FINC6014
Fixed Income Securities
Presented by
Dr James Cummings
Discipline of Finance
The University of Sydney
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Welcome to FINC6014
Lecturer
Dr James Cummings
– Office: Codrington Building H69 Room 420
– Consultation hour: Friday, 10:00-11:00 am
– Email: james.cummings@sydney.edu.au
The University of Sydney
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Welcome to FINC6014
Tutors
Mr Salaar Bin Tassadaq
Mr Jun Wu (Andoreal) Chen
Dr Adam Corbett
Dr Thanh Son (Alex) Luong
Mr Qian (Clement) Peng
Mr Ahasan Sarkar
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Assessment
Mid-semester test
Due: Weeks 7-8
25%
Mid-semester test
50%
Group assignment
Due: 20 October 2023
Group assignment
Final exam
25%
Final exam
Formal exam period
Weightings
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Learning activities
Preparation for class
– Readings
– Homework problems
Required text
– Fabozzi, F.J. and Fabozzi, F.A. (2021), Bond Markets, Analysis, and
Strategies, 10th edition, MIT Press
Online support
– Canvas (https://canvas.sydney.edu.au)
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Week 1
Introduction
Presented by
Dr James Cummings
Discipline of Finance
The University of Sydney
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Learning Objectives
After studying this topic, you will understand
– the fundamental features of bonds
– the types of issuers
– the importance of the term to maturity of a bond
– floating-rate and inverse-floating-rate securities
– what is meant by a bond with an embedded option and the effect of this
option on cash flow
– the various types of embedded options
– convertible bonds
– the types of risks faced by fixed-income investors
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Sectors of the U.S. Bond Market
1.
2.
3.
4.
5.
6.
Treasury sector – securities issued by the U.S. government
Agency sector – securities issued by federally related institutions and
government-sponsored enterprises
Municipal sector – securities issued by state and local governments
Corporate sector – securities issued in the U.S. by U.S. corporations and
foreign corporations
Asset-backed sector – securities backed by a pool of assets
Mortgage sector – securities backed by mortgage loans
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Sectors of the U.S. Bond Market
– Bond investors include retail investors and institutional investors.
– Bond investors have an opportunity to invest in a pooled investment vehicle
in lieu of constructing their own portfolio to obtain exposure to the broad
bond market and/or specific sectors of the bond market.
– For retail investors, the benefits of investing in pooled funds rather than the
direct purchase of individual bonds to create a portfolio are
1. better diversification in obtaining the desired exposure
2. better liquidity, and
3. professional management.
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Overview of Bond Features
1.
2.
3.
4.
5.
6.
Type of Issuer
Term to Maturity
Principal and Coupon Rate
Amortisation Feature
Embedded Options
Describing a Bond Issue
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Overview of Bond Features
1.
2.
Type of Issuer – there are three issuers of bonds
– the federal government and its agencies
– municipal governments
– corporations (domestic and foreign)
Term to Maturity – refers to the date that the issuer will redeem the bond
by paying the principal
– There may be provisions in the indenture that allow either the issuer or
bondholder to alter a bond’s term to maturity.
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Overview of Bond Features
3.
Principal and Coupon Rate
– Principal Value – amount that the issuer agrees to repay the
bondholder at the maturity date
– Zero-Coupon Bond – interest is paid at the maturity with the exact
amount being the difference between the principal value and the price
paid for the bond
– Coupon Rate – the nominal or interest rate that the issuer agrees to pay
each year; the annual amount of the interest payment is called the
coupon
– Floating-rate bonds – issues where the coupon rate resets periodically
(the coupon reset date) based on the coupon reset formula given by:
reference rate + quoted margin
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Overview of Bond Features
3.
Principal and Coupon Rate (continued)
– LIBOR (London Interbank Offered Rate) – rate at which the highest
credit quality banks borrow from each other in the London interbank
market. The rate is reported in 10 currencies
– Linkers – bonds whose interest rate is tied to the rate of inflation
– Inverse-floating-rate bonds – coupon interest rate moves in the
opposite direction from the change in interest rates
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Overview of Bond Features
4.
Amortisation Feature – the principal repayment of a bond issue can call
for either the total principal to be repaid at maturity or the principal
repaid over the life of the bond
– In the latter case, there is a schedule of principal repayments called an
amortisation schedule.
– For amortising securities, a measure called the weighted average life or
simply average life of a security is computed.
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Overview of Bond Features
5.
Embedded Options – it is common for a bond issue to include a provision
in the indenture that gives either the bondholder and/or the issuer an
option
– Call provision - grants the issuer the right to retire the debt, fully or
partially, before the scheduled maturity date
– Put provision - gives the bondholder the right to sell the issue back to the
issuer at par value on designated dates
– Convertible bond - provides the bondholder the right to exchange the
bond for shares of common stock
– Exchangeable bond - allows the bondholder to exchange the issue for a
specified number of common stock shares of a corporation different
from the issuer of the bond
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Overview of Bond Features
6.
Describing a Bond Issue – most securities are identified by a ninecharacter CUSIP number
– CUSIP stands for Committee on Uniform Security Identification
Procedures
– First six characters of CUSIP identify the issuer
– The next two characters identify whether the issue is debt or equity and
the issuer of the issue
– The last character is a check character that allows for accuracy checking
– The CUSIP International Numbering System (CINS) identifies foreign
securities and includes 12 characters
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Risks Associated with Investing in Bonds
1.
2.
3.
4.
5.
6.
7.
8.
9.
Interest-rate Risk
Reinvestment Risk
Call Risk
Credit Risk
Inflation Risk
Exchange Rate Risk
Liquidity Risk
Volatility Risk
Risk Risk
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Risks Associated with Investing in Bonds
1.
Interest-Rate Risk
– Interest-rate risk or market risk refers to an investor having to sell a bond
prior to the maturity date.
– An increase in interest rates will mean the realisation of a capital loss
because the bond sells below the purchase price.
– Interest-rate risk is by far the major risk faced by an investor in the
bond market.
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Risks Associated with Investing in Bonds
2.
Reinvestment Risk
– Reinvestment risk is the risk that the interest rate at which interim cash
flows can be reinvested will fall.
– Reinvestment risk is greater for longer holding periods, as well as for
bonds with large, early, cash flows, such as high-coupon bonds.
– It should be noted that interest-rate risk and reinvestment risk have
offsetting effects.
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Risks Associated with Investing in Bonds
3.
Call Risk
– Call risk is the risk that a callable bond will be called when interest
rates fall.
– Many bonds include a provision that allows the issuer to retire or ‘call’
all or part of the issue before the maturity date; for investors, there are
three disadvantages to call provisions:
a) cash flow pattern cannot be known with certainty
b) investor is exposed to reinvestment risk
c) bond’s capital appreciation potential will be reduced
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Risks Associated with Investing in Bonds
4.
Credit Risk
– Credit risk is the default risk that the bond issuer will fail to satisfy the
terms of the obligation with respect to the timely payment of interest
and principal.
– Credit spread is the part of the risk premium or spread attributable to
default risk.
– Credit spread risk is the risk that a bond price will decline due to an
increase in the credit spread.
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Risks Associated with Investing in Bonds
5.
Inflation Risk
– Inflation risk arises because of the variation in the value of cash flows
from a security due to declines in purchasing power.
– If investors purchase a bond on which they can realise a coupon rate of
7% but the rate of inflation is 8%, the purchasing power of the cash
flow falls.
– For all but floating-rate bonds, an investor is exposed to inflation risk
because the interest rate the issuer promises to make is fixed for the life
of the issue.
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Risks Associated with Investing in Bonds
6.
Exchange-Rate Risk
– Exchange-rate risk refers to the unexpected change in one currency
compared to another currency.
• From the perspective of a U.S. investor, a non-dollar-denominated
bond (i.e., a bond whose payments occur in a foreign currency) has
unknown U.S. dollar cash flows.
• The dollar cash flows are dependent on the exchange rate at the
time the payments are received.
• The risk of the exchange rate causing smaller cash flows is the
exchange-rate risk or currency risk.
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Risks Associated with Investing in Bonds
7.
Liquidity Risk
– Liquidity risk or marketability risk depends on the ease with which an
issue can be sold at or near its value.
• The primary measure of liquidity is the size of the spread between
the bid price and the ask price quoted by a dealer.
• The wider the dealer spread, the more the liquidity risk.
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Risks Associated with Investing in Bonds
8.
Volatility Risk
– Volatility risk is the risk that a change in volatility will adversely affect
the price of a bond.
– The value of an option rises when expected interest-rate volatility
increases.
• In the case of a bond that is callable, or a mortgage-backed
security, in which the investor has granted the borrower an option,
the price of the security falls because the investor has given away a
more valuable option.
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Risks Associated with Investing in Bonds
9.
Risk Risk
– Risk risk refers to not knowing the risk of a security.
– Two ways to mitigate or eliminate risk risk are:
1) Keep up with the literature on the state-of-the-art methodologies
for analysing securities
2) Avoid securities that are not clearly understood
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Required reading
– Fabozzi, F.J. and Fabozzi, F.A. (2021), Bond Markets, Analysis, and
Strategies, 10th edition, MIT Press
– Chapter 1
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Homework problems
– Fabozzi and Fabozzi (2021)
– Chapter 1
• Questions 1, 2, 4, 5, 17, 19
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