BUS 424: Fixed Income Security Analysis

CHAPTER 1: INTRODUCTION
I.

Introduction
A bond is a debt instrument requiring the issuer to repay the investor the amt borrowed plus interest over a
specified period of time
Characteristics of a Bond:
Fixed date on which the principal is due (maturity date)
Amt of interest due (paid semiannually)

II.

Sectors of the US Bond Market

A. Treasury sector securities issued by the US govt (e.g., T-bills, Treasury notes, Treasury bonds)
o Plays key role in valuation and determination of interest rates globally (risk-free rate)
B. Agency sector securities issued by federally-related institution and govt-sponsored enterprises (GSEs)
o Not backed by any collateral referred to as agency debenture securities
o Smallest sector
C. Municipal sector state and local govts raise funds
o 2 sectors:
Non-taxable largest sector
Taxable increased in 2009 with Build America Bonds
o 2 structures:
Tax-backed/general obligation bonds
Revenue bonds
D. Corporate sector securities issued by US corporations, and those issued in US by non-US corporations
o 2 sectors:
Investment grade
Non-investment grade, aka, junk debt
E. Asset-backed securities sector a corporation will pool loans/receivables and use the pool of assets as
collateral for the issuance of a security
F. Mortgage sector the issued securities are backed by mortgage loans
o 2 sectors:
Residential mortgage sector
Commercial mortgage sector

III.

Overview of Bond Features

A. Type of Issuer 3 main issuers: fed govt+agencies, municipal govts, and corporations
B. Term to maturity the term is important because 1) the yield is dependent on it 2) its volatility is
dependent on it (longer-term = more volatility), and 3) indicates over what period holder can expect to
receive coupon pmts and how long until principal is repaid
o Short-term = 1-5 yrs
o Intermediate-term = 5-12 yrs
o Long-term = 12+ yrs
C. Principal & coupon rate principal the amount the issuer agrees to repay the holder at maturity;
coupon rate the interest rate the issuer agrees to pay each year
o Zero-coupon bond holder realizes interest by buying the bond at substantially below
par/principal value
o Floating-rate bond the coupon rate resets periodically based on a formula:

reference rate+ quoted margin

The most widely used reference rate is LIBOR

D. Amortization feature the principal amt is repaid over the life of the loan
E. Embedded options:
1. Call provision gives issuer the right to retire the debt before the scheduled maturity date, generally
activated if market interest rates decline
2. Put provision grants bondholder right to sell the issue back to the issuer at par value, generally
activated if market interest rates rise
3. Convertible bond gives bondholder the right to exchange the bond for a specified number of shares
of common stock
IV.

Risks associated with Investing in Bonds

A. Interest rate risk the risk of an increase in market interest rates, thereby incurring a capital loss as the
price falls
B. Reinvestment risk variability in the reinvestment rate of a given strategy because of changes in market
interest rates
o Should be noted that interest rate risk and reinvestment risk have offsetting effects
C. Call risk 3 disadvantages to call provisions:
1. The cash flow pattern is not known with certainty
2. Because the issuer will call bonds when interest rates have dropped, the investor is exposed to
reinvestment risk (i.e., the investor will have to reinvest proceeds when the bond is called at relatively
lower interest rates)
3. Capital appreciation of the bond is reduced because the price of the callable bond might not rise
much above the price at which the issuer will call the bond
D. Credit risk risk that the issuer of the bond will fail to satisfy the terms of the obligation with respect to the
timely payment of interest and repayment of the amount borrowed (i.e., default risk)
E. Inflation risk
F. Exchange-rate risk
G. Liquidity risk
o Marking to market the portfolio mgr must periodically determine the market value of each bond
in the portfolio, and in order to get prices reflective of market value, the bonds must trade with
enough frequency
H. Volatility risk risk that a change in volatility will affect the price of a bond adversely
I.

Risk risk defined as not knowing what the risk of a security is (i.e., we didnt know this could happen)