GROUP 9;

Punuh Firgina, Souisa Gladness, Lumenta Faldi, Kontu Utary

Chapter 10
Fixed-Income Securities
Learning Goals:

Explain the basic investment attributes of

bonds and their use as investments 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.
Learning Goals:
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 security.
What Are Bonds?
Liabilities, or “publicly traded IOUs”.

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.

Lumenta, Faldi
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.
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.
Figure 10.1
Behavior of Interest
Rates Over Time (1962–2011)

(Source: Aswath Damodaran, The Data Page, http://pages.stern.nyu.edu/~adamodar/.)

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.
Figure 10.2
Comparative Performance of
Stocks and Bonds (1992-2011)
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.

Lumenta, Faldi
 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.

Souisa, Gladness
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.
Figure 10.3
The Price Behavior of a Bond
 Essential Features of a Bond
• 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.
• 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.
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.
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.
 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.
Table 10.2
Bond Ratings

Souisa, Gladness
The Market for Debt Securities

Kontu, Utary
Major Market Segments

Treasury Bonds
Agency Bonds
Municipal Bonds
Corporate Bonds
 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
Specialty Issues

Zero-Coupon Bonds
Mortgage-Backed Securities
Collateralized Mortgage Obligations
Asset-Backed Securities
 (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.
 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
 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
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

Kontu, Utary
 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

Punuh, Firgina
 Convertible Securities
Convertibles as Investment Outlets

Conversion privilege
Conversion period
Conversion ratio
Conversion price
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 pre specified prices,
providing downside protection
 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 free fall
Measuring the Value of a Convertible

Conversion Value

Conversion Equivalent
 Conversion Premium

Payback Period

Punuh, Firgina
Thankyou.