Fixed-Income

Securities
 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

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 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

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 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

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 Figure 10.1 Behavior of Interest
Rates Over Time (1962–2011)

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

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 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

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

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 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

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 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

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 Principles of Bond Price
Behavior
• Price of a bond is a function of its coupon rate, its maturity,
and market movements 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

• The maturity of an issue has a greater impact on price

volatility than the coupon does
– Prices of bonds with longer maturities are affected more by
changes in interest rates

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 Figure 10.3 The Price Behavior of a
Bond

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 Essential Features of a Bond (cont’d)

• 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

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 Essential Features of a Bond (cont’d)

• 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

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 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

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 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

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 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

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 Table 10.2 Bond Ratings

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 The Market for Debt Securities

• Bonds are traded mainly over the counter

• Bond price activity is remarkably stable
compared to stock market
• Bond market is larger than the U.S. stock
market
• Bond market is growing rapidly

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 Treasury Bonds

• Considered risk free—no risk of default

• Interest is exempt from state and local taxes
• Sold in $1,000 denominations
• Types of Treasury Bonds
– Treasury notes: maturities of 2, 3, 5, 7, and 10 years
– Treasury bonds: mature in 30 years
• Treasury Inflation-Indexed Obligations (TIPS)
– Protect against inflation by adjusting investor returns
– Interest rates are very low
– Maturities of 5, 10, and 20 years

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 Agency Bonds

• Issued by U.S. government agencies

– Federal Home Loan Bank
– Federal National Mortgage Association
– Small Business Administration
• High quality securities with almost no risk
of default
• Interest rates usually higher than Treasury
issues

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 Municipal Bonds

• Issued by states, counties, cities and any

other political subdivision
• Issued to fund public projects
• Two basic types
– General obligation bonds are paid from general
fund of the issuer
– Revenue bonds are paid from revenues from the
project being financed
• Often guaranteed by private insurers to
lower risk and interest rates
• Give tax exempts
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 Corporate Bonds

• Issued by corporations from four major

segments
– Industrials
– Public utilities
– Rail and transportation bonds
– Financial issues
• Provide higher returns than government
bonds due to higher risk of default
• Wide variety of bond quality and bond types
available

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 Zero-Coupon Bonds

• Do not pay interest

• Sold at deep discount from par value
• Value increases over time
• Subject to tremendous price volatility as interest
rates fluctuate
• Interest must be reported as it is accrued for tax
purposes, even though no interest is actually
received.
• Treasury strips are zero-coupon bonds created
from U.S. Treasury securities.

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 Mortgage-Backed Securities

• Bond backed by pool of residential mortgages

• Principal and interest are paid monthly
• Governmental agencies are major issuers:
– Government National Mortgage Association (GNMA)
– Federal Home Loan Mortgage Corporation (FHLMC)
– Federal National Mortgage Association (FNMA)
• Self-liquidating investment since portion of
principal is received each month

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 Collateralized Mortgage Securities

• Mortgage-back bond pool that is divided

into “tranches,” or classes of investors
• All principal payments go first to the
shortest tranche until it is fully retired, then
the next in sequence is paid
• Allows investors to choose short-term,
medium-term or long-term investment
• Potentially complex; interest rate
fluctuations may have significant impact
upon bond prices

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 Asset-Backed Securities

• Issued by corporations and backed by pools

of loans
– Auto loans
– Credit card loans
– Home equity loans
• Provide relatively high yields
• Short maturities, typically 3 to 5 years
• Interest and principal payments are monthly
• High credit quality

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 Junk Bonds (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

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 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

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 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

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 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

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 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

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 Convertible Securities (cont’d)

• Conversion privilege: the conditions and specific

nature of the conversion feature on convertible
securities
• Conversion period: the time period during which
a convertible issue can be converted
• Conversion ratio: the number of shares of
common stock into which a convertible issue can
be converted
• Conversion price: the stated price per share at
which common stock will be delivered to the
investor in exchange for a convertible issue

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 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 prespecified prices, providing downside
protection

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 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 freefall

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 Measuring the Value of a Convertible

• Conversion Value: indication of what a

convertible issue would trade for if it were
priced to sell on the basis of its stock value

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 Measuring the Value of a
Convertible (cont’d)

• Conversion Equivalent: the price at which

the common stock would have to sell in
order to make the convertible security
worth its present market price

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 Measuring the Value of a
Convertible (cont’d)

• Conversion Premium: amount above the

conversion value that investors are willing to pay;
typically due to the higher current income provided
by convertibles over common stock

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 Measuring the Value of a
Convertible (cont’d)

• Payback Period: the length of time it takes

for the buyer of a convertible to recover the
conversion premium from the extra current
income earned on the convertible

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