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Chapter 1: Introduction

- A bond is a debt instrument requiring the issuer(also called the debtor or borrower) to repay to
the lender/investor the amount borrowed plus interest over a specifed period of time.
- A typical plain vanilla bond issued in the !nited "tates specifes a f#ed date when the amount
borrowed (the principal) is due$ and the contractual amount of interest$ which typically is paid
every si# months %he date on which the principal is required to be repaid is called the maturity
date
- %he !" bond mar&et is the largest bond mar&et in the world. %he mar&et is divided into si#
sector
%he treasury sector' treasury bills$ notes$ and bonds
%he agency sector' includes securities issued by federally related institutions and
government-sponsored enterprises. %his sector is the smallest sector of the bond mar&et.
%he municipal sector' is where state and local governments and their authorities raise
funds. %his sector is divided into two subsectors' ta#-bac&ed bond and revenue bonds.
%he corporate sector' includes securities issued by !" corporations and securities issued in
the !( by non !" corporations.
Asset-bac&ed securities sector' in this sector a corporation pools loans or receivables and
uses the pool of assets as collateral for the issuance of a security.
%he mortgage sector is the sector where the securities issued are bac&ed by mortgage
loans
- %here are three issuers of bonds' the federal government and its agencies$ municipal
governments$ and corporations.
- %he term to maturity of a bond is the number of years over which the issuer has promised to
meet the conditions of the obligation. %he maturity of a bond refers to the date that the debt will
cease to e#ist$ at which time the issuer will redeem the bond by paying the outstanding
principal.
- "hort-term' bonds with a maturity of between one and fve years
- )ntermediate-term' bond with a maturity between fve and *+ years
- ,ong-term' bonds are those with a maturity of more than *+ years
- -easons why the term to maturity of a bond is important'
)ndicates the time period over which the holder of the bond can e#pect to receive the
coupon payments and the number of years before the principal will be paid in full
%hat the yield on a bond depends on it
%he price of a bond will .uctuate over its life as yields in the mar&et change
- %he principal value of a bond is the amount that the issuer agrees to repay the bondholder at
the maturity date (redemption value$ maturity value$ par value$ face value)
- %he coupon rate (nominal rate) is the interest rate that the issuer agrees to pay each year. %he
annual amount of the interest payment made to owners during the term of the bond is called
the coupon
- %he holder of a /ero-coupon bond reali/es interest by buying the bond substantially below its
principal value. )nterest is then paid at the maturity date$ with the e#act amount being the
di0erence between the principal value and the price paid for the bond
- 1loating-rate bonds are issues where the coupon rate resets periodically based on a formula.
- %he reference rate for most .oating-rate securities is an interest rate or and interest rate inde#.
%he mostly widely used reference rate throughout the world is the ,ondon )nterban& 20ered
-ate (,)32-).
- 3onds whose interest rate is tied to the rate of in.ation are referred to generically as lin&ers
- 4hile the coupon on .oating-rate bonds benchmar&ed o0 an interest rate benchmar& typically
rises as the benchmar& rises and falls as the benchmar& falls$ there are issues whose coupon
interest rate moves in the opposite direction from the change in interest rate-5inverse-.oating-
rate bonds.
- 6eferred-coupon bonds that let the issuer avoid using cash to ma&e interest payments for a
specifed number of years
- %here are three types of deferred-coupon structures' deferred interest bonds$ step-up bonds and
payment-in-&ind bonds
- Amorti/ation schedule' schedule of principal repayments
- Amorti/ing securities' securities will then have a schedule of periodic principal repayments
- 7onamorti/ing securities' securities that do not have a schedule of periodic principal repayment.
- 8all provision' this provision grants the issuer the right to retire the debt$ fully or partially$
before the scheduled maturity date.
- A convertible bond is an issue giving the bondholder the right to e#change the bond for a
specifed number of shares of common stoc&.
- %he frst si# characters identify the issuer ' the corporation$ government agency$ or municipality.
%he ne#t two characters identify whether the issue is debt or equity and the issuer of the issue.
%he last character is simply a chec& character that allows for accuracy chec&ing and is
sometimes truncated or ignored
- %he interest-rate ris&' the price of a typical bond will change in the opposite direction from a
change in interest rates' as interest rates rise$ the price of a bond will fall$ as interest rates fall$
the price of a bond will rise.
- -einvestment income o reinvestment ris&' %his ris& is that the prevailing mar&et interest rate at
which interim cash .ows can be reinvested will fall. -einvestment ris& is greater for longer
holding periods$ as wll as for bonds with large$ early cash .ows$ such as high-coupon bonds.
- 8all ris&' bonds may include a provision that allows the issuer to retire or call al or part of the
issue before the maturity date %he issuer usually retains this right in order to have .e#ibility to
refnance the bond in the future if the mar&et interest rate drops below the coupon rate
%hree disadvantages to call provisions (investor9s perspective)'
%he cash .ow pattern of a callable bond is not &nown with certainty
3ecause the issuer will call the bonds when interest rates have dropped$ the investor is
e#posed to reinvestment ris&
%he capital appreciation potential of a bond will be reduced because the price of a
callable bond may not rise much above the price at which the issuer will call the bond
- 8redit ris&' as the ris& that the issuer of a bond will fail to satisfy the terms of the obligation with
respect to the timely payment of interest and repayments of the amount borrowed.
8redit spread ris&' the ris& that a bond issue will decline due to an increase in the credit
spread
An in improvement in the credit quality of an issuer is rewarded with a better credit rating
as an upgrade.
A deterioration in the credit quality of an issue or issuer is penali/ed by the assignment of
an inferior credit rating referred to as a downgrade
- )n.ation ris& (purchasing-power ris&) arises because of the variation in the value of cash .ows
from a security due to in.ation
- (#change-rate ris&' 1rom the perspective of a !" investor$ a non-dollar-denominated bond has
un&nown !.". dollar cash .ows. %he dollar cash .ows are dependent on the e#change rate at
the time the payments are received.
- ,iquidity ris& depends on the ease with which an issue can be sold at or near its value. :ar&ing
to mar&et means that the portfolio manager must periodically determine the mar&et value of
each bond in the portfolio
- ;olatility ris&' the ris& that a change in volatility will a0ect the price of a bond adversely.
- -is& ris&' is defned as not &nowing what the ris& of a security is. %here are two ways to mitigate
or eliminate ris& ris&'
%o &eep up with the literature on the state-of-the-art methodologies for analy/ing securities.
%o avoid securities that are not clearly understood

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