CHAPTER 2 _ FIXED INCOME INSTRUMENTS AND RETURN

COMPUTATION

FIXED INCOME INSTRUMENT

A fixed-income instrument is a debt instrument issued by a government, corporation or

other entity to finance and expand their operations.

Fixed-income securities provide investors a return in the form of fixed periodic payments
and eventual return of principal at maturity. The purchase of a bond, treasury bill,
Guaranteed Investment Certificate (GIC), mortgage, preferred share or any other
fixed-income product represents a loan by the investor to the issuer.

Often companies and governments need to take loans from the public in exchange for
interest payments. The debt instruments that are used are called ​fixed income securities​.
They can be issued by a corporation, government, or any other entity to raise debt. These
entities become borrowers, and the public becomes the lender. These instruments are also
commonly known as ​bonds​ or money market instruments.

These instruments are called fixed income securities because they provide ​periodic
income payments at a predetermined fixed interest rate. The borrower issues bonds to

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raise debt from investors with a promise to repay the principal on a fixed date and to
make pre-scheduled interest payments.

The principal amount of a bond is called its face value, the fixed annual interest rate is
called a coupon, and the date at which the principal amount is to be repaid is called its
maturity date. The price at which the bond is sold at is called the price or value of the
bond.

For example, a 10-yr bond with 5% coupon and $100 face value would give $5 per year
as a coupon for 10 years and will then repay the face value of $100 at the end of 10 years.

Bonds can be classified according to their maturity as follows:

● Short-term bonds​ have a maturity of 1 to 3 years.

● Medium-term bonds​ have a maturity of 3 to 10 years.

● Long-term bonds​ have a maturity of more than 10 years.

Bonds can also be classified on the basis of their price or value:

● A bond whose price is equal to its face value is called to be sold ​at par​.

● A bond whose price is less than its face value is called to be sold ​below par​.

● A bond whose price is more than its face value is called to be sold ​above par​.

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WHY TO INVEST IN FIXED INCOME SECURITIES

Fixed-income securities can be an important part of a well-diversified portfolio. For many

investors, particularly retirees, fixed-income investments are a secure, low-risk way to
generate a steady flow of income. As long as they are held to maturity, fixed-income
securities will provide a guaranteed return on your investment, with payments known in
advance.

ORGANIZATION OF FIXED INCOME MARKET

​ISSUERS INTERMEDIARIES: INVESTORS​:

1. Government 1. Primary dealers 1. Governments

2. Corporations 2. Other dealers 2. Pension funds

3. Commercial banks 3. Investment banks 3. Insurance companies

4. States and municipalities 4. Credit rating agencies 4. Commercial banks

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5. Special purpose vehicle 5. Credit and liquidity 5. Mutual funds
enhancers

6. Foreign institutions 6. Foreign institutions

7. Individual investors

TYPES OF FIXED INCOME INSTRUMENTS

● Municipal Bonds

Bonds issued by a government entity are called municipal bonds. Usually, they are
issued by a state, municipality, or any local government body to finance
infrastructure projects. These bonds are also commonly called munis. These
usually have a maturity of more than 5 years.

● Corporate Bonds

Bonds issued by companies are called corporate bonds. These are issued mainly to
fund expansion projects, mergers and acquisitions, or ongoing operations. These
bonds are usually medium to long-term bonds and pay regular coupons.

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● Treasury Bills

The government bodies usually issue Treasury bills, commonly called T-bills, to
raise money from the investors. These are basically similar to bonds but with a
maturity up to 1 year. Most commonly available T-bills have maturities of
3-months, 6-months, or 9-months.

T-bills usually don't pay regular interest payments. They are typically sold below
par, and the difference between the face value and price of a T-bill becomes the
interest payment. Let's look at an example: suppose you purchased a 6-month
T-bill with a face value of $100 at the price of $98. At the end of six months, you
will get $100, earning $2 as interest.

● Saving Bonds

Savings bonds issued by the Canadian and various provincial governments are
different from conventional bonds. Canada Savings Bonds (CSBs) typically pay a
minimum guaranteed interest rate (there are also compound interest bonds
available). A CSB carries no fees and is cashable at any time. The amount received
for a CSB will never go below its face value if redeemed by the issuer, while the
price received in the market for a conventional bond will depend on the level of
interest rates at the time of sale. In addition, only residents of Canada (or of the
province of issue) are eligible to purchase CSBs, and only up to a predetermined
amount.

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● Guaranteed Investment Certificates

A GIC is a note issued by a trust company with a fixed yield and term. The Canada
Deposit Insurance Corporation (CDIC) insures many GICs for interest and
principal totaling up to $100,000. GICs are generally non-redeemable before the
term is complete.

● Banker’s Acceptances

Banker’s Acceptances (BAs) are short-term promissory notes issued by a

corporation, bearing the unconditional guarantee (acceptance) of a major Chartered
Bank. BAs offer yields superior to T-bills, and a higher quality and liquidity than
most commercial paper issues.

● NHA Mortgage Backed Securities

A National Housing Act (NHA) MBS is an investment that combines the features
of residential mortgages and Canadian government bonds. MBS investors receive
monthly income consisting of a blend of principal and interest payments from a
pool of mortgages.

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● Strip Coupon Bonds And Residuals

Strip coupons and residuals are instruments purchased at a discount that mature at
par (100). They grow over time and while any interest income is not payable until
maturity, a nominal amount of interest is accrued each year and must be claimed as
income by the purchaser for tax purposes. For example, a Canada strip coupon
maturing on March 15, 2006 with a yield of 5.31% would be priced at 77.07 to
mature at 100. The difference between the purchase price and 100 is treated as
interest income.

Strip coupons generally offer higher yields and can also fluctuate more than the
price of a bond of similar terms and credit quality. All of the aforementioned
features make strip coupons a popular choice for tax-sheltered accounts such as
Retirement Savings Plans (RRSPs) and Registered Retirement Income Funds
(RRIFs).

● Laddered Portfolio

A laddered portfolio consists of several bonds, each of which has a successively

longer term to maturity. Each position in the portfolio is usually the same size as
the next, with intervals between maturity dates roughly equal. A laddered portfolio

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 helps spread reinvestment risk over the long term, helping to average out the
effects of overall interest rate changes.

● Certificate of Deposits

A certificate of deposit (CD) is a document issued by the bank to an investor who

chooses to deposit his funds in the bank for a specific amount of time. A certificate
of deposit can also be referred to as a promissory note issued by a bank. One
feature of the CD is that once the money has been deposited for a period of time
the depositor cannot withdraw the funds without incurring a penalty for early
withdrawal. Since funds cannot be withdrawn as pleased, the interest paid to the
depositor of a CD is higher than for a savings account.

Once the CD matures, at the end of the specified term of holding the funds are
repaid to the depositor alongside the interest calculated for the period. CDs issued
by banks can be negotiable or non-negotiable. A negotiable CD allows the holder
to sell it on the money market before maturity. A non-negotiable CD mandates the
depositor hold the funds till maturity or incur a penalty for early withdrawal.

● Commercial Papers

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 Commercial paper is a short term money market instrument that matures within a
period of 270 days. Commercial papers are used as a means of raising funds,
sometimes used instead of a bank loan, and are usually preferred over a bank loan
since large amounts of funds can be raised within a short period of time.
Commercial papers are not backed by collateral and, therefore, only creditworthy
institutions with high debt ratings can issue them to obtain funds at a lower cost of
interest.

If the organization does not have a very attractive debt rating they may have to
offer a high interest rate that covers investment risk, to attract investors to invest.
An advantage to the issuer of a commercial paper is that since the instrument has a
very short maturity it does not require a registration with the Securities and
Exchange Commission (SEC), which makes it much less complicated and a
cheaper form of obtaining finance.

(​NOTE​: RETURN COMPUTATION IS SHARED IN A DIFFERENT EXCEL

FILE-​BOND CALCULATION​)

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