CHAPTER THREE

3. FIXED INCOME SECURITIES

3.1. What are fixed income securities?
Fixed Income Securities are investment where the cash flows are according to a pre-determined
amount of interest, paid on a fixed schedule. Unlike a variable-income security, where payments
change based on some underlying measure such as short-term interest rates, the payments of a
fixed-income security are known in advance. They are popularly known as Debt instruments.
There are different types of fixed income securities include government securities, corporate
bonds, Treasury Bills, Commercial Paper, Strips etc. The types of Fixed Income securities are
based on their issuance, i.e., by the government, banks or financial institutions or by the corporate
sector.
 Government issues Treasury Bills, Government Securities
 Banks/Financial institutions issue Certificate of Deposit
 Companies issue Commercial paper, Bonds
Advantages of fixed income securities
 Lower volatility than other asset classes providing stable returns.
 Higher returns than traditional bank fixed deposits.
 Predictable and stable returns offer hedge against the volatility and risk of equity
investments, and thus allow an investor to create a diversified portfolio.
Disadvantages of fixed income securities
 Low liquidity: investors’ money is locked for full maturity period unless the security is
traded in the secondary market.
 Not actively traded: this lack of competition prevents their prices rising very high.
 Sensitivity to market interest rate: change in market interest rate changes the yield on held
securities.
3.2. Treasury Bills
Treasury Bills are short-term money market instruments that finance the short-term requirements
of the Government. They are offered at a discount on their face value and at the end of the maturity
period, they are repaid at their face value.

1
Types of T-bills
The T-bills can be categorized according to their respective maturity periods:
 3 Month T-Bill 91 days
 6 Month T-Bill 182 days
 12 Month T-Bill 364 days
Ad-hoc Treasury Bills are also present which are usually issued for a specific intended purpose.
Features of treasury bills
a. No default risk
b. Ideal short-term investments, which can also be traded in the secondary market
c. Preferred securities for Liquid or Money Market and Ultra Short Term mutual funds
for high liquidity along with returns higher than traditional bank accounts
3.3. Bond
3.3.1. Bond Characteristics
Public bonds are long-term, fixed-obligation debt securities packaged in convenient, affordable
Denominations for sale to individuals and financial institutions. They differ from other debt, such
as individual mortgages and privately placed debt obligations, because they are sold to the public
rather than channeled directly to a single lender. Bond issues are considered fixed-income
securities because they impose fixed financial obligations on the issuers. Specifically, the issuer
Agrees to:
1. Pay a fixed amount of interest periodically to the holder of record
2. Repay a fixed amount of principal at the date of maturity
Normally, interest on bonds is paid every six months, although some bond issues pay in intervals
As short as a month or as long as a year. The principal is due at maturity; this par value of the issue
is rarely less than $1,000. A bond has a specified term to maturity, which defines the life of the
issue. The public debt market typically is divided into three time segments based on an issue’s
original maturity:
1. Short-term issues with maturities of one year or less. The market for these instru ments is
commonly known as the money market.
2. Intermediate-term issues with maturities in excess of 1 year but less than 10 years. These
Instruments are known as notes.

2
 3. Long-term obligations with maturities in excess of 10 years, called bonds. The lives of
debt obligations change constantly as the issues progress toward maturity. Thus, issues that
have been outstanding in the secondary market for any period of time eventually move
from long-term to intermediate to short-term. This change in maturity is important because
a major determinant of the price volatility of bonds is the remaining life (maturity) of the
issue.
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.
Intrinsic Features the coupon, maturity, principal value, and the type of ownership are important
intrinsic features of a bond.
The coupon of a bond indicates the income that 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.
The term to maturity specifies the date or the number of years before a bond matures (or expires).
There are two different types of maturity.
The most common is a term bond, which has a single maturity date. Alternatively, a serial
obligation bond issue has a series of maturity dates, perhaps 20 or 25. Each maturity, although a
subset of the total issue, is really a small bond issue with generally a different coupon.
Municipalities issue most serial bonds.
The principal, or par value, of an issue represents the original value of the obligation. This is
generally stated in $1,000 increments from $1,000 to $25,000 or more. Principal value is not the
same as the bond’s market value.
The bond indenture is a contract that states the lender’s rights and privileges and the borrower’s
obligations. Any collateral offered as security to the bondholders will also be described in the
indenture.
The market prices of many issues rise above or fall below their principal values because of
differences between their coupons and the prevailing market rate of interest. If the market interest
rate is above the coupon rate, the bond will sell at a discount to par. If the market rate is below the
bond’s coupon, it will sell at a premium above par. If the coupon is comparable to the prevailing
market interest rate, the market value of the bond will be close to its original principal value.

3
Finally, bonds differ in terms of ownership. With a bearer bond, the holder, or bearer, is the owner,
so the issuer keeps no record of ownership. Interest from a bearer bond is obtained by clipping
coupons attached to the bonds and sending them to the issuer for payment. In contrast, the issuers
of registered bonds maintain records of owners and pay the interest directly to them.

3.3.2. Bond yield and price

The value of bonds can be described in terms of dollar values or the rates of return they promise
under some set of assumptions. In this section, we describe both the present value model, which
computes a specific value for the bond using a single discount value, and the yield model, which
computes the promised rate of return based on the bond’s current price.
The Present Value Model
The value of a bond (or any asset) equals the present value of its expected cash flows. The cash
flows from a bond are the periodic interest payments to the bondholder and the repayment of
principal at the maturity of the bond. Therefore, the value of a bond is the present value of the
semiannual interest payments plus the present value of the principal payment. Notably, the
standard technique is to use a single interest rate discount factor, which is the required rate of
return on the bond. We can express this in the following present value formula that assumes
semiannual compounding.
Pm = ∑𝑛𝑡=1 𝑐𝑖/2 + pp
(1+i/2)t (1+i) 2n

4
Where:
Pm = the current market price of the bond
n = the number of years to maturity
𝑐𝑖 = the annual coupon payment for bond i
i = the prevailing yield to maturity for this bond issue
pp = the par value of the bond
The value computed indicates what an investor would be willing to pay for this bond to realize a
rate of return that takes into account expectations regarding the RFR, the expected rate of inflation,
and the risk of the bond. The standard valuation technique assumes holding the bond to the
maturity of the obligation. In this case, the number of periods would be the number of years to the
maturity of the bond (referred to as its term to maturity). In such a case, the cash flows would
include all the periodic interest payments and the payment of the bond’s par value at the maturity
of the bond.
When you know the basic characteristics of a bond in terms of its coupon, maturity, and par value,
the only factor that determines its value (price) is the market discount rate-its required rate of
return. Price moves inverse to yield, it shows three other important points:
1. When the yield is below the coupon rate, the bond will be priced at a premium to its par
value.
2. When the yield is above the coupon rate, the bond will be priced at a discount to its par
value.
3. The price-yield relationship is not a straight line; rather, it is convex. As yields decline the
price increases at an increasing rate; and, as the yield increases the price declines at a
declining rate. This concept of a convex price-yield curve is referred to as convexity.
Computing bond yields
Bond investors traditionally have used five yield measures for the following purposes:
Yield measures Purpose
Nominal yield Measures the coupon rate.
Current yield Measures the current income rate.
Promised yield to maturity Measures the estimated rate of return for bond held to maturity.
Promised yield to call Measures the estimated rate of return for bond held to first call date.
Realized (horizon) yield Measures the estimated rate of return for a bond likely to be sold prior to maturity.

5
 1. Nominal yield
Nominal yield is the coupon rate of a particular issue. A bond with an 8 percent coupon has an 8
percent nominal yield. This provides a convenient way of describing the coupon characteristics of
an issue.
2. Current yield
The current yield is an approximation of the yield to maturity on coupon bonds that is often
reported because it is easily calculated. It is defined as the yearly coupon payment divided by the
price of the security. Current yield is to bonds what dividend yield is to stocks.
It is computed as:

Because this yield measures the current income from the bond as a percentage of its price, it is
important to income-oriented investors who want current cash flow from their investment
portfolios. Current yield has little use for investors who are interested in total return because it
excludes the important capital gain or loss component.

6
 3. Promised yield to Maturity
Promised yield to maturity is the most widely used bond yield figure because it indicates the fully
compounded rate of return promised to an investor who buys the bond at prevailing prices, if two
assumptions hold true. Specifically, the promised yield to maturity will be equal to the investor’s
realized yield if these assumptions are met. The first assumption is that the investor holds the bond
to maturity. This assumption gives this value its shortened name, yield to maturity (YTM). The
second assumption is implicit in the present value method of computation. Referring to the above
equation, recall that it related the current market price of the bond to the present Value of all cash
flows as follows:
Pm = ∑2𝑛
𝑡=1 𝑐𝑖/2 + pp
(1+i/2)t (1+i) 2n
To all cash flows from the bond to maturity as noted, this resembles the computation of the internal
rate of return (IRR) on an investment project. Because it is a present value–based computation, it
implies a reinvestment rate assumption because it discounts the cash flows. That is, the equation
assumes that all interim cash flows (interest payments) are reinvested at the computed YTM. This
is referred to as a promised YTM because the bond will provide.
This computed YTM only if you meet its conditions:
1. You hold the bond to maturity.
2. You reinvest all the interim cash flows at the computed YTM rate.
To compute the YTM for a bond, we solve for the rate i that will equate the current price (P M);
If a bond promises an 8 percent YTM, you must reinvest coupon income at 8 percent to realize
that promised return. If you spend (do not reinvest) the coupon payments or if you cannot find the
final measure of bond yield.
4. Realized yield or horizon yield
Realized yield or horizon yield (i.e., the actual return over a horizon period) measures the expected
rate of return of a bond that you expect to sell prior to its maturity. In terms of the equation, the
investor has a holding period (HP) or investment horizon that is less than n. Realized (horizon)
yield can be used to estimate rates of return attainable from various trading strategies. Although it
is a very useful measure, it requires several additional estimates not required by the other yield
measures. Specifically, the investor must estimate the expected future selling price of the bond at
the end of the holding period. In addition, this measure requires a specific estimate of the

7
reinvestment rate for the coupon flows prior to the liquidation of the bond. Investors to measure
their actual yields after selling bonds also can use this technique. The realized yields over a
horizon-holding period are variations on the promised yield equations. The substitution of Pf in
place of Pp and Hp in place of Pm into the present value model in the above equation provides the
following realized yield model:
2ℎ𝑝
Hp = ∑𝑡=1 𝑐𝑖/2 + pf
(1+i/2) t (1+i) 2n
Calculating future bond value
Dollar bond prices need to be calculated in two instances:
(1) when computing realized (horizon) yield, you must determine the future selling price (Pf)
of a bond if it is to be sold before maturity or first call, and
(2) when issues are quoted on a promised yield basis, as with municipals. You can easily
convert a yield-based quote to a dollar price by using the above, which does not require
iteration. (You need only solve for P m).
The coupon (Ci) is given as is par value (Pp) and the promised YTM, which is used as the discount
rate. In contrast to the current market price, you will need to compute a future price (P f) 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 (horizon) yield rather than promised yield. They would compute P f through the following
variation of the realized yield equation:
2𝑛−2ℎ𝑝
Pf = ∑𝑡=1 𝑐𝑖/2 + pp
(1+i/2) t (1+i) 2n-2hp
Pf = the future selling price of the bond
pp = the par value of the bond
n = the number of years to maturity
hp = the holding period of the bond (in years)
𝑐𝑖 = the annual coupon payment of bond i
i = the expected market YTM at the end of the holding period
This equation is a version of the present value model that is used to calculate the expected price of
the bond at the end of the holding period (hp). The term 2n – 2hp equals the bond’s remaining term
to maturity at the end of the investor’s holding period, that is, the number of six-month periods

8
remaining after the bond is sold. Therefore, the determination of Pf is based on four variables: two
that are known and two that must be estimated by the investor. Specifically, the coupon (C i) and
the par value (Pp) are given. The investor must forecast the length of the holding period and,
therefore, the number of years remaining to maturity at the time the bond is sold (n – hp). The
investor also must forecast the expected market YTM at the time of sale (i). With this information,
you can calculate the future price of the bond. The real difficulty (and the potential source of error)
in estimating Pf lies in predicting hp and i.
3.4. Risks in bond
Statements Such as "stock is risky, bonds are not," are not accurate. Bonds do carry risk, although
the nature of their risk; is different from that of an equity security. To properly manage a group of
bonds, an investor must understand the types of -risk they bear.
1. Price Risks:
The two components of price risk are default risk and interest rate risk.
Default Risk: The possibility that a firm will be unable to pay the principal and interest on a bond
in accordance with the bond indenture is known as the default risk.
Interest Rate Risk: Bonds also carry interest rate risk, which is the chance of loss because of
changing interest rates. If someone buys a bond with a 10.4% yield to maturity and market interest
rates rise a week later, the market price of this bond will fall. It would fall because risk -averse
investors will always prefer a higher yield for a given level of risk. Changing interest rates will
change the market value of a bond investment. While it is true that investors who hold bonds until
maturity almost always get their investment back, they can never know for certain what path the
price will take as it moves toward its maturity date.
2. Convenience Risks:
Convenience risks comprise another category of risk associated with bond investments. These risks
may not be easily measured in dollars and cents, but they still have a cost.
3.4. Rating Bonds
Agencies ratings are an integral part of the bond market because most corporate and municipal
bonds are rated by one or more of the rating agencies. The exceptions are very small issues and
bonds from certain industries, such as bank issues. These are known as non-rated bonds.

9
There are three major rating agencies:
(1) Fitch Investors Service,
(2) Moody’s, and
(3) Standard and Poor’s.
Standard & Poor's and Moody's are the two leading advisor)' services reporting on the default risk
of individual bond issues. Standard & Poor's gives bonds a rating based on a scale of AAA (least
risk) to D (bonds in default). The ratings from AA to CCC may carry a plus or minus.
An investment grade bond is rated BBB or higher; any bond with a lower rating is known as a junk
bond. Many fiduciaries are limited by law to bonds that are investment grade. Some bonds
originate with an investment grade, but are later downgraded below BBB.
Standard & Poor's has a separate description for each of the ratings AAA, AA, A, and BBB. Junk
bonds, however, are all covered by a single definition, the salient portion of which states that these
bonds are regarded on balance, as predominately speculative with respect to capacity to pay
interest and repay principal in accordance with the terms of the obligation.
Bond ratings provide the fundamental analysis for thousands of issues. The rating agencies analyze
the issuing organization and the specific issue to determine the probability of default and inform
the market of their analyses through their ratings.
The primary question in bond credit analysis is whether the firm can service its debt in a timely
manner over the life of a given issue. Consequently, the rating agencies consider expectations over
the life of the issue, along with the historical and current financial position of the company. We
consider default estimation further when we discuss high-yield (junk) bonds. Several studies have
examined the relationship between bond ratings and issue quality as indicated by financial
variables. The results clearly demonstrated that bond ratings were positive related to profitability,
size, and cash flow coverage, and they were inversely related to financial leverage and earnings
instability.

10
11