INTRODUCTION TO

FIXED INCOME
SECURITIES
Fixed Income Securities
MBA F 504
Outline
◦Introduction to the Course
◦Why a separate course only on Fixed Income
Securities?
◦What are fixed-income securities?
◦Participants/Players
◦Meaning of a Bond
◦Features of a Bond
◦Types of Bonds
◦Sources of Risk and Return in Debt Securities
◦Regulation of Fixed Income Securities
Why a Separate Course on Fixed
Income Securities?
◦Markets Prior to 1980s
◦ Dominated by plain vanilla bonds with simple cash flow
structures
◦ Valuation was simple and straightforward
◦Markets After 1980s
◦ Complex cash flow structures
◦ A variety of securities
◦ Derivative products to facilitate portfolio strategies to control
interest rate risk and to enhance return
◦ Wider range of investors
◦ Two thirds of the market value of all the securities outstanding in
world classified as fixed income
◦ Most participants in the corporate and financial sectors
participate in this market
◦ Federal governments, state governments, and municipalities
have not choice but to issue fixed income securities
◦ Therefore, a need to have well informed participants so that they
understand
◦ the forces that drive the bond market
◦ The valuation of complex cash flow structures
◦ Portfolio management strategies
Objective of this Course
◦ A detailed coverage of the fixed income securities markets in contrast to one or two
chapters in a book on investments
◦ Coverage of securities available in the market—Treasury, Agency, Municipals,
International, Mortgage, Mortgage-backed securities, CMOs.
What are fixed Income Securities?
◦Financial claims issued by government, government
agencies, state governments, corporations, municipalities,
and banks and other financial institutions
◦The cash flows promised to the buyer of fixed income
securities represent contractual obligations of the respective
issuers.
◦Typically, when such contractual obligations are not met,
the buyers of fixed income securities will have the right to
take control of the firm that issued such debt securities
What are fixed Income Securities?
(Cont’d)
◦ A fixed income security is a financial obligation of an entity that promises to pay a
specified sum of money at specified future dates. The entity promising the payment is
called the issuer of the security
◦ Two categories:
◦ Debt obligations—Bond Markets
◦ Preferred Stock
Participants
◦Issuers/sellers
◦ government, government agencies, state governments, corporations,
municipalities, and banks and other financial institutions
◦ To receive a fair value for their securities
◦ Be able to issue securities that best fit their needs
◦Investors
◦ Large institutions such as pension funds, insurance companies,
commercial banks, corporations, mutual funds, and central banks
◦ Smaller institutions
◦ Individual investors
Participants
◦ Objective is to buy/sell at a fair market price and at narrow bid/offer spread.

◦Intermediaries
◦ Help issuers in the initial offering of the security, assist in pricing
and distribution of the securities, make a secondary market,
provide liquidity, and engage in proprietary trading activities
◦ Produce information about credit quality of different issuers
◦ Provide liquidity and credit enhancement for a fee
Bond Markets
◦ Global Bond Markets
◦ U.S. Bond Markets
Meaning of a Bond
◦A debt instrument requiring the issuer also called the
debtor or borrower to repay to the lender/investor the
amount borrowed plus interest over some specified
period of time
◦A typical “plain vanilla” bond issued in the U.S. specifies
◦ A fixed date when the amount borrowed is due
◦ The contractual amount of interest, which is typically paid every
six months
◦Cash flow pattern is know assuming no default
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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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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Essential Features of a Bond (cont’d)
◦ Put Provision
A putable bond grants the investor the right to sell the issue back to the issuer at par
value on designed dates.
◦ Convertible or Exchangeable Debt
A convertible bond can be exchanged for specified amounts of common stock in the
issuing firm.
Compounding Intervals and Time
Value of Money
◦ At first we’ll review the concepts of present values and future values
that are central to bond valuation
◦ r : Annual Interest Rate
◦ P : Value of investment today
◦ PN : Value of investment after N periods compounded at interest
rate r
Compoundi Future Value (PN Future Value when P = 100, r=
ng Interval ) 10%, and N = 1

Annual PN = P(1+r)N PN = 100(1+.1)1 = 110

Semi-annual PN =P(1+r/2)2*N PN = 100(1+.1/2)2*1 = 110.25

Continuous PN = P*er*N PN = 100*e1*1 = 110.52
Compounding Effect: How $1 grows
Compounding Effect : How $1 grows
Rate 10.00% Principal 1
Time Annual Semiannual Quarterly Monthly Continuous
1 1.1000 1.1025 1.1038 1.1047 1.1052
3 1.3310 1.3401 1.3449 1.3482 1.3499
5 1.6105 1.6289 1.6386 1.6453 1.6487
7 1.9487 1.9799 1.9965 2.0079 2.0138
9 2.3579 2.4066 2.4325 2.4504 2.4596
11 2.8531 2.9253 2.9638 2.9905 3.0042
13 3.4523 3.5557 3.6111 3.6496 3.6693
15 4.1772 4.3219 4.3998 4.4539 4.4817
17 5.0545 5.2533 5.3607 5.4355 5.4739
19 6.1159 6.3855 6.5315 6.6335 6.6859
21 7.4002 7.7616 7.9580 8.0954 8.1662
Effective Annual Yield
◦ The rate of return that an investor earns over a year, regardless of the compounding
interval is the effective annual yield.

Effective Annual Yield (EAI) = (1+ r/m)m -1

◦ An annuity is a series of equal dollar payments that are made at
the end of equidistant points in time such as monthly, quarterly, or
annually over a finite period of time.
Perpetuities
❑ A perpetuity is an annuity that continues forever or has no
maturity. For example, a dividend stream on a share of preferred
stock. There are two basic types of perpetuities:
❑ Growing perpetuity in which cash flows grow at a constant rate, g, from
period to period.
❑ Level perpetuity in which the payments are constant rate from period to
period.
❑ Even if the cash flows are infinite, present values can be finite if
the discount rate is higher than the growth rate.

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Present Value of a Level Perpetuity
with n=infinity

= PMT/ i
❑ PMT = level (constant) payment per period.
❑ I = rate per period.

FIN3000, Liuren Wu 21
Examples
❑ Example :What is the present value of $600
perpetuity at 7% discount rate?
◦ PV = $600 ÷ .07 = $8,571.43
❑ If you decide to rent an apartment with a fixed rent
of $2,000 per month and live there forever (subletting
it to your children after you die), how much is this
apartment worth if the mortgage rate is 6% per year
(Ignore tax, liquidity and other concerns).
The present value of paying $2000 per month forever at 6%
rate per year is: PV=2000/(0.06/12)=400,000.
200 times your rent is about the house value.

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Checkpoint
The Present Value of a Level Perpetuity
❑ What is the present value of a perpetuity of $500 paid annually discounted back to the
present at 8 percent?
❑ What is the present value of stream of payments equal to $90,000 paid
annually and discounted back to the present at 9 percent?

Verify: 6250; 1,000,000

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 Yield to Maturity

◦ Interest rate that makes the present value of the bond’s

payments equal to its price is the YTM.
Solve the bond formula for r

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Yield to Maturity Example
Suppose an 8% coupon, 30 year bond is selling for
$1276.76. What is its average rate of return?

r = 3% per half year

Bond equivalent yield = .03*2 = 6%
EAR = ((1.03)2)-1=6.09%
 Bank Discount Yield

The prices of T-bills are conventionally quoted in terms of Bank Discount

Yield, Yd
Yd = [(100-P)/100]*[360/t]
t = number of days to maturity.
The price that has to be paid is determined based on a bill’s Y d and t. For
example, the price of a 90-day bill with a quoted discount yield of 10% is
determined by first computing its dollar discount from face value:

Dollar Discount (D) = 100-P = 100*(90/360)*0.1 = 2.5

The invoice price for this bill is P = 100-2.5 = 97.50. Note that Y d is not a rate
of return and it is different from YTM or BEY.
 Bank Discount Yield

• What is the effective Annual

Yield (EAY) if you buy this T-bill at
Yd = 10%?

365/90
EAY = [1+ (2.5/97.5 )] –1
= 1.081
 YTM vs. Current Yield
YTM
◦The YTM is the bond’s
internal rate of return.
◦YTM is the interest rate that
makes the present value of
a bond’s payments equal
to its price.
◦YTM assumes that all bond
coupons can be reinvested
at the YTM rate.
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Current Yield
◦The current yield is the
bond’s annual coupon
payment divided by the
bond price.
◦For bonds selling at a
premium, coupon rate >
current yield>YTM.
◦For discount bonds,
relationships are reversed.
Yield to Call
◦ If interest rates fall, price of straight bond can rise considerably.
◦ The price of the callable bond is flat over a range of low interest rates because the risk
of repurchase or call is high.
◦ When interest rates are high, the risk of call is negligible and the values of the straight
and the callable bond converge.

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 Bond Pricing Relationships

1. Bond prices and yields are inversely related.

2. An increase in a bond’s yield to maturity results in a smaller
price change than a decrease of equal magnitude.
3. Long-term bonds tend to be more price sensitive than
short-term bonds.

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Bond Pricing Relationships

4. As maturity increases, price sensitivity increases at a

decreasing rate.
5. Interest rate risk is inversely related to the bond’s coupon
rate.
6. Price sensitivity is inversely related to the yield to maturity
at which the bond is selling.

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The Price Behavior of a Bond

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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: mature in 2 to 10 years
◦ Treasury bills: mature in 20 and 30 years
◦Treasury Inflation-Indexed Obligations (TIPS)
◦ Protect against inflation by adjusting investor
returns
◦ Interest rates are very low

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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

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Municipal Bonds
◦Interest is tax-exempt for Federal taxes

◦Interest can be tax-exempt from state taxes if you live in

the state where the bond was issued

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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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Risks Faced by a Bond Investor
◦ Default risk
◦ Interest rate risk (price risk)
◦ Reinvestment risk
◦ Call risk
◦ Inflation risk
◦ Foreign exchange risk
◦ Liquidity risk

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