APS 502

Fixed Income Securities

Lecture 1 Part 2
Jan 21, 2021

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 Definitions
Financial Instrument – a legal obligation or claim having
monetary value.

Ex: stocks, bonds, mortgages, futures, insurance, etc...

Security – A tradable financial instrument satisfying legal

and regulatory requirements.
Fixed income security – Securities that promise a fixed income
to the holder over some span of time.

Ex: bonds, mortgages, annuities.

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 Annuity Formulas

Annuity – A contract that pays the holder money periodically

according to a fixed schedule.
Perpetual Annuity (perpetuity) – Pays a fixed sum periodically,
forever.
A

0 1 2 3 4 5 6

At a per period interest rate of r, the present value is


A A
P= =
k =1 (1 + r )
k
r
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 Example

Consider a perpetual annuity of $1000 each year at 10%

interest/year.

Then, its present value is

A $1,000
P= = = $10,000
r 0.1

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 Finite-Life Streams
Consider a stream that pays A for n periods, starting at
period 1. What is its present value?

A

0 1 2 3 n-1 n n+1

n
A A 1 
P= k =
1 − 
n 
where r is the interest
k =1 (1 + r ) r  (1 + r )  rate per period.

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 Finite-Life Streams
A finite life stream can be thought of as the difference
between two perpetuities.

 
0 1 2 n n+1 n+2


0 1 2 n n+1 n+2


0 1 2 n n+1 n+2
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 Finite-Life Streams
A finite life stream can be thought of as the difference
between two perpetuities.
A
 
0 1 2 n n+1 n+2

A
PV =
r

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 Finite-Life Streams
A finite life stream can be thought of as the difference
between two perpetuities.

A 1  A
PV =  
n 
PVn =
r  (1 + r )  r
A

0 1 2 n n+1 n+2

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 Finite-Life Streams
A finite life stream can be thought of as the difference
between two perpetuities.

A A 1  A 1 
PV = −   = 1 −
n 

n 
r r  (1 + r )  r  (1 + r ) 

 A

0 1 2 n n+1 n+2

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 Example: Loan Calculation
Suppose you have borrowed $1,000 at 12% interest
compounded monthly, and you have agreed to repay this
loan with equal monthly payments over 5 years. How
much are the monthly payments?
Given: P = $1,000
12%
r= = 1% per month
12
n = 5 *12 = 60

A 1  A=
rP
= $22.24 per month
P = 1 − 
n   1 
r  (1 + r )  1 − 
n 
 (1 + r ) 

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 Bonds
Bond Details:

Bond – an agreement to pay money according to

the rules of the issue.

Generally, bonds have:

• Face Value, Par Value, Principal - An amount to
be paid at the maturity date.
• Coupon Payments – An amount paid periodically.
Expressed as a percentage of the face value.
Last coupon is paid at maturity.

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 Example
Face Value = $1,000
Coupon = 9%

The yearly coupon amount is $1000(0.09)=$90.

Note: In the U.S., coupons are usually paid every six

months, in an amount equal to half of the yearly rate.
For example, with US treasury bonds you would
receive $45 every 6 months.

In general, coupons may be paid m times per year.

In that case, for this example you would receive
$90/m at each of the m times.
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 Payoff Structure of a Bond
C/m
F

0
C/m C/m C/m C/m
 maturity

When there are no coupons, the only payoff is the face value
at maturity.
F

0
 maturity

This is known as a zero-coupon bond, or a zero.

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 Accrued Interest
Bond price quotes ignore accrued interest, which must
be added to the price.
tc
C/m C/m

t you purchase

You must pay the previous owner their “portion” of

the next coupon payment.
days since last coupon t
AI =  (C / m) = (C / m)
days in current coupon period tc
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 Example
A treasury bond is purchased on May 8 and matures on
August 15 in some future year. The coupon rate is 9%
and coupon payments are made every Feb 15 and
August 15. How much accrued interest is owed?

On May 8th, there have been 83 days since the last

coupon, and 99 days until the next. Therefore:

83
AI =  4.5% = 2.05%
83 + 99

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 (A little) Bond Terminology

• Market bond prices (which don’t include accrued

interest) are often referred to as the clean price.
When accrued interest in included, then it is
referred to as the dirty or cash price.

• Government Securities
– Bill – up to 1 year
– Note – 1 to 10 years
– Bond – 10 to 30 years

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 A Bond Quote from yahoo.com

Type Issue Price Coupon Maturity YTM CY

Treas T-NOTE 1.625 31-Oct-2005 99.91 1.625 31-Oct-2005 2.923 1.626

Treas T-NOTE 3.500 15-Jan-2011 109.71 3.500 15-Jan-2011 1.574 3.190

Treas T-BOND 7.875 15-Feb-2021 135.49 7.875 15-Feb-2021 4.622 5.812

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 Bond Price and Yield
C/m
F

0
C/m C/m C/m C/m
 n
P

One can easily map out the entire cash flow stream
corresponding to the purchase of a bond.

Here, P represents the entire amount paid for the bond.

That is, P is the market price plus accrued interest (i.e. it
is the dirty price).

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 Bond Price and Yield
C/m
F

0
C/m C/m C/m C/m
 n
P

When one computes the internal rate of return of this

cash flow stream, in bond terminology it is referred to
as the yield (or yield to maturity) of the bond.
The yield captures the “rate of return” that one would
obtain by purchasing the bond and holding it to
maturity.
We will often denote the yield by the symbol l.
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 Bond Price and Yield
C/m
F

0
C/m C/m C/m C/m
 n
P

Formula relating Price and Yield with exactly n coupon payments remaining.

Price (including accrued interest) = P

Face Value = F
 
 
Coupon payments/year = m F C
m  1 
P= + 1 −
l 
Each coupon payment = C/m
 l  l 
n n

1 +   1 +  
m
Yield per coupon period = l/m
Coupon payments left = n  m   m 
(Note that we are compounding m times per year)
PV of Face Annuity formula
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 Example

• Calculate the price of a bond with a par

value of $1,000 to be paid in ten years,
a coupon rate of 10%, and a yield of
12%. Assume that coupon payments
are made semi-annually i.e. coupon
payments are made every 6 months.

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Solution

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 The Price-Yield Curve
What is the relationship between price and yield for a bond.

For a fixed maturity:

price

yield

Price and yield go opposite directions

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 Bond Prices vs. Yield

Principal 1000
Coupon 0%
Maturity 30
Price vs. Yield
Yield Price
1% 741.3722
2% 550.4496 2500
3% 409.296
4% 304.7823
2000
5% 227.2836
6% 169.7331
7% 126.9343
1500
8% 95.0604
Price

9% 71.28901
10% 53.53552 1000
11% 40.25802
12% 30.31434
13% 22.85723 500
14% 17.25732
15% 13.04644
16% 9.875854 0
17% 7.485412 0% 5% 10% 15% 20%
18% 5.680808
Yield
19% 4.31671
20% 3.28427

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 The Price-Yield Curve
What is the influence of time to maturity?

price 10 years

5 years

yield

The longer the time to maturity, the more sensitive the price
of the bond is to the yield.

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 More Terminology

People sometimes refer to the current yield, which is the

coupon divided by the current price.

In this course, yield will always mean yield to maturity.

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Bond ratings
Standard & Poors, and Moody’s are two independent bond
rating agencies.

S&P Moody’s
Investment AAA Aaa Best quality, Smallest credit risk. US gov. bonds.
Grade AA Aa High grade.
A A High to medium grade.
BBB Baa Medium grade.
BB Ba Judged to be speculative.
Speculative B B Increasingly speculative.
Grade
(Junk Bonds) CCC Caa Danger of default.
CC Ca Very speculative, high chance of default.
C C Small chance of not defaulting.
D D In default.

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