Figure 1: The Price Behavior of a Bond
Bond Valuation
 Value:
 Book Value – value of an asset as shown on a firm’s balance sheet, i.e. historical
cost.
 Liquidation value – amount that could be received if an asset is sold individually.
 Market value – observed value of an asset in the marketplace; determined by
supply and demand.
 Intrinsic value – economic or fair value of an asset; the present value of the
asset’s expected future cash flows.
4
 Bond Valuation:
 In general, intrinsic value of a bond is equal to the PV of stream of expected cash
flows discounted at appropriate required rate of return.
Can the intrinsic value of a bond differ from its market value?
5
 The Yield Model:
 Rather than in birr terms, investors often price bonds in terms of yields—the
promised rates of return on bonds under certain assumptions
 To compute an expected yield, we use the current market price (Pm) and the
expected cash flows to compute the expected yield on the bond.
 Using the PV formula, we compute the discount rate (yield) that will give us the
given current market price (Pm).
Bond investors traditionally have used five yield measures for the following purposes:
Yield Measure Purpose

Nominal yield Measures the coupon rate.
Current yield Measures the current income rate
Yield to maturity Measures the estimated rate of return for bond held to maturity
Yield to call Measures the estimated rate of return for bond held to first call date
Realized (horizon) Measures the estimated rate of return for a bond likely to be sold
yield
prior to maturity. It considers specific reinvestment assumptions and
an estimated sales price. It also can measure the actual rate of return
on a bond during some past period of time
6
7
YTM for a Zero coupon Bond:
A bond with only one cash flow at maturity.
Assuming a Zero coupon bond maturing in 10 years
with a maturity value of Br 1,000 selling for Br 311.80.
The Bond pays interest semiannually.
Then,
Thus, annual interest rate is 12 percent.
8
Yield to Call (YTC):
Return on bond with callable feature is measured in YTC.
the YTC will provide the lowest yield measure which increases
with time to call
the PV method assumes that the bond to be hold until the first
call date and reinvest all coupon payments at the YTC rate
Where, Pm is market price, Pc is call price of the bond, nc is

number of years to call date.
9
Realized (Horizon) Yield:
Is the actual return over the horizon period
Measures the expected rate of return of a bond that you expect to sell
prior to its maturity.
The holding period or investment horizon is less than n.
this measure requires a specific estimate of future selling price of the
bond at the end of the holding period and the reinvestment rate for the
coupon flows prior to the liquidation of the bond.
This technique used to measure actual yields after selling bonds
Where, hp is holding period, and Pf is future selling price

Realized (Horizon) Yield:
Is the actual return over the horizon period
Measures the expected rate of return of a bond that you expect to sell
prior to its maturity.
The holding period or investment horizon is less than n.
this measure requires a specific estimate of future selling price of the
bond at the end of the holding period and the reinvestment rate for the
coupon flows prior to the liquidation of the bond.
This technique used to measure actual yields after selling bonds
Where, hp is holding period, and Pf is future selling price

10
Calculating future Bond prices:
Current market price is determined using current market YTM.
But, investors need to compute a future price when estimating the
expected realized (horizon) yield performance of alternative bonds.
Investors or portfolio managers who consistently trade bonds for capital
gains need to compute expected realized yield rather than promised
yield.
Where,
Pf is future selling price, Pp is par value, n is years to maturity, hp is
holding period,Ciis annual coupon payment andiis expected market
YTM at the end of holding period
 Example:
Assume you bought Br 1,000, 10%, 25 year bond at Br 842, with a promised YTM of
12% that pays interest semiannually. Based on an analysis of the economy and the capital
market, you expect this bond’s market YTM to decline to 8% in five years. Thus, you
want to compute its future price at the end of year 5 to estimate your expected rate of
return.
11
The fully taxable equivalent yield (FTEY):
adjusts the promised yield computation for the bond’s tax-
exempt status.
The tax-exempted status of Municipal bonds, Treasury
issues, and many agency obligations possess affects the
valuation of taxable Vs nontaxable bonds.
Where, i= the promised yield on the tax-exempt bond, and

T is investor’s marginal tax rate
Example: If the promised yield on tax-exempt bond is 6%
and marginal tax rate is 30%, the taxable equivalent yield
would be;
4.4. Risks in bond and Bond Rating
 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
12
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
13
14

CHAPTER 4 FIXED INCOME SECURITIES (1)

Uploaded by

Copyright:

Available Formats

CHAPTER 4 FIXED INCOME SECURITIES (1)

Uploaded by

Document Information

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

CHAPTER 4 FIXED INCOME SECURITIES (1)

Uploaded by

Copyright:

Available Formats

CHAPTER 4 – FIXED INCOME SECURITIES

 What Are Bonds?

 Long-term, fixed-obligation debt securities packaged in convenient and affordable

Why Invest in Bonds?

 They can provide current income for conservative investors

Bonds Versus Stocks:

 Compared to stocks, bonds offer lower returns

4.2. Bond characteristics

 A bond can be characterized based on:

1. Intrinsic Features: Includes,

 Bonds can have different types of collateral and be either;

4. Features Affecting Bond’s Maturity:

 Longer maturities move more with changes in interest rates

Figure 1: The Price Behavior of a Bond

Yield Measure Purpose

Thus, annual interest rate is 12 percent.

Where, Pm is market price, Pc is call price of the bond, nc is

Where, hp is holding period, and Pf is future selling price

Where, hp is holding period, and Pf is future selling price

Where, i= the promised yield on the tax-exempt bond, and

 Bond ratings are letter grades that designate investment quality

You might also like