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Chapter 1

Introduction
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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
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After reading this chapter, you will understand
the various types of embedded options
convertible bonds
the types of risks faced by fixed-income
investors
Learning Objectives (continued)
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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)
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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
Sectors of the U.S. Bond Market
(continued)
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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
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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
bonds term to maturity.
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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
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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
The Bond Features (continued)
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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)
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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)
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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
The Bond Features (continued)
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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
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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)
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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.
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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. bonds capital appreciation potential will be
reduced
Risks Associated with Investing
in Bonds (continued)
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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)
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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)
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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)
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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)
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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)
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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 Associated with Investing
in Bonds (continued)