CHAPTER-3

FIXED INCOME SECURITIES

3-1
 FIXED INCOME SECURITIES

• Fixed-income securities are longer-term debt obligations of corporations

or governments.
• These securities promise to make fixed payments according to
a pre-set schedule.
• When they are issued, their lives exceed one year.
Examples: U.S Treasury notes, Bonds, and corporate bonds
• Potential gains/losses:
• Fixed coupon payments and final payment at maturity, except
when the borrower defaults.
• Possibility of gain (loss) from fall (rise) in interest rates
• Depending on the debt issue, illiquidity can be a problem.
(Illiquidity means it is possible that you cannot sell these
securities quickly.)

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 What is a Bond?
• A bond is a tradable instrument that represents a debt.
• Most commonly, bonds pay interest periodically
(usually semiannually) and then return the principal at
maturity.
• Advantages of Bonds over Stocks
• Bonds, while a more conservative investment than
stocks, can offer certain investors some very attractive
features:
• Safety
• Reliable income
• Potential for capital gains
• Diversification (especially for an otherwise all-equity
portfolio)
• Tax advantages
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 What is a bond?
• A long-term debt instrument in which a borrower
agrees to make payments of principal and interest, on
specific dates, to the holders of the bond.
•Bond markets
• Primarily traded in the over-the-counter (OTC) market.
• Most bonds are owned by and traded among large
financial institutions.
• Full information on bond trades in the OTC market is
not published, but a representative group of bonds is
listed and traded on the bond division of the Stock
Exchange market.
 Key Features of a Bond/Characteristics
• Par value – face amount of the bond, which
is paid at maturity (assume $1,000).
• Coupon interest rate – rate of interest usually paid
semiannually for U.S. issues; multiplied by par value
yields dollar value of coupon
• Coupon – periodic interest payment made to
bondholders
• Maturity date – years until the bond must be repaid.
• Issue date – when the bond was issued.
• Yield to maturity - rate of return earned on
a bond held until maturity (also called the “promised
yield”). Current yield plus capital gain/loss yield
Key Features of a Bond/Characteristics
• Current yield: annual coupon divided by bond price
• Capital gains yield: difference between purchase
price and selling price of a bond divided by purchase
price.
• Term to maturity – date when debt ceases, with
maturity being that exact date and term denoting the
number of years till that date
• Zero-coupon bonds – no periodic interest
payments; principal and interest paid at term
• Floating rate security – coupon rate is reset
periodically

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 Key Features of a Bond
• Call provision:
• Allows issuer to refund the bond issue if rates decline (helps
the issuer but hurts the investor).
• Borrowers are willing to pay more, and lenders require more,
for callable bonds.
• Most bonds have a deferred call and a declining call premium.
• It has reinvestment risk to the bondholder
• Put provision:
• Allows holder to redeem the bond if rates increase (helps the
investor but hurts the issuer).
• Borrowers are willing to pay less, and lenders require less, for
puttable bonds.
• It has refinancing risk to the issuer.
 Types of bonds
• Convertible bond – may be exchanged for common stock
of the firm, at the holder’s option.
• Warrant – long-term option to buy a stated number of
shares of common stock at a specified price.
• Income bond – pays interest only when interest is earned
by the firm.
• Indexed bond – interest rate paid is based upon the rate of
inflation.
• Zero coupon bond: has no coupon and hence its current
yield is zero as it is sold at a discount.
 Risks of Bonds
• Bonds are generally less risky than stocks, but they do
suffer from several types of risk:
• Credit risk – Risk of default.
• Price risk – Risk of unexpected changes in rates, causing a
capital loss.
• Reinvestment risk – Risk that rates will fall, and you will
reinvest at a lower rate.
• Purchasing power risk – Risk that inflation will be higher
than expected.
• Call risk – Risk that the bond will be called because of lower
rates.
• Liquidity risk – The risk that you will not be able to sell the
bond at a price near its full value.
• Foreign exchange risk – Risk that a foreign currency will
decline in value, causing a decline in the value of your interest
payments and principal.
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The value of financial assets
Is computed by present value of cash flows from the asset

0 1 2 n
k ...
Value CF1 CF2 CFn

CF1 CF2 CFn

Value = 1
+ 2
+ ... +
(1 + k) (1 + k) (1 + k)n
What is K?
• The discount rate (ki ) is the opportunity cost of capital
and
• is the rate that could be earned on alternative
investments of equal risk.

ki = k* + IP + MRP + DRP + LP
 Basic Bond Valuation

• The intrinsic value of a bond, like stocks, is the present

value of its future cash flows.
• Bonds, however, have much more predictable cash
flows and a finite life.
• The cash flows promised by a bond are:
• A series of (usually) constant interest payments
• The return of the face value of the bond at maturity

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 Basic Bond Valuation (cont.)
• The value of a bond is determined by four variables:
❖The Coupon Rate – This is the promised annual rate of interest.
It is normally fixed at issuance for the life of the bond.
❖The Face Value – This is nominally the amount of the loan to the
issuer. It is to be paid back at maturity.
❖Term to Maturity – This is the remaining life of the bond and is
determined by today’s date and the maturity date.
❖Do not confuse this with the “original” maturity which was the
life of the bond at issuance.
❖Yield to Maturity – This is the rate of return that will be earned
on the bond if it is purchased at the current market price, held to
maturity, and if all the remaining coupons are reinvested at this
same rate.
❖This is the IRR of the bond.

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Basic Bond Valuation Example
• Suppose that you are interested in purchasing a 3-year bond with
a 10% semiannual coupon rate and a face value of $1,000.
• If your required return is 7%, what is the intrinsic value of this
bond?
• Here is a timeline showing the cash flows:

1000
50 50 50 50 50 50

0 1 2 3 4 5 6

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Basic Bond Valuation Example (cont.)
• Note that the cash flows of the bond consist of:
• An annuity, the interest payments, paid every six
months. This is calculated as:

CR  FV 0.10 1000
Pmt = = = 50
2 2
• A lump sum which is the return of the face value
of the bond at the end of its life.
• This payment is made at the same time as the last
interest payment.

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 Basic Bond Valuation Example (cont.)
• We can find the intrinsic value of these cash flows by finding the
present value of the interest payments and then adding the present
value of the face value:
 1 
1 − 6 
 1   0 .07 
1 − (1 + k   1 +  
= Pmt 
)N
+
FV   2   1000
= 50 
(
 + 1 + 0.07 )
d
VB
 kd  (1 + k d )N 
0.07
2  2
 
   

 


CPN 1 CPN 2 CPN 3 CPN n + FV n

Price = + + + ... + or Price =  CPN tt + FV
(1 + r )1 (1 + r ) 2 (1 + r ) 3 (1 + r ) n t =1 (1 + i ) (1 + i )n

• Note that the first term is the present value of an annuity, and the
second is the present value of a lump sum
• Do the math, and you’ll find that the bond is worth $1,079.93.
• Note that this value must decline until it reaches $1,000 at maturity.

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 Bond Valuation Notes
• A few things of note regarding the example:
• The interest is paid semiannually, so we first calculated the
annual interest & divided it by two.
• If interest was paid, say, quarterly, we would have divided the
annual amount by four.
• Similarly, we must convert the number of years to maturity (3)
into the total number of periods (6).
• Finally, we also must adjust your annual required return (7%)
to a semiannual return (3.5%).
• These three variables must always be stated on a per period
basis.
• Nearly all bonds pay interest more often than annually.
• Most often this is semiannually, but it could also be quarterly
or monthly.

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 What is the value of a 10-year, 10%
annual coupon bond, if kd = 10%?

0 1 2 n
k ...
VB = ? 100 100 100 + 1,000

$100 $100 $1,000

VB = 1
+ ... + 10
+
(1.10) (1.10) (1.10)10
VB = $90.91 + ... + $38.55 + $385.54
VB = $1,000
The price path of a bond
• What would happen to the value of this bond if its required
rate of return remained at 10%, or at 13%, or at 7% until
maturity?
VB

1,372 kd = 7%.
1,211
1,000 kd = 10%.

837
775
kd = 13%.

Years
to Maturity
30 25 20 15 10 5 0
 Bond values over time

• At maturity, the value of any bond must equal its

par value.
• If kd remains constant:
• The value of a premium bond would decrease over time,
until it reached $1,000.
• The value of a discount bond would increase over time,
until it reached $1,000.
• A value of a par bond stays at $1,000.
 Bond value: Using Formula
• V = Pv(interest) + PV(maturity value)
• = Int (1-1/ (1+Kd) N) + M/ (1+Kd)N
• Kd
➢Where: Kd is the discount rate (required return) or yield to
maturity and N is number of (perids)years before the bond
matures
➢The value of bonds changes with the fluctuations in the
market interest rate.
➢When the market rate increases the value of the bond
declines (the bond is sold at a discount) and
➢when the market rate declines the bonds value increases (the
bond is issued at a premium).
➢How ever, the value of the bond approaches its par value as
its maturity date approaches.
 Bond Yield to maturity (YTM)
• This represents a return earned on bonds held until
maturity.
• It can be viewed as the expected return from a bond if
there is no default risk and the bond is not callable.
• It is the discount rate that equates the future cash flows
to the price of the bond.
• Hence, it equal to the market interest rate.
• The YTM on a bond changes as the market interest rate
fluctuates.
• However, one who purchases and holds it until maturity
will earn the YTM that existed on the purchase date.
• YTM = Interest yield + capital gains yield
 Bond Yield to maturity (YTM)
• Unless financial calculator or computer program is in use, the
YTM on a bond is found using a trial and error (interpolation)by
substituting various discount rates until a rate that equates the
bonds price to the future cash flows is found.
• However, the rate could be approximated using the following
formula:
• YTM = Annual Interest + Capital gain/ N
• 0.6 (Market price of the bond) + 0.4 (Par value)
• Holding Period Yield (HPY)
• This is the return earned over holding period of a bond.
• This is the discount rate that equates the price of the bond with
interest received when held and the price of the bond when sold.
• It is composed of interest and capital gain/loss upon selling the
bond.
What is the YTM on a 10-year, 9% annual
coupon, $1,000 par value bond, selling for
$887?

• Must find the kd that solves this model.

INT INT M
VB = 1
+ ... + N
+
(1 + k d ) (1 + k d ) (1 + k d )N
90 90 1,000
$887 = 1
+ ... + 10
+
(1 + k d ) (1 + k d ) (1 + k d )10
 Bonds Yield to Call (YTC)
• Yield to Call (YTC):- When a bond is callable there is a high
probability that the YTM will not be earned.
• This is the discount rate that equates the periodic interest
payments and the call price with the current price of the bond.
• Example: M Co. issued $1,000 par, 10%, on Jan. 1, year 1. The
bond has a provision to call 10 years after the issue date at a price
of $1,100.00.
• Suppose [Link]. acquired the bond for $1,494.93 on Jan , year 2.
Calculate the YTC of the bond.
• $1,494.93 = $100 [(1- 1/ (1+YTC)N] + $1,100
• YTC (1+YTC)N
• YTC = 4.21%
 Illustration
• ABC Co. issued bonds on January 1, 1978.
• The bonds were sold at par ($1,000.00) have a 12% coupon rate
and mature in 30 years on December 31, 2007.
• Interest is paid semi-annually (June 30 and Dec.31).
• Required:
I. YTM on the date of issuance
II. The price of the bond on Jan. 1, 1983, assuming a market
interest rate of 10%.
III. Current yield and capital gains yield based on your answer for
II above.
IV. On July 1, 2001, the bond is sold for $916.42. What is the
YTM?
 Illustration…
• Solution:
I. As far as the bond is issued at par, YTM maturity is equal to coupon rate
12%.
II. VB = $60[1-1/(1.05)50] + $1000
.05 (1.05)50
= $60(18.2559) + $1,000.00(0.0872)
=$1,182.55
III. Current yield = Annual Interest Payment/Price
• = $120.00/$1,182.55
• = 10.15%
YTM = Current yield + capital gain (loss)
• 10% = 10.15% - Capital gain (loss)
• Capital Loss = 0.15%
 Illustration…
IV. $916.42 = $60[1-1/(1+K/2)13] + $1,000.00
• K/2 (1+K/2)13
• K = 14%
• Usually, YTM is calculated through trial and error or using
interpolation
An example: Current and capital gains yield
• Find the current yield and the capital gains yield for a 10-year,
9% annual coupon bond that sells for $887, and has a face value
of $1,000.
• Note that interpolation tells that YTM is 10.91%

Current yield = $90 / $887

= 0.1015 = 10.15%
Calculating capital gains yield

YTM = Current yield + Capital gains yield

CGY = YTM – CY
= 10.91% - 10.15%
= 0.76%
Could also find the expected price one year from now
and divide the change in price by the beginning price,
which gives the same answer.
 What is interest rate (or price) risk?
• Interest rate risk is the concern that rising kd will cause
the value of a bond to fall.

% change 1 yr kd 10yr % change

+4.8% $1,048 5% $1,386 +38.6%
$1,000 10% $1,000
-4.4% $956 15% $749 -25.1%

The 10-year bond is more sensitive to interest rate

changes and hence has more interest rate risk.
 What is reinvestment rate risk?
• Reinvestment rate risk is the concern that kd will fall,
and future CFs will have to be reinvested at lower
rates, hence reducing income.
• EXAMPLE: Suppose you just won $500,000 playing
the lottery.
• You intend to invest the money and live off the interest.
 Reinvestment rate risk example
• You may invest in either a 10-year bond or a series of ten
1-year bonds.
• Both 10-year and 1-year bonds currently yield 10%.
• If you choose the 1-year bond strategy:
• After Year 1, you receive $50,000 in income and have
$500,000 to reinvest.
• But, if 1-year rates fall to 3%, your annual income
would fall to $15,000.
• If you choose the 10-year bond strategy:
• You can lock in a 10% interest rate, and $50,000
annual income.
Conclusions about interest rate and
reinvestment rate risk

Short-term AND/OR Long-term AND/OR

High coupon bonds Low coupon bonds
Interest
Low High
rate risk
Reinvestment
High Low
rate risk

•CONCLUSION: Nothing is riskless!

 Default risk
• If an issuer defaults, investors receive less than the
promised return.
• Therefore, the expected return on corporate and
municipal bonds is less than the promised return.
• Influenced by the issuer’s financial strength and the
terms of the bond contract.
 The Relationship Between Interest Rates and
Option-Free Bond Prices
• Bond Prices and Interest Rates are Inversely Related
• Consider a bond which pays semi-annual interest
payments of $470 with a maturity of 3 years.
• If the market rate of interest is 9.4%, the price of the bond
is: 6
470 10,000
Price =  t
+ 6
= $10,000
t =1 (1 .047 ) (1.047 )
• If the market rates of interest increases to 10%, the
price of the bond falls to:
6
470 10,000
Price =  t
+ 6
= $9,847 .72
t =1 (1 .05 ) (1.05 )
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 Bond Return Measures
• There are three ways in which the expected return of the bond is
reported:
• Current Yield (CY)
• Yield to Maturity (YTM)
• Yield to Call (YTC)
• The current yield is simple, but inaccurate.
• The yield to maturity (or yield to call) is much more
representative of the return you will receive but suffers from a
problem of its own.

3-38
The Current Yield
• The current yield on a bond is simply the annual interest
payment divided by its current price.
CR  FV
CY =
P0
• For our example bond, the current yield is:
100
CY = = 0.0926
1079.93
• Note that the current yield is ignoring the capital loss that you
will suffer over the remaining life of the bond (it must sell for
$1,000 at maturity),
• so, it overstates the expected return for bonds selling at a
premium.
• For discount bonds, the expected return is understated.
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 The Yield to Maturity
• The yield to maturity gives the exact return that you will
actually earn under the following conditions:
• You purchase the bond at today’s price
• You hold the bond to maturity
• You reinvest all interest payments at the same YTM
• The last condition is the most difficult to achieve with interest
rates changing all the time.
• So, YTM is just an estimate of your actual return.
• However, the YTM does take into account the increase or
decrease in the price of the bond (capital gain or loss) over the
life of the bond.

3-40
 The Yield to Maturity (cont.)
• Suppose that we didn’t know that our required return was 7%
per year, but we did know that the current bond price was
$1079.93.
• We could solve for the yield implied by that price (i.e., the
YTM).
• Unfortunately, there is no closed-form solution to the bond
valuation equation, so we need to use a trial-and-error
algorithm to find the yield.

3-41
The Yield to Maturity (cont.)
• Here is the bond valuation equation, slightly restated to make the
point:
 1 
 1 − 
PB = Pmt 
(1 + YTM )
N
+
FV
 (1 + YTM )
N
 YTM
 

• Note that I have replaced the bond’s intrinsic value (VB) with its
price (PB), and its required return (kd) with its yield (YTM).
• Our problem now is to solve for that YTM given the price.

3-42
 The Yield to Maturity (cont.)
• To find the YTM, we first make a guess at the yield.
• Say that we choose 10%.
• That gives us a price of $1,000 which is lower than the actual
price.
• To get the price to go up, we must lower our estimated yield.
• Suppose we now try 5%.
• The price now is $1,137.70 which is too high.
• We need to try a higher estimated yield.
• Now, we know that the YTM must be between 5% and 10%,
• so, let’s “split the difference” and try 7.5%.
• We get $1,066.06.
• Close, but not close enough.

3-43
 The Yield to Maturity (cont.)
• We now know the YTM is between 5% and 7.5%,
• And so on.
• Keep splitting the difference until you arrive at the
correct price.
• The yield that achieves this is the YTM.
• This is the type of process that your calculator goes
through when solving for the YTM (the “i” key).
• Eventually, you will find that the actual yield is 7%.

12/3/2025 3-44
The Yield to Call
• The yield to call (YTC) is exactly the same as the YTM,
except that it assumes that the bond will be called at the next
call date.
• The only differences from calculating the YTM are:
• We need to change the number of periods until
maturity to the number of periods until it can be
called.
• If a “call premium” is to be received, we must add
that premium to the face value of the bond.

3-45
The Relationship Between Interest Rates and
Option-Free Bond Prices

• Bond Prices and Interest Rates are Inversely Related

• Par Bond
• Yield to maturity = coupon rate
• Discount Bond
• Yield to maturity > coupon rate
• Premium Bond
• Yield to maturity < coupon rate

3-46
Five bond pricing theorems
• Bond prices move inversely to changes in interest
rates
• Bonds with longer maturities are more price sensitive
• Price sensitivity increases at a decreasing rate
• Bonds with lower coupon rates are more price
sensitive
• A price increase caused by a decrease in interest rates
is larger than a price decrease caused by an increase
in interest rates of the same magnitude

3-47
 Valuation of Fixed-Income Securities
• Traditional fixed-income valuation methods are too
simplistic for three reasons:
• Investors often do not hold securities until maturity
• Present value calculations assume all coupon payments
are reinvested at the calculated Yield to Maturity
• Many securities carry embedded options, such as a call or
put, which complicates valuation since it is unknown if
the option will be exercised and at what price .

3-48
Evaluating default risk: Bond ratings

Investment Grade Junk Bonds

Moody’s Aaa Aa A Baa Ba B Caa C

S&P AAA AA A BBB BB B CCC D

• Bond ratings are designed to reflect the

probability of a bond issue going into default.
Factors affecting default risk and bond ratings

• Financial performance
• Debt ratio
• TIE (times Int Earned) ratio
• Current ratio
• Bond contract provisions
• Secured vs. Unsecured debt
• Senior vs. subordinated debt
• Guarantee and sinking fund provisions
• Debt maturity
 Other factors affecting default risk
• Earnings stability
• Regulatory environment
• Potential antitrust or product liabilities
• Pension liabilities
• Potential labor problems
• Accounting policies
 Bond Ratings
• Credit risk is the most important source of risk for owners of
bonds.
• As a result, various rating agencies (S&P, Moody’s, Fitch, and
Dominion Bond) assign grades to indicate the credit quality of
various bond issues.
• As you should guess, yields on lower rated bonds will be
higher (more risk) than those on higher rated bonds (less risk).
• Bond ratings are a lot like grades:
• The agencies give A’s, B’s, C’s, and D’s with various schemes
to differentiate within the category (i.e., AAA is better than
AA).

3-52
 Bond Ratings (cont.)
Bond Ratings by Agency
Moody's S&P Fitch DBRS DCR Definitions
Aaa AAA AAA AAA AAA Prime. Maximum Safety
Aa1 AA+ AA+ AA+ AA+ High Grade High Quality
Aa2 AA AA AA AA
Aa3 AA- AA- AA- AA-
A1 A+ A+ A+ A+ Upper Medium Grade
A2 A A A A
A3 A- A- A- A-
Baa1 BBB+ BBB+ BBB+ BBB+ Lower Medium Grade
Baa2 BBB BBB BBB BBB
Baa3 BBB- BBB- BBB- BBB-
Ba1 BB+ BB+ BB+ BB+ Non Investment Grade
Ba2 BB BB BB BB Speculative
Ba3 BB- BB- BB- BB-
B1 B+ B+ B+ B+ Highly Speculative
B2 B B B B
B3 B- B- B- B-
Caa1 CCC+ CCC CCC+ CCC Substantial Risk
Caa2 CCC - CCC - In Poor Standing
Caa3 CCC- - CCC- -
Ca - - - - Extremely Speculative

C - - - - May be in Default
- - DDD D - Default
- - DD - DD
- D D - -
- - - - DP
Source: [Link] 3-53
Q&A