Chapter 3- Fixed Income Securities

Learning Objectives

Explain who buys bonds, Examine the concepts of

Introduce what is fixed
who issues bonds, and yield, coupon, and day
Income and what is a bond count
the bond market

Discuss yield curve and Price a bond and understand the

credit spread relationship between price and yield
What is Fixed Income

Fixed income is a broad class of financial Common fixed income investment products:

products that comprises any investment

where the investor earns a set payment
Bonds
on a pre- determined schedule.

Preferred securities
Bonds

 A bond is the simplest form of fixed income.

 Is a publicly traded long-term debt securities, whereby the issuer agrees
to pay a fixed amount of interest over a specified period of time and to
repay a fixed amount of principal at maturity
 Like shares, bonds can potentially provide investors with two kinds of
income: (1) interest(coupon), and (2) capital gains/losses.
 Bond prices do rise and fall as market interest rates change.
 interest rates and bond prices move in opposite directions.
 When interest rates rise, bond prices fall, and when rates drop, bond
prices move up
Cash flow from the Bonds

Principal Coupon

The amount that the issuer The set interest paid in a pre-
owes to the investor; paid at determined schedule (e.g.
maturity annually or semi-annually)

Par value:
$100 for calculation Government bonds:
purposes
Minimum $100, €100 or £100
Face value / nominal value: Corporate bonds:
the actual investment amount
Minimum $5,000; $100,000 for higher risk
bonds
 Bond Description

$1000

The Great Western Petroleum Company

ONE THOUSAND DOLLARS Face value / nominal value

MATURITY DATE
30 September 1970 Maturity date
$1000
TGWPC

$50 $50 $50 $50 $50 Coupon (paid annually)

$50 $50 $50 $50 $50

Corporate Finance
Institute®
Who Invests in Bonds(Investor) and why?

Central banks / governments

Reasons to invest in bonds: Who buys bonds ?
Assets managers

Institutional Insurance companies

Liquidity
investors
Pension funds

Different risk profile Hedge funds

relative to equities
Corporates / family
offices
Easy for investors to
match their liabilities Individuals
Individual
investors
Private banks /
brokers
Who Issues Bonds(seller)
 Bonds are essentially loans. Issuers are entities that are looking for
financing.
 The bond issuers are:
a. National governments: Borrow money when they have a budget deficit or to finance social
mandates

b. Corporate: Raise money in bond markets to fund operations and growth

c. Region governments and municipalities: Raise money to fund projects or when they have
budget deficits

d. Supranational and agencies(Yankee bonds ): Examples include the World Bank and the Asian
Development Bank
 Types of bond
 There are two types of bonds based on the issuer’s plans to mature
the debt:
 Term Bond is a bond that has a single maturity date
 Serial Bond is a bond that has a series of different maturity dates
Risks of Investing in Bonds

 The risks of investing in bonds are similar to time value of money

(TVM) concept.

Inflation Interest Rate Risk Default risk FX and capital

control risks

Liquidity Risk
Bond Market

The bond market is one of the largest Example: 2018 US bond market
financial markets in the world.
• Bond issued: $2.2 trillion

Global equity market (2018): • Equity issued: $221 billion

$74.7 trillion • Bond traded per day: $827 billion
• Stock traded per day: $270 billion
Global bond market (2018):
$102.8 trillion

Trades in all Trades 24/5 across different

major currencies financial centers
 The Life Cycle of a Bond
Purchase at issuance Purchase in the secondary market
(primary market)
Premium Discount

Par value Bond price

Bond
Year 1 Year 2 Year 3 Year 4 Year 5 (Maturity)
issuance

Coupon Coupon Coupon Coupon Coupon & principal

• The par value will not change during the bond The bond price may fluctuate based on:
life cycle. • Inflation
• The bond price should equal the par value at • Market yield(market interest rate)
issuance and at maturity. • Issuer and/or sector fundamentals
Coupon(interest) on Bond
Coupon and Accrued Interest

Coupon: the set interest of a bond paid in a pre-determined schedule.

Accrued interest: accumulated interest that is unpaid.

Accrued interest Coupon payment

Year 1 Year 2 Year 3

Day Count Basics

How is accrued interest calculated?

Day count convention: affects how coupons are calculated and paid.

There are three Day count market conventions:

Actual/Actual 30/360 Actual/365

 Actual/Actual
Interest accrues based on the actual number of days since the last coupon payment over the
actual number of total days between coupon periods.

Example: Coupon: Coupon:

• Face value: $100
• Maturity: December 31
Jan 1 Mar 15 Jun 30 Sep 15 Dec 31
• Annual interest: 5%
74 Days 77 Days 101 Days
• Frequency: Semi-annually
181 Days 184 Days

• Compute Accrued interest

on Mar 15 and Sep 15 using Accrued interest on Mar 15 Accrued interest on Sep 15
actual/actual day count.
74 = $1.02 77 = $1.05
=100 x 0.025 x 181 =100 x 0.025 x
184
 30/360
30/360 day count assumes:

• Every month has 30 days.

30 Days 1/12 th of the coupon evenly
• Every year has 360 days.
360 Days

Example: Jan 1 Mar 15 Jun 30 Sep 15 Dec 31

75 Days 75 Days
• Face value: $100
180 Days 180 Days
• Maturity: December 31

• Annual interest: 5%

• Frequency: Semi-annually Coupon = 100 x 5% = $2.5

2
Accrued interest on Mar 15 Accrued interest on Sep 15
• Compute Accrued interest 75 75
on Mar 15 and Sep 15 =2.5 x = $1.04 =2.5 x = $1.04
180 180
using 30/360 day count
 Actual/365
Actual/365: A hybrid of ACT/ACT and 30/360

• The two semiannual (6months) have equal number of days

• Each half of the year is 182.5 days.
• The daily rate of accrual is constant between coupon periods.

Jan 1 Mar 15 Jun 30 Sep 15 Dec 31

Example:
74 Days 77 Days
• Face value: $100
182.5 Days 182.5 Days
• Maturity: December 31

• Annual interest: 5%
Coupon = 100 x 5% = $2.5
• Frequency: Semi-annually 2
Accrued interest on Mar 15 Accrued interest on Sep 15
74 77
=2.5 x = $1.01 =2.5 x = $1.05
182.5 182.5
Credit Rating Agencies
Credit Rating
Is the evaluation of the creditworthiness of bonds issued by companies and governments
The rating is made Commercial rating companies that assess the overall credit quality of
an issuer
The rates shows the issuer's financial ability to make interest payments and repay the bond in full at maturity
 The rating companies are:

Independent Unbiased Professional

Credit Rating

Moody’s S&P/ Fitch Definition Example

• Prime JNJ Aaa/AAA
Aaa AAA
• Maximum safety MSFT Aaa/AAA
Aa1 AA+
• High grade AAPL Aa1/AA+
Aa2 AA
• High quality PG Aa3/AA-
Aa3 AA- Investment grade
A1 A+
TENCNT A1/A+ (Rating of BBB- or
A2 A • Upper medium grade
JPM A2/A
A3 A- higher)
Baa1 BBB+
WBA Baa2/BBB
Baa2 BBB • Lower medium grade
GM Baa3/BBB-
Baa3 BBB-
Ba1 BB+
• Non-investment grade SOFTBK Ba1/BB+
Ba2 BB
• Speculative TMUS Ba2/BB
Ba3 BB-
B1 B+
TTMTIN B1/B+
B2 B • Highly speculative High yield or junk
YUM B1/B+
B3 B-
Caa1 CCC+ (Rating of BB+ or
JCREWB Caa2/CCC lower)
Caa2 CCC • Substantial risk
JCP Caa3/CCC-
Caa3 CCC-
- D

Bonds with a rating of BBB- (on the Standard & Poor's and Fitch scale) or Baa3 (on Moody's) or better are considered "investment-
grade." Bonds with lower ratings are considered "speculative" and often referred to as "high-yield" or "junk" bonds.
Yield(interest income) Curves and
Credit Spread
Yield Curves

yield curve is a graphical representation at a

point of time of the yields for a range of
Yield (%)

maturities.

•The yield curve DOES NOT show change in yields

over time from same security.
It constructed by observing and plotting bond
yields trading in the secondary market of
different maturities.

Maturity (years) Yield curves can plot bonds that are

from:
The upwards slope means that long-term • the same issuer (the security are of d/t
maturity)
investments pay a higher return than
• the same group of issuers by industry
shorter- term investments.
• the same credit rating (rating yield curve)
 Credit Spreads( risk premium)

• The higher the level of credit

risk, the greater the cost of
borrowing.
B rated
Yield (%)

corporates

AA rated corporates

AAA rated corporates

Government treasury
curve

Credit
spread

Maturity (years)

Corporate Finance
Institute®
 Bond Prices and Yields

CCoorrppoorartaeteFiFniannacnecIensItnitsuttietu®teⓇ
 Bond Valuation
0 1 2 n
r ...

Value CF1 CF2 CFn

CF1 CF2 CFn

Value    ... 
(1  r)1 (1  r) 2 (1  r) n
Bond Price

• A Bond is made up of a series of periodic interest

payments and a principal repayment at maturity.
• The bond price is the discounted value of all the PV = FV x 1 + i -n
P
future cash flows generated by a bond.:
-n
PV = R(1-(1+I) - 1)
Bond Price = The present value of all coupon C i
payments
+
The present value of the par value at • PV = Present value of principal
maturity P
• PV = Present value of coupons
C
Example:
• FV: Future value/par value of the bond
• Bond: 3 years
• Par value: $100 • i: Market rate (yield-to-maturity)
• Coupon: 5% ($5 per year) • n: total number of periods
• Yield-to-maturity( market rate) 4%
• Compute price of bond
 Bond Price

Example 1:
Year Future cash flows Present values
• Bond: 3 years
• Par value: $100 1 5 4.81
• Coupon: 5% ($5 per year)
• Yield-to-maturity( market rate) 4% 2 5 4.62

Price =100(1.04) -3 + 5(1-(1.04) -3 3 105 93.34

04 3
.04
= 88.89 + 13.87 )
Price 102.78

= 102.77 Yield-to-
maturity Price

Corporate Finance
Institute®
 Bond Price

Example 2:
Year Future cash flows Present values
• Bond: 3 years
• Par value: $100 1 5 4.72
• Coupon: 5% ($5 per year)
• Yield-to-maturity( market rate) 6% 2 5 4.45

Price =100(1.06) -3 + 5(1-(1.06) -3 3 105 88.16

04 3
.06
= 83.96 + 13.36 )
Price 97.33

= 97.33 Yield-to-
maturity Price

Corporate Finance
Institute®
 Bond Price

Example 3:
Year Future cash flows Present values
• Bond: 3 years
• Par value: $100 1 5 4.76
• Coupon: 5% ($5 per year)
• Yield-to-maturity( market rate) 5% 2 5 4.54

Price =100(1.05) -3 + 5(1-(1.05) -3 3 105 90.70

04 3
.05
= 86.38 + 13.62 )
Price 100

= $100 Yield-to-
maturity Price

Corporate Finance
Institute®
 Bond Price and Yield Three-year bond with a 5% coupon rate

 Interest rates(yield) and bond

prices move in opposite directions.
 When interest rates rise, bond
prices fall, and when rates drop, YTM( market rate) Price
bond prices move up
5% 100.00

.When yield( market rate) is equal to

coupon rate, the price will be par value

Corporate Finance
Institute®
 Bond Price and Yield

Three-year bond with a 5% coupon rate

Yield Price

6% 97.33

As bond yields increase, prices will fall.

When yield( market rate) is greater

than coupon rate, the price will be less
than par value(discount)

Corporate Finance
Institute®
 Bond Price and Yield

Three-year bond with a 5% coupon rate

Yield Price

4% 102.53

As bond yields decrease, prices will rise.

When yield( market rate) is less than

coupon rate, the price will be more
than par value(premium ) If the coupon rate > yield, the bond will sell for a premium price .
 Summary:- Relationship Between Bond Prices and Yields

Bond prices are inversely related to interest rates (or yields).

A bond sells at par only if its coupon rate equals the required yield.
A bond sells at a premium if its coupon rate is above the required yield.
A bond sells at a discount if its coupon rate is below the required yield.
 Measures of Yield rate( market interest rate)

Is market interest rate computed when price of the bond is given

market interest rate is also called : Yield to maturity

Yield-to-maturity

Total anticipated return if the

bond is held to maturity

Corporate Finance
Institute®
 Yield-to-Maturity (YTM) when bond price is given

Yield-to-maturity: Market interest rate or the internal rate of return (IRR) of all the cash flows
from the bond.

Example: 5 5 5 5 100 + 5
105 = 1+ 2+ 3+ +
1+YTM 1+YTM 1+YTM 1+YTM 4 1+YTM 5
• Face value: $100
• Term to maturity: 5 years

• Coupon rate: 5%, paid annually Yield-to-maturity = 3.88%

• Current price: $105

Approximated YTM= $5 + (100-105)
5
100+105
2
= 5+(-1) = 4/102.5= 3.9%
102.5
Nominal vs. Effective Interest rate(Yields)

Nominal rate Effective rate

•Coupon interest rate Without How much interest would be earned if the
compounding(without re-investment) interest was compounding(reinvested at the
•Considers total income from the bond same rate by the bond holder)
only and doesn't consider income from Assumes income from re-investment of
re-investment interest collected as well.
 Is greater than nominal rate
effective rate =(1+ nominal rate)f −1
f
Where= frequency of compounding per year.
 Nominal vs. Effective Yields

Example 1: Example 2:
• Face value: $100 • Face value: $100

• Nominal interest: • Nominal interest: 5%

5%
• Compound: Semi-annually
• Compound: Annually
Total return in 6 month = 100 x (1+2.5%) = $102.5
Total return = 100 x (1+5%) = $105
Total return in 1 year = 102.5 x (1+2.5%) = $105.0625
Effective yield = 5% or
Effective yield = 5.0625%

effective rate =(1+ nominal rate)f −1

effective rate =(1+ nominal rate)f −1 f
f = (1+5%/2)2-1
= (1+5%/1) 1 -1 = 5.0625%
= 5% Effective rate is more because of income from re-
investment of the first six months income
Nominal vs. Real Yields

Nominal yields

• Include inflation expectations.

• Not always an accurate measure of the current purchasing
power.

Real yields = Nominal yields –Inflation

• Expected inflation (forward-

looking)
• Actual inflation (rear-looking)
Example:

• Nominal yield:
5%
Real yields = 5% - 3 % = 2%
• Inflation: 3%
End