Chapter 4- Fixed Income Securities

Learning Objectives

Explain who buys bonds, who Examine the concepts of yield,

Introduce what is fixed
issues bonds, and the bond coupon, and day count
Income and what is a bond
market

Discuss yield curve and Price a bond and understand the

credit spread relationship between price and yield
What is Fixed Income

❖Fixed income is a broad class of Common fixed income investment products:

financial products that comprises any

investment where the investor earns a set
Bonds
payment on a pre- determined
schedule.

Preferred securities
 Bonds

▪ A bond is the simplest form of fixed income.

▪ Is a publicly traded long-term debt securities, whereby the issuer agrees to pay a fixed
amount of interest over a specified period of time and to repay a fixed amount of principal
at maturity
▪ Like shares, bonds can potentially provide investors with two kinds of income: (1)
interest(coupon), and (2) capital gains/losses.
▪ Bond prices do rise and fall as market interest rates change.
▪ interest rates and bond prices move in opposite directions.
▪ When interest rates rise, bond prices fall, and when rates drop, bond prices move up
 Cash flow from the Bonds

Principal Coupon

The amount that the issuer The set interest paid in a pre-
owes to the investor; paid at determined schedule (e.g. annually or
maturity semi-annually)

Par value:
$100 for calculation purposes
Government bonds:
Face value / nominal value: Minimum $100, €100 or £100
the actual investment amount Corporate bonds:
Minimum $5,000; $100,000 for higher risk bonds
 Bond Description

$1000

The Great Western Petroleum Company

ONE THOUSAND DOLLARS Face value / nominal value

MATURITY DATE
30 September 1970 Maturity date
$1000
TGWPC

$50 $50 $50 $50 $50 Coupon (paid annually)

$50 $50 $50 $50 $50

Corporate Finance Institute®

 Who Invests in Bonds(Investor) and why?

Central banks / governments

Reasons to invest in bonds: Who buys bonds ?
Assets managers

Insurance companies
Liquidity Institutional
investors
Pension funds

Different risk profile Hedge funds

relative to equities
Corporates / family offices

Easy for investors to

match their liabilities Individuals
Individual
investors
Private banks / brokers
 Who Issues Bonds(seller)
▪ Bonds are essentially loans. Issuers are entities that are looking for financing.
▪ The bond issuers are:
a. National governments: Borrow money when they have a budget deficit or to finance social mandates

b. Corporate: Raise money in bond markets to fund operations and growth

c. Region governments and municipalities: Raise money to fund projects or when they have budget
deficits

d. Supranational and agencies(Yankee bonds ): Examples include the World Bank and the Asian
Development Bank
 Types of bond
✓ There are two types of bonds based on the issuer’s plans to mature
the debt:
▪ Term Bond is a bond that has a single maturity date
▪ Serial Bond is a bond that has a series of different maturity dates
Debentures: a long-term security yielding a fixed rate of interest, issued by
a company and unsecured against assets.
Mortgage bonds: is a bond secured by a lien on real property.
Eurobonds(International Bonds)- are bonds issued in a country other
than that of the currency of denomination.(currency that is not native to
the country where it is issued)
Thus bonds issued in US dollars in London are eurobonds, as are yen bonds issued in New
York.
Euro bonds(Foreign Bonds)-A bond that is denominated in euros (€), the
currency of the Eurozone.
Example: The German government issues bonds denominated in euros → those are
Euro bonds. Key Point: “Euro bond” refers strictly to the currency denomination
(euro), not where it is issued.
Zero coupon bonds: allow the issuing firm to issue
bonds at a substantial discount from their face value
with a zero coupon rate.
Floating rate notes (FRNs). These are corporate bonds
where the coupon can be adjusted at pre determined
intervals.
Junk bonds: are high-risk debt with very low ratings.
Junk bonds are also called high-yield bonds for the high
interest rates they pay the investor.
• Callable and Putable bonds.
•
• Callable bonds can be redeemed at the
issuer’s discretion prior to the specified
maturity (redemption) date.
• Putable bonds can be sold back (returned)
to the issuer on specified dates at the holder’s
discretion, prior to the redemption date.
• Convertible bonds. These are usually corporate
bonds, issued with the option for holders to
convert into some other asset on specified terms
at a future date.
Risks of Investing in Bonds

▪ The risks of investing in bonds are similar to time value of money (TVM) concept.

Inflation Interest Rate Risk Default risk FX and capital

control risks

Liquidity Risk
Bond Market

The bond market is one of the largest Example: 2018 US bond market
financial markets in the world.
• Bond issued: $2.2 trillion

Global equity market (2018): • Equity issued: $221 billion

$71.1 trillion • Bond traded per day: $827 billion
• Stock traded per day: $270 billion
Global bond market (2018):
$102.8 trillion

Trades in all Trades 24/5 across different

major currencies financial centers
 The Life Cycle of a Bond
Purchase at issuance Purchase in the secondary market
(primary market)
Premium Discount

Par value Bond price

Bond
Year 1 Year 2 Year 3 Year 4 Year 5 (Maturity)
issuance

Coupon Coupon Coupon Coupon Coupon & principal

• The par value will not change during the bond The bond price may fluctuate based on:
life cycle. • Inflation
• The bond price should equal the par value at • Market yield(market interest rate)
issuance and at maturity. • Issuer and/or sector fundamentals
Coupon(interest) on Bond
Coupon and Accrued Interest

❖Coupon: the set interest of a bond paid in a pre-determined schedule.

❖Accrued interest: accumulated interest that is unpaid.

Accrued interest Coupon payment

Year 1 Year 2 Year 3

 Day Count Basics

How is accrued interest calculated?

Day count convention: affects how coupons are calculated and paid.

There are three Day count market conventions:

Actual/Actual 30/360 Actual/365

 Actual/Actual
Interest accrues based on the actual number of days since the last coupon payment over the actual number
of total days between coupon periods.

Example: Coupon: Coupon:

• Face value: $100
• Maturity: December 31
Jan 1 Mar 15 Jun 30 Sep 15 Dec 31
• Annual interest: 10%
74 Days 77 Days 101 Days
• Frequency: Semi-annually
181 Days 184 Days

• Compute Accrued interest

on Mar 15 and Sep 15 using Accrued interest on Mar 15 Accrued interest on Sep15
actual/actual day count.
 30/360
30/360 day count assumes:

• Every month has 30 days.

30 Days 1/12 th of the coupon evenly
• Every year has 360 days.
360 Days

Example: Jan 1 Mar 15 Jun 30 Sep 15 Dec 31

75 Days 75 Days
• Face value: $100
180 Days 180 Days
• Maturity: December 31

• Annual interest: 10%

• Frequency: Semi-annually 2

Accrued interest on Mar 15 Accrued interest on Sep15

• Compute Accrued interest on
Mar 15 and Sep 15 using
30/360 day count
 Actual/365
Actual/365: A hybrid of ACT/ACT and 30/360
• The two semiannual (6months) have equal number of days
• Each half of the year is 182.5 days.
• The daily rate of accrual is constant between coupon periods.

Jan 1 Mar 15 Jun 30 Sep 15 Dec 31

Example:
74 Days 77 Days
• Face value: $100
182.5 Days 182.5 Days
• Maturity: December 31

• Annual interest: 10%

• Frequency: Semi-annually

Accrued interest on Mar 15 Accrued interest on Sep15

74 77
=100 x0.05 = $2.02 =100 x 0.05 = $2.10
182.5 182.5
Credit Rating Agencies
Credit Rating
❖Is the evaluation of the creditworthiness of bonds issued by companies and governments
❖The rating is made Commercial rating companies that assess the overall credit quality of an issuer
❖The rates shows the issuer's financial ability to make interest payments and repay the bond in full at maturity
❖ The rating companies are:

Independent Unbiased Professional

Credit Rating

Moody’s S&P/ Fitch Definition Example

• Prime JNJ MSFT Aaa/AAA
Aaa AAA
• Maximum safety Aaa/AAA
Aa1 Aa2 Aa3 AA+ AA AA-
• High grade AAPL Aa1/AA+
• High quality PG Aa3/AA-
Investment grade
A1 A2 A3 A+ A A-
TENCNT A1/A+ (Rating of BBB- or higher)
• Upper medium grade
JPM A2/A
Baa1 Baa2 BBB+ BBB
WBA GM Baa2/BBB
Baa3 BBB- • Lower medium grade
Baa3/BBB-
Ba1 BB+
• Non-investment grade SOFTBK Ba1/BB+
Ba2 Ba3 BB BB-
• Speculative TMUS Ba2/BB
B1 B2 B3 B+ B B-
TTMTIN B1/B+ B1/B+
• Highly speculative High yield or junk
YUM
Caa1 Caa2 CCC+ CCC (Rating of BB+ or lower)
JCREWB Caa2/CCC
Caa3 CCC- • Substantial risk
JCP Caa3/CCC-
- D

Bonds with a rating of BBB- (on the Standard & Poor's and Fitch scale) or Baa3 (on Moody's) or better are considered "investment-
grade." Bonds with lower ratings are considered "speculative" and often referred to as "high-yield" or "junk" bonds.
Yield(interest income) Curves and
Credit Spread
Yield Curves

❑yield curve is a graphical representation at a point of

time of the yields for a range of maturities.
Yield (%)

•The yield curve DOES NOT show change in yields over

time from same security.

It constructed by observing and plotting bond yields

trading in the secondary market of different maturities.

Maturity (years) Yield curves can plot bonds that are from:

The upwards slope means that long-term • the same issuer (the security are of d/t maturity)
investments pay a higher return than shorter- • the same group of issuers by industry
• the same credit rating (rating yield curve)
term investments.
 Credit Spreads( risk premium)

• The higher the level of credit risk, the greater

the cost of borrowing.

B rated
Yield (%)

corporates

AA rated corporates

AAA rated corporates

Government treasury
curve

Credit spread

Maturity (years)

Corporate Finance Institute®

 Bond Prices and Yields

CCoorrppoorartaeteFiFniannacnecI
ensItnitsuttietu®teⓇ
 Bond Valuation
0 1 2 n
r ...

Value CF1 CF2 CFn

CF1 CF2 CFn

Value = + + ... +
(1 + r)1 (1 + r) 2 (1 + r) n
Bond Price

• A Bond is made up of a series of periodic interest

payments and a principal repayment at maturity.
• The bond price is the discounted value of all the PV = FV x 1 + i -n
P
future cash flows generated by a bond.:
-n
PV = R(1-(1+I) )
Bond Price = The present value of all coupon C i
payments
+
The present value of the par value at maturity • PV = Present value of principal
P
• PV = Present value of coupons
C
Example:
• FV: Future value/par value of the bond
• Bond: 3 years
• Par value: $100 • i: Market rate (yield-to-maturity)
• Coupon: 5% ($5 per year) • n: total number of periods
• Yield-to-maturity( market rate) 4%
• Compute price of bond
 Bond Price

Example 1:
Year Future cash flows Present values
• Bond: 3 years
• Par value: $100 1 5 4.81
• Coupon: 5% ($5 per year)
• Yield-to-maturity( market rate) 4% 2 5 4.62

Price =100(1.04) -3 + 5(1-(1.04) -3 3 105 93.34

04)3
.04
= 88.89 + 13.87 Price 102.78

= 102.77 Yield-to-
maturity Price

Corporate Finance Institute®

 Bond Price

Example 2:
Year Future cash flows Present values
• Bond: 3 years
• Par value: $100 1 5 4.72
• Coupon: 5% ($5 per year)
• Yield-to-maturity( market rate) 6% 2 5 4.45

Price =100(1.06) -3 + 5(1-(1.06) -3 3 105 88.16

04)3
.06
= 83.96 + 13.36 Price 97.33

= 97.33 Yield-to-
maturity Price

Corporate Finance Institute®

 Bond Price

Example 3:
Year Future cash flows Present values
• Bond: 3 years
• Par value: $100 1 5 4.76
• Coupon: 5% ($5 per year)
• Yield-to-maturity( market rate) 5% 2 5 4.54

Price =100(1.05) -3 + 5(1-(1.05) -3 3 105 90.70

04)3
.05
= 86.38 + 13.62 Price 100

= $100 Yield-to-
maturity Price

Corporate Finance Institute®

 Bond Price and Yield Three-year bond with a 5% coupon rate

▪ Interest rates(yield) and bond prices move

in opposite directions.
▪ When interest rates rise, bond prices fall,
and when rates drop, bond prices move up YTM( market rate) Price

5% 100.00

❖.When yield( market rate) is equal to

coupon rate, the price will be par value

Corporate Finance Institute®

 Bond Price and Yield

Three-year bond with a 5% coupon rate

Yield Price

6% 97.33

❖As bond yields increase, prices will fall.

❖When yield( market rate) is greater

than coupon rate, the price will be less
than par value(discount)

Corporate Finance Institute®

 Bond Price and Yield

Three-year bond with a 5% coupon rate

Yield Price

4% 102.53

As bond yields decrease, prices will rise.

❖When yield( market rate) is less than

coupon rate, the price will be more
than par value(premium ) If the coupon rate > yield, the bond will sell for a premium price .
 Measures of Yield rate

Is market interest rate computed when price of the bond is given

The measurement of yield rates are: Current yield and Yield to maturity

Current yield Yield-to-maturity

Annual income divided Total anticipated

by the current price of return if the bond is
the investment held to maturity

Corporate Finance Institute®

 Summary:- Relationship Between Bond Prices and Yields

➢Bond prices are inversely related to interest rates (or yields).

➢A bond sells at par only if its coupon rate equals the required yield.
➢A bond sells at a premium if its coupon rate is above the required yield.
➢A bond sells at a discount if its coupon rate is below the required yield.
 Yield-to-Maturity (YTM) when bond price is given

Yield-to-maturity: Market interest rate or the internal rate of return (IRR) of all the cash flows from the bond.

Example: 5 5 5 5 100 +5
105 = 1+ 2+ 3+ +
• Face value: $100 1+YTM 1+YTM 1+YTM 1+YTM 4 1+YTM 5

• Term to maturity: 5 years

• Coupon rate: 5%, paid annually Yield-to-maturity = 3.88%

• Current price: $105

An investor will only realize the YTM stated at the
time of purchase if:

The coupons are reinvested at the same YTM.

The bond is held to maturity.

 Nominal vs. Effective Interest rate(Yields)

Nominal rate Effective rate

•Coupon interest rate Without ▪How much interest would be earned if the interest
compounding(without re-investment) was compounding(reinvested at the same rate by
•Considers total income from the bond only the bond holder)
and doesn't consider income from re- ▪Assumes income from re-investment of interest
investment collected as well.
▪ Is greater than nominal rate
effective rate =(1+ nominal rate)f −1
f
Where= frequency of compounding per year.
 Nominal vs. Effective Yields

Example 1: Example 2:
• Face value: $100 • Face value: $100
• Nominal interest: 5% • Nominal interest: 5%
• Compound: Annually • Compound: Semi-annually

Total return in 6 month = 100 x (1+2.5%) = $102.5

Total return = 100 x (1+5%) = $105
Total return in 1 year = 102.5 x (1+2.5%) = $105.0625
Effective yield = 5% or
Effective yield = 5.0625%

effective rate =(1+ nominal rate)f −1

effective rate =(1+ nominal rate)f −1 f
f = (1+5%/2)2-1
= (1+5%/1) 1 -1 = 5.0625%
= 5% Effective rate is more because of income from re-investment of
the first six months income
Nominal vs. Real Yields

Nominal yields
• Include inflation expectations.
• Not always an accurate measure of the current purchasing power.

Real yields = Nominal yields –Inflation

• Expected inflation (forward-looking)

• Actual inflation (rear-looking)

Example:
• Nominal yield: 5%
• Inflation: 3% Real yields = 5% - 3 % = 2%