Lecture Note One: Introduction to

Fixed Income Securities

FINA3323 Fixed Income Securities

HKU Business School
University of Hong Kong

Dr. Huiyan Qiu

1-1
 Outline ⼩ ho forule
sheets
1. What is fixed income securities?
的 mtlexan
2. Fixed income market: players
Fixed income securities: types
Pfmamiel
3.

4. Fixed income terminology

calonator .

5. Risks in investing in bond

6. Bond market in Hong Kong ☆ 5 asm .

⼩ ut = 2 W .

• Reference: Fabozzi’s chapter 1, Tuckman’s Overview

1-2
 1. What is Fixed Income Security?
• Fixed income securities are debt instruments that
provide a return in the form of periodic interest
payments and the eventual return of principal at
maturity.
• Many fixed income securities have cash flows that are not
fixed. E.g., callable bonds; floaters.
• Fixed income market means the market for debt, and debt-
related instrument.
• The best known type of fixed income security is bond.

1-3
 Why Study Fixed Income Securities?
• Fixed income securities are important and relevant in the
financial economic domain.
• Borrowing/lending is essential for efficient economic
development.
• Domestically and internationally, pension and mutual
funds, among others, have largely been specializing in
bond investing.
• Much of the most successful and unsuccessful investment
strategies have involved fixed income instruments.

1-4
 Why Study Fixed Income Securities?
(cont’d)
• It’s essential to have fixed income derivatives to
effectively manage interest rate risk and credit risk.
• More than 90% of the world's largest 500 companies use
fixed income derivatives to manage interest rate and credit
risk exposures.
• Further more, financial engineers keep inventing new fixed
income derivatives to help firms transfer risk more
effectively and selectively.

1-5
 Why Study Fixed Income Securities?
(cont’d)
• About two-thirds of the market value of all securities
outstanding in the world can be classified as fixed income
securities.
• The worldwide bond market’s total value exceeds US$100
trillion.
• It is therefore critical for anyone involved in corporate
finance or financial risk management to have deep-
rooted understanding of interest rate risk and fixed
income securities.

1-6
 2. Fixed Income Market: Players
• Issuers
• Governments and agencies, corporations, commercial
banks, states and municipals, special-purpose vehicles
• Financial Intermediaries
• Primary dealers, investment banks, credit rating agencies,
credit and liquidity enhancers
• Investors
• Governments, pension funds, insurance companies, mutual
funds, commercial banks, retail investors

1-7
 Issues for Issuers
• To issue debt securities that best suit their needs
• To sell securities at a fair value (valuation)
• To have liquid secondary markets in their securities
• To have flexibility in modifying their securities after
issuance

1-8
 Issues for Financial Intermediaries
• To carry out market-making activities in the primary
market: auction, underwriting, and distribution
• To provide liquid secondary market
• Risk management and asset liability management
• How much interest rate risk they are taking on
• What is the credit risk exposure

1-9
 Issues for Investors
• Valuation of the security
• Buy securities with a risk-return profile that best fits
their needs (diversification, investment, hedging, …)
• Understand well the risk and return characteristics of the
portfolio
• Get information on credit rating

1-10
 3. Fixed Income Securities: Types
• Publically traded
• Issued by governments
• Issued by corporations

• Not publically traded: loans; mortgages

• Fixed income derivatives

1-11
 Fixed Income Securities
– issued by Governments Cpubnelytraded )
• Bonds and notes:
• Bonds have time to maturity more than 10 years and notes
have time to maturity up to 10 years
anua
• Bonds and notes pay a regular coupon seii
-

coruypou
• Bond and notes are sometimes “callable” – they can be
repurchased, usually at par by the issuer
• Bills l 8 Treasury
.

• Short maturity, ≤ 1 year, and no coupon

• Essentially short dated bonds
1-12
 S Rfasset
U.S. Treasury Market

Source: [Link] 1-13

U.S. debt from 1940 to
2021Q2
• The top panel is deflated so
every year is in 2012 dollars
• The second panel shows the
two debt figures as a
percentage of U.S. GDP
(dollar value of U.S.
economic production for
that year).

• Source: Wikipedia.

1-14
 Government Debt: US
• Besides Treasury bills, notes, and bonds, US states and
districts have a large amount of Municipal Bonds
outstanding. statel proouee
• General Obligation Bonds (GOBs)
SC
• Revenue Bonds suppmt s
ufastructune
that are revene genaets
-

• There are also debts issued by Government Sponsored

Enterprises (GSEs), e.g., Fannie Mae and Freddie Mac.
• These agencies issue regular debt as well as securities
backed by mortgages (or assets).

1-15
 Government Debt: China
• Government bonds: issued by the Ministry of Finance
in a range of maturities to finance government spending.
Local governments also issue bonds, similar to
municipal bonds in US.
• Central Bank bills: short-term securities issued by the
People’s Bank of China as a tool for implementing
monetary policy.
• Some financial or non-financial corporate bonds may
also be considered as government debt based on the type
of the issuer. →
—

e
8
LGFE
—

1-16
 Government Debt: Hong Kong
• Government bonds: to promote the development of the
local bond market. Weblink ⼼ asml
• Exchange Fund Bills and Notes (EFBNs): to provide
benchmark yields that guide private debt pricing, i.e., to
set a foundation for HK$ bonds.
• Bonds issued by statutory bodies (e.g., Hong Kong
Housing Authority).
• Bonds issued by government-related corporations (e.g.,
Hong Kong Mortgage Corporation, Hong Kong Link
2004 Limited, etc.)
1-17
 Government Debt: UK
• Gilts: (gilt-edged securities)
A
7 ~
Treasumy
• Conventional / standard gilts: nominal bonds that
promise to pay a fixed coupon rate every six months;
representing the majority of government debt.
⼀ TIPS
→
• Inflation-linked gilts: coupon rates adjusted to reflect
changes in the U.K. retail prices index, a proxy for
inflation.
• British consols: perpetual bonds; fully redeemed in
2015

1-18
 Government Debt: Eurozone

Source: Fixed Income Securities: Tools for Today’s Markets, Tuckman

1-19
Sowue :
OECD
 Fixed Income Securities
– issued by Corporations
• Three primary categories:
• Money market instruments – less than 1 year maturity,
such as commercial papers.
• Medium Term Notes – maturity ranging from 1 year to
30 years, flexible issuance schedule as they are shelf-
registered.
• Corporate bonds/notes – usually longer than 5 years
maturity.
• Corporate debt is much more complicated in structure
and design than government securities.
1-20
 Fixed Income Securities
– issued by Corporations
• Following is description of one corporate bond issued by
Hysan Development Co. Ltd.

← matumed

I sei-
aurually
• Security Profile on HKEX

1-21
 Fixed Income Securities
– Not Publically Traded
• Loans:
• A loan is just like a bond or note, except that it is an
agreement between the lender and the borrower, and is not
publicly traded.
• Mortgages:
• Technically, a mortgage is a loan, which is secured against
the thing which it is being used to purchase.
• Residential mortgages can have fixed or floating interest
payments.

1-22
 Fixed Income Derivatives
• Plain vanilla interest rate derivatives:
• Forward rate agreement (FRA)
• Eurodollar futures – settle against 3 month LIBOR
• Bond forward and bond futures
• Interest rate swaps – LIBOR for fixed
• Options on bonds, on bond futures, on interest rate swaps
• Interest rate options

1-23
 Fixed Income Derivatives (cont’d)
• Exotic interest rate derivatives, examples:
• CMT (Constant Maturity Treasury) swaps
• Variable amortization rate swaps.
• Structured notes (e.g. range accrual notes).
• Credit derivatives:
• CDS (Credit Default Swaps) – essentially insurance
against default of a bond.
• CDOs (Collateralized Debt Obligations) – structured
hierarchy of claims on a portfolio of debt contracts.

1-24
 4. Fixed Income Terminology
契
• Indenture: the contract that set forth the promises of a
bond issuer and the rights of the investors, usually
specifying the coupon rate, maturity date, options,
covenants, provisions, and other terms.
• Bond covenants: a legally binding term of agreement
between a bond issuer and a bondholder, specifying the
exact contractual rules and restrictions.
• Bond covenants are designed to protect the interests of
both parties.

1-25
 Term to Maturity
• Term to maturity: the number of years over which the
issuer has promised to meet the conditions of the
obligation.

• There may be provisions in the indenture that allow

either the issuer or bondholder to alter a bond’s term to
maturity.
• Example: a callable bond allows the bond issuer to buy
back the bond before it matures.

1-26
 Par Value and Coupon Rate
asame PV = loo110 oo

• Par value (also called the principal of bond, maturity

value, face value): the amount that the issuer agrees to
repay the bondholder at the maturity date
•
assme
Coupon rate:paytheseni
-
amelly
interest rate that the issuer agrees to
pay each year. The annual amount of the interest
payment is called the coupon.
• Most bonds pay interest on an annual, semi-annual or
quarterly basis. Many mortgage-related bonds, however,
pay interest on a monthly basis.

1-27
 More on Coupon Rate
• Some bonds have their coupon rates reset according to pre-
determined benchmark. flouta
的
.

• Floating-rate bonds: coupon rate reset periodically

according to: reference rate + quoted margin
• Inverse-floating-rate bonds: coupon rate moves in the
opposite direction from the change in interest rates.
• Linkers: bonds whose interest rate is tied to the inflation
rate.
• TIPS: Treasury Inflation Protected Securities in US.

1-28
 Fixed Income Terminology
• Amortization feature: the principal of a bond issue to
be repaid over the life of the bond
• Amortization schedule: the schedule of principal
repayments.
• Sinking fund provision is similar. Sinking fund provision
requires the bond issuers periodically retire a specified
portion of the bond issuance.
• Mortgage-related bonds usually have amortization
feature.

1-29
 Fixed Income Terminology
• Embedded options: provision in the indenture that gives
either the bondholder and/or the issuer an option
• Call provision - grants the issuer the right to retire the
debt, fully or partially, before the scheduled maturity date
• Put provision - gives the bondholder the right to sell the
issue back to the issuer at par value on designated dates
• Convertible bond - provides the bondholder the right to
exchange the bond for shares of common stock

1-30
 5. Risks Inherent in Bonds
Bonds may expose an investor to one or more of the
following risks:

• Interest Rate Risk • Exchange Rate Risk

• Reinvestment Risk • Liquidity Risk
• Call Risk • Volatility Risk
• Default Risk • Risk Risk
• Inflation Risk

1-31
 Interest Rate Risk
• If investor must sell bond prior to maturity date, current
value of the bond depends upon current interest rates.
• If rates rise, bond prices will fall, and investor will lose
money
• If rates fall, bond prices will rise, and investor will make
money
• Interest rate risk (or market risk) is by far the major
risk faced by an investor in the bond market.

1-32
 Reinvestment Risk
• If investor receives cash flows earlier than desired
holding period, the rate at which she will be able to
reinvest is unknown today.
• If rates fall in the interim, then the rate she can reinvest at
will be below today’s prevailing rates.
• Note that this risk moves in the opposite direction of
interest rate risk.
• Reinvestment risk is greater for longer holding periods,
as well as bonds with large, early, cash flows, such as
high-coupon bonds.

1-33
 Call Risk
• Many bonds include a call provision that allows issuer to
retire debt before maturity date. Issuer will take
advantage of this when firm can reissue debt at lower
interest.
• There are three disadvantages to call provisions for
investors:
• cash flow pattern cannot be known with certainty
• investor is exposed to reinvestment risk
• bond’s capital appreciation potential will be reduced

1-34
 Credit Risk and Inflation Risk
visel osp HYhond )
mafw
E

• Credit risk is the risk that the bond issuer will fail to
satisfy the term of the obligation with respect to the
timely payment of interest and principal.
default vusk ?

• Inflation risk (purchasing power risk) arises because

even if promised future cash flows are ‘risk-free’, the
purchasing power of these cash flows is not guaranteed.

1-35
 Exchange Rate Risk
• Exchange rate risk (or currency risk) refers to the
unexpected change in one currency compared to another
currency.
• From the perspective of a U.S. investor, a non-dollar-
denominated bond has unknown U.S. dollar cash flows.
• The dollar cash flows are dependent on the exchange rate
at the time the payments are received.
• The risk of the exchange rate causing smaller cash flows is
the exchange rate risk or currency risk.
LNGFER 2T
og
.
Chuese bank hldy 1-36
 Liquidity Risk
→ bid - ase smead
• Liquidity risk or marketability risk depends on the
ease with which an issue can be sold at or near its value.
• The primary measure of liquidity is the size of the spread
between the bid price and the ask price quoted by a dealer.
• The wider the dealer spread, the more the liquidity risk.
• To get prices that reflect market value, the bonds must
trade with enough frequency.

1-37
 Volatility Risk and Risk Risk
最
Volatility risk is the risk that a change in volatility might
•

•
adversely affect the price of a bond. es wth
Risk risk refers to not knowing what the risk of a
opttorentieddec
security is (due to a new and innovative structure). Two
ways to mitigate or eliminate risk risk are:
• Keep up with the literature on the state-of-the-art
methodologies for analyzing securities
• Avoid securities that are not clearly understood

1-38
 6. Bond Market in Hong Kong
• The bond market in Hong Kong is one of the most liberal
debt markets.
• The range of product offerings, in both domestic and
foreign currencies,
• the open access for issuers and investors, both domestic
and international, and
• the significance of offshore RMB bond issuances
• make Hong Kong one of the most frequented
international bond markets in Asia.

1-39
 Government Bond Market
• Public Sector Bonds come in the form of
• Government bonds
• Exchange Fund Bills and Notes (EFBNs) issued and
managed by the Hong Kong Monetary Authority
(HKMA).
• Bonds issued by statutory bodies (e.g., Hong Kong
Housing Authority)
• Bonds issued by government-related corporations (e.g.,
Hong Kong Mortgage Corporation, Hong Kong Link 2004
Limited, etc.)

1-40
 Corporate Bond Market
• Corporate bond market is very active and liquid in Hong
Kong, accounting for around 40-50% of Hong Kong
dollar debt instruments.

1-41
 Foreign Currency-Denominated Bond
• Hong Kong has developed into a multi-currency capital
market and a major debt market.
• US dollar Clearing System was introduced in August
2000.
• Euro Clearing System was implemented in April 2003.
• Renminbi (RMB) real-time gross settlement (RTGS)
interbank payment system was implemented in June 2007.

1-42
 Bond Market Size

*: The reported data includes both the domestic debt securities and international debt
securities.
1-43
End of the Notes!

1-44