Chapter 12 Supplement A
Fixed-Income Securities
Chapter 12 Supplement A: Fixed-Income Securities
2
Basic Concepts of Lending
Securities
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Fixed-income securities are securities with
specified payment dates and amounts,
primarily bonds
Lending securities are securities where an
investor of bonds lends funds to the issuer in
exchange for a promise to a stream of
periodic interest payments and a repayment
of the loaned principal at the maturity of the
bond
Chapter 12 Supplement A: Fixed-Income Securities
 2005 Kaplan Financial
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Basic Concepts of Lending
Securities (cont.)
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Coupon payments are interest payments paid
to the bondholder on a semiannual basis and
based on a percentage of the face value, or
par value, of the bond
Maturity is the period of time through which
the issuer has control over the bond proceeds
and the period of time it must continue to
pay coupon payments
Chapter 12 Supplement A: Fixed-Income Securities
 2005 Kaplan Financial
4
Valuation of Fixed-Income
Securities
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The value of a bond is equal to the
present value of the expected future
cash flows
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Cash flows
Discount rate
Zero-coupon bonds
Chapter 12 Supplement A: Fixed-Income Securities
 2005 Kaplan Financial
5
Measures of Return
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Current Yield = Annual Coupon
Market Price
Yield to Maturity = IRR
Yield to Call
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Maturity
Call Price
Chapter 12 Supplement A: Fixed-Income Securities
 2005 Kaplan Financial
6
Corporate Returns vs. Municipal
Returns
Tax-exempt yield
Pretax yield =
1 – marginal tax rate
Chapter 12 Supplement A: Fixed-Income Securities
 2005 Kaplan Financial
7
Types of Fixed-Income
Securities
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The Money Market
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Treasury Bills
Commercial Paper
Certificates of Deposit
Banker’s Acceptances
Repurchase Agreements
Treasury Notes and Bonds
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Inflation indexed
STRIPS
Chapter 12 Supplement A: Fixed-Income Securities
 2005 Kaplan Financial
8
Types of Fixed-Income
Securities (cont.)
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U.S. Savings Bonds
Federal Agency Securities
Municipal Bonds
Corporate Bonds
Convertible Bonds
Mortgage-Backed Securities and
Collateralized Mortgage Obligations
Chapter 12 Supplement A: Fixed-Income Securities
 2005 Kaplan Financial
9
Rating Agencies
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Standard & Poor’s
Moody’s
Chapter 12 Supplement A: Fixed-Income Securities
 2005 Kaplan Financial
10
Standard Credit Rating System
Bonds
Standard & Poor’s
Moody’s
Investment Grade:
q
High Grade
q
Medium Grade
AAA - AA
Aaa - Aa
A - BBB
A - Baa
BB - B
Ba - B
CCC - D
Caa - C
Non-Investment Grade:
q
Speculative
q
Default
Overall Range
Chapter 12 Supplement A: Fixed-Income Securities
AAA - D
Aaa - C
 2005 Kaplan Financial
11
Risks of Fixed-Income
Securities
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Systematic Risks
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Interest Rate Risk
Reinvestment Risk
Purchasing Power Risk
Exchange Rate Risk
Unsystematic Risks
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Default (Credit) Risk
Call Risk
Liquidity Risk
Chapter 12 Supplement A: Fixed-Income Securities
 2005 Kaplan Financial
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Volatility of Fixed-Income
Securities
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Two key factors that influence volatility are:
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Coupon rate – the volatility in price for a bond is
inversely related to the bond’s coupon payment
when interest rates change
Maturity – bonds with longer terms are subject to
more volatility with changing interest rates than
bonds with shorter terms
Chapter 12 Supplement A: Fixed-Income Securities
 2005 Kaplan Financial
13
Term Structure of Interest
Rates
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Yield Curves
Yield Curve Theories
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Pure Expectations Theory
Liquidity Preference Theory
Preferred Habitat Theory
Market Segmentation Theory
Chapter 12 Supplement A: Fixed-Income Securities
 2005 Kaplan Financial
14
Duration & Immunization
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Duration – a concept developed by Fred
Macaulay in 1938 that provides a timeweighted measure of a security’s cash
flows in terms of payback
Immunization – the concept of
minimizing the impact of changes in
interest rates on the value of
investments
Chapter 12 Supplement A: Fixed-Income Securities
 2005 Kaplan Financial
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Uses for Duration
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Measuring a bond’s volatility
Estimating the change in the price of a
bond based on changes in interest rates
Immunizing a bond or bond portfolio
against interest rate risk
Chapter 12 Supplement A: Fixed-Income Securities
 2005 Kaplan Financial
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Traditional Methods of
Immunizing Bond Portfolios
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The Ladder Strategy
The Barbell Strategy
The Bullet Strategy
Chapter 12 Supplement A: Fixed-Income Securities
 2005 Kaplan Financial