week 23 Fixed-Income Securities Notes

Fixed-Income Securities

• Bonds are publicly traded, long-term debt securities often called "fixed income securities" due to fixed payments.

Why Invest in Bonds?

• Provide current income and potential capital gains.

• Interest rate behavior significantly influences bond returns.

  • Interest rates ⬆️, bond prices ⬇️.

  • Interest rates ⬇️, bond prices ⬆️.

• Corporate bonds have higher rates than government bonds due to higher risk; the difference is the yield spread or credit spread.

• Compared to stocks, bonds:

  • Offer lower risk.

  • Provide high current income.

  • Offer diversification and portfolio stability.

Exposure to Risk

• Interest Rate Risk: Changes in interest rates affect bond value.

• Purchasing Power Risk: Yields lag behind inflation.

• Business/Financial Risk: Issuer defaults on payments.

• Liquidity Risk: Difficulty selling at a reasonable price.

• Call Risk: Bond is retired before maturity.

Essential Features of a Bond

• Bond Interest and Principal

  • Coupon: Annual interest income.

  • Principal (par value; face value): Capital repaid at maturity.

  • Coupon rate: Interest payment as a percentage of par value.

  • Current Yield: Annual coupon divided by current market price.

  • Current\ Yield = {Annual\ Coupon \over Bond's\ Market\ Price}

• Maturity Date

  • Maturity date: Date principal is repaid.

  • Term to maturity: Time remaining until maturity.

  • Term bond: Single maturity date for all bonds in the issue.

  • Serial bond: Series of bonds with different maturity dates.

  • Note: Debt security with a maturity of 2-10 years.

• Principles of Bond Price Behavior

  • Price is a function of coupon, maturity, and market interest rates.

  • Premium bond: Sells above par value when market rates drop below the coupon rate.

  • Discount bond: Sells below par value when market rates are above the coupon rate.

  • Longer maturities have greater price volatility.

• Quoting Bond Prices

  • Expressed as a percentage of par.

  • Corporate and municipal bonds in decimals (e.g., 87.562 = 875.62 for 1,000 par value).

  • Treasury bonds in thirty-seconds of a point (e.g., 94.16 = 94.5\%, or $945.00 for 1,000 par).

• Call Features

  • Call feature: Allows issuer to retire the bond before maturity under certain conditions.

  • Freely callable: Can be retired anytime.

  • Noncallable: Cannot be retired before maturity.

  • Deferred call: Cannot be called until after a certain period.

  • Call premium: Amount added to par value upon call.

  • Call price: Par value plus call premium.

• Sinking Funds

  • Sinking fund: How the issuer will pay off the bond over time, applies to term bonds.

  • Usually begins 1-5 years after issue, with annual payments until most of the issue is paid off.

• Secured or Unsecured Debt

  • Senior bonds: Secured by a legal claim or specific property.

    • Mortgage bonds: Secured by real estate.

    • Collateral trust bonds: Secured by financial assets held in trust.

    • Equipment trust certificates: Secured by equipment.

  • Junior bonds: Unsecured debt, backed by the issuer's promise.

    • Debenture: Totally unsecured bond.

    • Income bonds: Interest paid only after a certain income is earned.