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Chapter 10
Fixed-Income Securities
Fixed-Income Securities
 Learning Goals
1.
Explain the basic investment elements of bonds and
their use as investment means.
2.
Describe the essential features & provisions of a
bond.
3.
Explain how bonds are priced in the market.
2
Fixed-Income Securities
 Goals
4.
Identify the different types of bonds and the kinds of
investment objectives these securities can fulfill.
5.
Discuss the global nature of the bond market and the
difference between dollar-denominated and non-dollar
denominated foreign bonds.
6.
Describe the basic features and characteristics of
convertible securities, and measure the value of a
convertible.
3
What Are Bonds?
 Liabilities, or “publicly traded IOUs”
 Also called “fixed income securities” since
payments are fixed amounts
 Borrower agrees to repay a fixed amount of
principal at a predetermined maturity date
 Borrower agrees to pay a fixed amount of
interest over a specified period of time
4
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
5
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
6
Bonds Versus Stocks
 Compared to stocks, bonds offer lower returns
 Main benefits of bonds in portfolio:
 Lower risk
 High levels of current income
 Diversification
 Bonds add an element of stability to a portfolio
7
Performance of Stocks and Bonds
1996 Through 2005
8
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
9
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
10
Principles of Bond Price Behavior
 Price of a bond is a function of its coupon rate, its maturity, and market
movements in interest rates
 Longer maturities move more with changes 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
11
The Price Behavior of a Bond
12
Essential Features of a Bond
 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
13
Essential Features of a Bond
 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
14
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
15
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
16
Bond Ratings
 Bond ratings are letter grades that designate investment quality,
from AAA to D
 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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Bond Ratings
18
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
19
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
20
Agency Bonds
 Issued by U.S. government agencies
 Federal Home Loan Bank
 Federal National Mortgage Association (FNMA)
 Small Business Administration (SBA)
 High quality securities with almost no risk of default
 Interest rates usually higher than treasury issues
21
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
22
Municipal Bonds
 Interest is tax-exempt for Federal taxes
Yield on municipal bond
Taxable equivalent yield 
1  Federal tax rate
 Interest can be tax-exempt from state taxes if you live
in the state where the bond was issued
Taxable equivalent yield for

both federal and state taxes
Municipal bond yield
 Federal
State 
Federal 
1 

1

 

tax
rate
tax
rate
tax
rate


23
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
24
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.
25
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
26
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
27
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
28
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
29
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
30
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
31
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
32
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
33
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
34
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
35
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
36
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
Conversion value  Conversion ratio  Current market price of the stock
37
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
Current market price of the convertible bond
Conversion equivalent 
Conversion ratio
38
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
Current market price
Conversion
Conversion premium (in $) 

of the convertible bond
value
Conversion premium (in %) 
Conversion premium (in $)
Conversion value
39
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
Payback period 
Conversion premium (in $)
Annual interest
Annual dividend
income from the 
income from the
convertible bond
underlying common stocks
40
Review

Goals
1.
Explained the basic investment elements of
bonds.
2.
Described the essential features of a bond,
noted the role that bond ratings play in the
market, and distinguished among different
types of call, refunding, and sinking-fund
provisions.
3.
Explained how bonds are priced in the
market.
41
Review

Goals
4.
Identified the different types of bonds and the kinds
of investment objectives these securities can fulfill.
5.
Discussed the global nature of the bond market and
the difference between dollar-denominated and nondollar denominated foreign bonds.
6.
Described the basic features and characteristics of
convertible securities, and measured the value of a
convertible.
42
The End!
43
Chapter 10
Additional Chapter Art
Table 10.1 Historical Annual Yields and Returns in the Bond
Market, 1961–2005* (Yields and returns based on performance
of high-grade corporate bonds)
45
Figure 10.4 Auction Results—The Return
of the 30-Year Treasury Bond
46
Table 10.3 Characteristics of Some
Popular Agency Issues
47
Table 10.4 Taxable Equivalent Yields for
Various Tax-Exempt Returns
48