ch 14: fixed-income securities Securities

Fixed-Income Securities

Bonds: Imagine a bond is like a special "I owe you" note. People (issuers) need money to do things, so they borrow it from others (bondholders). In return, they promise to pay back the original amount (principal) later and give tiny, fixed "treats" (interest) every year until then.
- Issuer = borrower; Bondholders = lenders.
- Income types: You can make money from bonds in two ways:
- Current income: The regular "treats" you get from the issuer.
- Capital gains: If you sell your "I owe you" note for more money than you paid for it to someone else.
Interest Rate Influence: Think of interest rates as how big the "treats" are on new "I owe you" notes being given out today.
- Prices fall when interest rates rise: If new "I owe you" notes are offering bigger treats, your old note (with smaller treats) becomes less desirable. So, if you try to sell your old note, its price will go down.
- Prices rise when interest rates drop: If new "I owe you" notes are offering smaller treats, your old note (with bigger treats) becomes more popular. So, if you try to sell your old note, its price will go up. Smart investors try to guess when rates will drop to buy bonds and sell them for a profit.
Corporate vs. Government Bonds:
- Corporate yields > Government yields due to higher risk: Lending money to a company (corporate bond) is often a bit riskier than lending to the government (government bond). Because of this extra risk, companies usually have to offer a bigger "treat" to bondholders to convince them to lend money.
- Yield spread = difference between corporate and government yields: This is just the extra "treat" amount a company has to offer compared to what the government offers.
Bonds vs. Stocks: Bonds are generally like a steady, predictable friend that gives you regular, smaller treats and ensures you get your money back. Stocks are like an exciting but sometimes unpredictable friend where you could get bigger treats or less, and getting your original money back isn't guaranteed. Bonds provide:
- Lower returns but with lower risk
- Current income (those regular treats!)
- Diversification (spreading out your money)
- Portfolio stability (they tend to not jump up and down as much as stocks).
Major Risks in Bonds: Even though bonds are often safer, they still have some risks:
- Interest Rate Risk: The risk that if new "treats" on "I owe you" notes become much bigger, your old bond—with its smaller, fixed treats—becomes less valuable if you try to sell it.
- Purchasing Power Risk: Imagine your 5 annual treat could buy 5 candies last year, but this year candy prices went up, and now it only buys 3 candies. This is the risk that inflation (prices going up) makes your bond's fixed payments worth less in terms of what they can buy.
- Default Risk: This is the scariest risk! It's the chance that the issuer (the one who borrowed money) can't make their promised payments or pay you back at all. For example, if a company goes out of business.
- Liquidity Risk: This is the difficulty you might have selling your "I owe you" note quickly at a fair price. Sometimes, no one wants to buy your specific note, or you have to sell it for much less than you wanted.
- Call Risk: Imagine you lend money to your friend, and they promise to give you a treat every year for 10 years. But if your friend finds a way to borrow money cheaper (like from another friend), they might decide to pay you back early. This is call risk – the issuer pays off the bond before its maturity, and you stop getting your regular treats.
Features of Bonds:
- Coupon: This is the annual interest payment you receive. For a bond with a 5\% coupon rate and a face value of 1,000, the annual coupon payment would be 5\% \times 1,000 = $50.
- Principal (Par Value/Face Value): This is the original amount of money you lend and the amount the issuer promises to pay back at maturity. It's usually 1,000.
- Current Yield: This tells you how much income your bond is generating right now, based on its current market price.
- Equation: \text{Current Yield} = \frac{\text{Annual Coupon Payment}}{\text{Current Market Price}}
- Example: If your bond pays a 50 annual treat and you bought it for 950, your current yield is 50 / 950 \approx 0.0526 or 5.26\%.
- Yield to Maturity (YTM): This is the most crucial measure for bonds. It's the total annual return you can expect if you buy the bond today and hold it until it matures, taking into account all future coupon payments and any gain or loss from the principal repayment. It's like the average annual "treat" rate over the bond's entire life.
- Approximate Equation: \text{YTM} \approx \frac{\text{Coupon Payment} + \frac{\text{Face Value} - \text{Market Price}}{\text{Years to Maturity}}}{\frac{\text{Face Value} + \text{Market Price}}{2}}
- This formula is complex because it considers the time value of money, meaning future treats are worth less than treats today.
- Bond Pricing: The price of a bond is essentially the current value of all the future "treats" (coupon payments) and the final principal repayment, all discounted by the market's current interest rates.
- General Bond Price Equation: P = \sum_{t=1}^{N} \frac{C}{(1+r)^t} + \frac{FV}{(1+r)^N} Where:
  - P = Current market price of the bond
  - C = Annual coupon payment
  - FV = Face value (par value) of the bond
  - r = Market interest rate (or yield to maturity)
  - N = Number of years to maturity
- Premium bond: A bond whose price is higher than its par value (e.g., 1,050 for a 1,000 bond). This happens when the bond's fixed coupon rate offers bigger "treats" than what new bonds in the market are currently offering.
- Discount bond: A bond whose price is lower than its par value (e.g., 950 for a 1,000 bond). This occurs when the bond's fixed coupon rate offers smaller "treats" compared to what new bonds are offering, or if market interest rates have risen since the bond was issued.