Chapter 3

Fixed Income Securities

Chapter 3
Section 1

Types of Fixed-Income Securities

Chapter 3
Fixed-Income Securities

An interest rate is a price, or rent, for the most popular of all

traded commodities - money
Markets for money are well developed and the corresponding
basic market price - interest - is monitored by market
participants
Financial instruments: Contracts or claims that promise the
holders some amount of money at some future times
Security: A (financial) instrument that can be traded freely
and easily in a market

Chapter 3
Fixed-Income Securities (Cont’d)

Fixed-income security: A security that pays a fixed, definite

cash flow stream to the holder over a span of time (otherwise,
it is called a variable income security)
Default risk: The risk of a fixed-income security that the
issuer might go bankrupt, in which case the stream may be
discontinued or delayed
Types of fixed-income securities: Saving deposits, government
securities, bonds, mortgages and annuities

Chapter 3
Saving Deposits

Demand deposit (saving account) Capital can be withdrawn

at any time: higher liquidity and lower interest
Time deposit: Capital can be withdrawn at a specified future
time: higher interest, and early withdrawal possible with some
penalty
Certificate of deposit (CD): Similar to time deposit, but with
standard denominations
Demand deposit and time deposit generally cannot be traded,
so they are not securities but (equivalently) cash

Chapter 3
Money Market Instruments

The market for short-term (1 year or less) loans by

corporations and financial intermediaries, including banks
CD, commercial paper, banker’s acceptance, asset-backed
securities ...
It is a well-organised market designed for large-amount of
money, but it is not of great importance to long-term investors

Chapter 3
Government Securities

U.S. Government Securities

Treasury bill: short terms (13, 26, 52 weeks) bond in
denominations ≥US$10,000
Treasury note: longer terms (from 1 year to 10 years) in
denominations ≥US$1,000
Treasury bond: longest term (10 years or longer) in
denominations ≥US$1,000
Hong Kong SAR Government Bonds: issued by Hong Kong
Monetary Authority (HKMA) – “the bond market may
complement the equity market and the banking sector as an
effective channel of financial intermediation”
(http://www.hkgb.gov.hk/en/overview/introduction.html)

Chapter 3
Mortgages

Mortgage: A loan secured by the collateral of some specified

real estate property, and the borrower is obliged to pay back
with predetermined set of payments
A standard mortgage arranges some equal monthly payment
throughout its term; Early settlement is generally allowed
(with probably some penalty)
Variable interest rates
Mortgages are not strict securities (they can not be traded);
but they are often bundled into other financial securities

Chapter 3
Annuities

Annuity: A contract that pays the holder money periodically,

according to a predetermined schedule or formula, over a
period of time
A typical example is pension: A pension fund will pay the
beneficiary a certain amount of money every year (or month)
in his/her life
Annuities are not really securities either. However, they are
regarded as investment opportunity

Chapter 3
Section 2

Amortization

Chapter 3
Amortization: Perpetual Annuities

Many fixed-income securities include an obligation to pay a

stream of equal periodic cash flows
Amortization: The process of substituting periodic payments
for a current obligation
Perpetual annuity or perpetuity: A fixed-income security that
pays a fixed sum periodically forever. It is rare, but does exist
in UK (called consols)

Chapter 3
Perpetual Annuity Formula

The present value of a perpetual annuity that pays an amount A

every period, beginning one period from the present, is
∞
X A A
P = k
= ,
(1 + r) r
k=1

where r is the one-period interest rate

Amortization of a perpetual annuity The periodic payment for a

perpetual annuity with an initial obligation P is

A = rP

Chapter 3
Amortization: Finite-Life Streams

Annuity formula The present value of an annuity that pays an

amount A every period for a total of n periods, beginning one
period from the present, is
n  
X A A 1
P = = 1− ,
(1 + r)k r (1 + r)n
k=1

where r > 0 is the one-period interest rate

Amortization of annuity The periodic payment for an annuity
with a total of n periods and an initial obligation P is

r(1 + r)n P
A=
(1 + r)n − 1

Chapter 3
Example: Mark’s Dream Laptop

Mark wants to buy a laptop. Browdway asks for $12000, but

accepts payment by monthly installments for 24 months. The
interest rate is 6%
Question: How much should Mark repay every month?
Solution: P = 12000, r = 0.06/12 = 0.005, n = 24. Therefore

A = rP/[1 − (1 + r)−n ] = 531.85

Chapter 3
Example (Cont’d)

Each monthly payment consists of two parts: one is to pay the

interest, and the other is to pay part of the principal
End of Month Pre Balance Payment Interest New Balance
0 12000
1 12000 532 60 11528
2 11528 532 58 11054
3 11054 532 55 10577
4 10577 532 53 10098

How much interest will be paid in this amortization? The total

payment is $531.85 × 24 = $12764, therefore the total interest is
$12764 − $12000 = $764

Chapter 3
Example: Car Loan Trick

A car sales company provides a two-year 5% p.a. “flat rate” car

loan for a $100,000 car
Monthly payment

$100000 × 1.052 /24 = $4593.8 (monthly)

Amortization: P = 100000, r = 0.05/12, n = 24. Therefore

A = rP/[1 − (1 + r)−n ] = $4387.1 (monthly)

Difference is (4593.8 − 4387.1) × 24 = $4960.8!

Chapter 3
Section 3

Bond: General Concepts

Chapter 3
Bond

Bond: An obligation by an issuer to pay money to the holder

according to rules specified at the time it is issued
Maturity: The day when the term of the bond ends
The issuer sells the bonds to raise capital immediately
Bonds are the most often traded fixed-income securities
Face value or par value: The specific amount paid to the
holder at the date of maturity
Coupon payments: The periodic payments the issuer pays to
the holder

Chapter 3
Zero-Coupon Bond

Zero-coupon bond: A bond without coupon (payment)

Coupon bond: A bond with coupon (payment)
Zero-coupon bond is sold at a discount to its face value
Example. At an interest rate 2%, a 6-month zero-coupon bond
with the face value $1000 is sold at 1000/1.01 = $990.10

Chapter 3
Coupon Payments

Coupons of a coupon bond are generally paid every half year

from the issue date to the maturity
Coupon rate: Total coupon payments in a year divided by the
face value
The coupon rate of a bond is generally close to the prevailing
interest rate at the issue time, so that the issue price is close
to the face value
After the issue time, the bond can be traded in the market,
and the price will depend on the market condition
Example. A coupon bond with face value $1000 and coupon rate
6% pays the a coupon $1000 × 6%/2 = $30 every half year

Chapter 3
Bond Market

The bond market is run by a market maker

A market maker provides two prices for each traded bond: bid
price and ask price
Any investor can sell the bond to the market maker at the bid
price, and buy the bond at the ask price
The market maker maintains the market, and is rewarded by
the price spread

Chapter 3
Bond Price Quotation

A quotation from The Wall Street Journal, July 23, 2000, C15
(Source: http://edis.ifas.ufl.edu/FE324)
Rate Maturity Bid Ask Change Yield
1 7 1/2 May 2001n 103:04 103:06 ... 3.48
2 11 November 2002 110:00 110:02 +2 3.69
3 7 1/4 May 2004 107:22 107:24 +1 4.29
4 5 February 2011n 99:02 99:03 -3 5.12
5 8 3/4 August 2020 135:20 135:26 -5 5.66

Chapter 3
Example: The First Bond

Question: How much should I pay if I would like to buy the first
bond with face value $1000 immediately on July 23, 2000?
Analysis:
Coupon rate is 7.5%, maturity is May 15, 2001, the ask price
is (103 + 06/32) × $1000/100 = $1031.88
Each coupon payment is $1000 × 7.5%/2 = $37.5, paid on
May 15 and Nov 15 every year

Chapter 3
Example (Cont’d)

The interest between May 15 and July 23 should be paid back

to the original holder, which is called the accrued interest
(A.I.)
The accrued interest is calculated as
# of days since the last coupon
A.I. = × coupon amount
# of days in current coupon period
69
The price I need to pay is $1031.88 + 183 × $37.5 = $1046

Chapter 3
Quality Ratings

Credit (default) risk: the risk that the issuer of a bond goes
bankruptcy
Some organizations, such as Moody’s, Stand & Poor’s, and
Fitch, rate bonds to measure the credit risk
A higher grade means the lower credit risk
The U.S. Government bonds used to be regarded as free of
credit risk (but not any longer)
The bonds in or below the speculative grade are often termed
junk bonds

Chapter 3
Moody’s and S&P’s Ratings

Moody’s S&P’s
High grade Aaa AAA
Aa AA
Medium grade A A
Baa BBB
Speculative grade Ba BB
B B
Default danger Caa CCC
Ca CC
C C
D

Chapter 3
Bond Price-Yield Formula

Yield to maturity (YTM): The internal rate of return of the bond

at the current price, namely, the interest rate at which the present
value of the bond payment stream is exactly equal to the current
price
Suppose a bond with face value F makes m coupon payments of
C
m each year and there are n periods remaining. Then the price P
and the YTM λ are related by
F Pn C/m
P = λ n
[1+ m ]
+ k=1 [1+ λ ]k
n m o
F C 1
= λ n
[1+ m ]
+ λ 1 − λ n
[1+ m ]

Chapter 3
Price-Yield Relations

Qualitative understanding of the relationship between price, yield,

coupon, and time to maturity helps motivate the idea underlying
bond portfolio construction and leads to an understanding of the
interest rate risk properties of bonds.
In general the yields of bonds track the prevailing interest
rates quite closely
Prices move as yields move

Chapter 3
Price-Yield Relations (Cont’d)

If yield goes up, price goes down; and vice versa. When
people say “the bond market went down,” they mean that
interest rates went up
Two special cases:
A bond with YTM = 0: The price equals the sum of all
payments
A bond with YTM = coupon rate (par bond): The price
equals the par value
The price tends to zero as the yield increase
The shape of the price-yield curve is convex
As the maturity is increased, the price-yield curve becomes
steeper
Interest rate risk incurred by a bond

Chapter 3
Price of 9% Coupon Bond

Yield
Time to maturity 5% 8% 9% 10% 15%
1 year 103.85 100.94 100.00 99.07 94.61
5 years 117.50 104.06 100.00 96.14 79.41
10 years 131.18 106.8 100.00 93.77 69.42
30 years 161.82 111.31 100.00 90.54 60.52

Chapter 3
Section 4

Bond Duration

Chapter 3
Duration

Everything else being equal, bonds with long maturities have

steeper price-yield curves than bonds with short maturities.
Hence the prices of long bonds are more sensitive to interest
rate changes than those of short bonds
Maturities itself does not give a complete quantitative
measure of interest rate sensitivity, while duration does give a
direct measure of interest rate sensitivity
Duration of a cash flow stream is the weighted average
payment times, where the weights are the ratios between the
present values of the individual cash flows and the total
present value

Chapter 3
Duration (Cont’d)

Mathematical formula: Suppose that the amount of a cash

flow occurring at time ti is ci (i = 0, 1, · · · , n), then the
duration is
n
X PVi
D= ti ,
PV
i=0

where PV
Pni is the present value of ci at time ti , and
PV = i=0 PVi is the total present value of the stream
If the stream includes only one cash flow at time t (e.g., a
zero-coupon bond), then the duration is t
If all the cash flows are positive (e.g. a coupon bond), then
the duration will be between t0 and tn

Chapter 3
Macaulay Duration

Macaulay duration: A duration when the bond’s yield is used

for calculating the PV
Suppose a stream makes payments m times a year, with the
payment in period k being ck , and there are n periods
remaining, then the Macaulay duration is
Pn
(k/m)ck /[1 + (λ/m)]k
D = k=1 ,
PV
where λ is the yield to maturity and
n
X ck
PV =
[1 + (λ/m)]k
k=1

(Notice the unit of D is year)

Chapter 3
Macaulay Duration: An Example

Consider a 7% bond with 3 years to maturity. Assume that the

bond is selling at 8% yield. Find the Macaulay duration.

Chapter 3
Solution to Example

Year Payment Discount factor PV of payment Weight Year×Weight

0.5 3.5 0.962 3.365 0.035 0.017

1 3.5 0.925 3.236 0.033 0.033
1.5 3.5 0.889 3.111 0.032 0.048
2 3.5 0.855 2.992 0.031 0.061
2.5 3.5 0.822 2.877 0.030 0.074
3 years 103.5 0.790 81.798 0.84 2.520
Sum 97.379 1.00 2.753

Chapter 3
Duration and Sensitivity
Suppose a stream is periodical and the payment sequence is
(c1 , · · · , cn )
If there are m payments per year and yield is λ, then the
present value of the kth payment
Pnis PVk = ck /(1 + (λ/m)) ,
k

the current bond price is P = k=1 PVk , and the duration is

D = n PVk (k/m)
P
k=1 P
Then
n
X n
X
P = PVk = ck /(1 + (λ/m))k
k=1 k=1

n
dP 1 X
= − (k/m) × PVk
dλ 1 + (λ/m)
k=1
DP
= − = −DM P
1 + (λ/m)
D Chapter 3
Modified Duration

DM is called the modified duration

DM = − P1 dP
dλ : the relative change in bond price
DM ≈ D when λ is small or m is large

Chapter 3
Duration of a Portfolio

Portfolio: A combination of different assets

What is the duration of a portfolio consisting of several bonds
with different maturities?
Consider a portfolio having two bonds, bond A and bond B.
Then
A
A
X
n
A A A
D = tk PVk /PV
k=0
B
B
X
n
B B B
D = tk PVk /PV
k=0
A B
X
n
A A
X
n
B B A B
D = [ tk PVk + tk PVk ]/(PV + PV )
k=0 k=0

A PVA B PVB
= D +D
PVA + PVB PVA + PVB

Duration of a portfolio is the weighted average of those

durations of individual bonds
Chapter 3
Immunization

An investor in the fixed-income security market faces the

interest rate risk of his portfolio
Immunization: The procedure to protect against interest rate
risk
Idea: To reduce the sensitivity of the present value of the
portfolio to the change in yield

Chapter 3
Example: Kenneth’s Headache

Kenneth promises to buy a car as a gift for his son’s wedding

planned one year later. Suppose it will cost $200,000. Now
Kenneth wants to make some investment to cover this expense.
The most convenient way is to put money into a time deposit
account for one year, whose interest rate is however very low.
Therefore Kenneth turns to the bond market. He finds two bonds
whose yields are acceptable at 6%. The details are
time to maturity coupon rate
Bond A 2 years 7%
Bond B 0.5 year 5%

Chapter 3
Example (Cont’d)

Question: How much should Kenneth invest on the two bonds so

that 1) the value of his investment will be close to that of the car,
and 2) the difference will not be sensitive to the change on the
interest rate?

Solution: Denote by V1 and V2 the present values of the

investment on bonds A and B respectively, and by PV the present
value of the cost of the car
The first requirement is V1 + V2 = PV
The second requirement requires the sensitivity of the
investment should be as close as possible to that of the car,
which can be realized by having the same duration:
D1 V1V+V
1
2
+ D2 V1V+V
2
2
=D

Chapter 3
Example (Cont’d)

So Kenneth can determine V1 , V2 by equations:

V1 + V2 = PV
D1 V1 + D2 V2 = D × PV

where
D1 = 1.90, D2 = 0.5, D = 1, PV = 200000/(1.03)2 = 188520.
Solving the equations, we get V1 = 67329, V2 = 121191

Chapter 3
Use Immunization Wisely

Immunization should be dynamic: When the yield really

changes, the present value of each bond will also change, and
hence the immunization should be repeated and the
investment re-balanced
Shortcoming: All yields are assumed equal
Still, the technique is widely used

Chapter 3