Chapter 1

Introduction

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Learning Objectives
After reading this chapter, you will understand the fundamental features of bonds the types of issuers the importance of term to maturity of a bond floating rate and inverse-floating rate securities what is meant by a bond with an embedded option and the effect of an embedded option on a bonds cash flow the various types of embedded options
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Learning Objectives
(continued)

After reading this chapter, you will understand

convertible bonds the types f risks faced by investors in fixed income securities the secondary market for bonds the various ways of classifying financial innovation

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Bond Basics
Bond are debt instruments Issuers (debtors) promise to repay the amount borrowed from investors plus interest over a specified period of time

Plain vanilla bonds: fixed maturity date; fixed coupon

Mortgage bonds (and their offspring)

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Bond Sectors
Treasuries and agencies Municipals (includes states, cities and others) Corporates (includes asset-backed securities) Mortgages (commercial and residential) : passthroughs, collateralized mortgage obligations, stripped mortgage backed securities

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Bond Features
Types of issuers: Federal government and its agencies Municipal governments Corporations Term to maturity Short term: 1-5 years Intermediate: 5-12 years Long term: 13 years + The term to maturity tells investors how long they will receive coupon interest and how long before they are repaid; it also affects the yield as market rates change
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Bond Features (continued)

Principal (also redemption value, maturity value, face or par) Coupon (nominal rate) Fixed coupon Floating coupon (reference rate) Deferred coupons (deferred-interest; step-up; payment in kindincluding pik toggles) Amortization (amortizing and nonamortizing) Embedded options (call provisions; put provisons; convertible or exchangeable bonds) To describe a bond, give its issuer, coupon and maturity (e.g., Treasury 8-3/4 of 8/15/2028)
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Bond Risks
Credit risk: risk investor will not get principal back Interest rate risk: market risk of price changes Reinvestment risk: risk that coupon payments may be reinvested at a different rate than the coupon Inflation risk: purchasing power risk Call risk: shortened maturity Exchange rate risk (for non $ bonds) Liquidity risk: marking to market Volatility risk: greater volatility enhances value of embedded options Risk risk: uncertainty of bond market innovations
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Bond Trading
Original issue securities Secondary markets

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All rights reserved. No part of this publication may be reproduced, stored in a retrieval system, or transmitted, in any form or by any means, electronic, mechanical, photocopying, recording, or otherwise, without the prior written permission of the publisher. Printed in the United States of America.

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