Fixed Income Securities
Bonds & Its Diversified
Dimensions
1
Real vs. Financial Assets
Real Assets have physical characteristics that
determine the value of the asset
– Size, Shape, Material, Color, etc.
– Price based on the benefits of the physical
characteristics
Financial Assets physical characteristics are
inconsequential
– Value based on claim to promised or anticipated
cash flows
– TVM concepts used to price financial assets
The U.S. Bond Market
U.S. Treasury is the
world’s single largest
borrower—also has the
most liquid market—an
informal OTC market.
3
Corporate Bonds in the U.S.
Market for corporate bonds is less liquid than
market for U.S. Treasuries
– IPOs for bonds are underwritten by investment
banking firms
Largest organized secondary bond market is
NYSE
– Uses matrix prices for most of the bonds listed on
its Automated Bond System (ABS)
• Based on price quotes for similar bonds (in terms of
coupon rate, maturity, quality rating, call provisions)
4
Bond Markets
Debt Issuers
U.S.
government
conducts
regularly
scheduled
auctions for
Treasury
securities.
Underwriter
Investors
U.S. government
U.S. Treasury
Governments, pensions, commercial banks,
insurance companies, mutual funds,
foreigners, households
Federal government agencies
Investment banks
Governments, pensions, commercial banks,
insurance companies, mutual funds,
foreigners, households
Municipalities
Commercial and investment
banks
Governments, commercial banks, insurance
companies, mutual funds, foreigners,
households
Corporations
Investment banks
Pensions, commercial banks, insurance
companies, mutual funds, foreigners,
households
Home buyers, commercial
real estate developers
Mortgage banks & pool
operators
Pensions, commercial banks, insurance
companies, REITs
Foreign governments
Investment banks
Pensions, mutual funds, foreigners,
households
Foreign corporations
Investment banks
Pensions, commercial banks, insurance
companies, mutual funds, foreigners,
households
5
Sectors of the Industrialized
World’s Bond Markets
In almost every country, the federal
government is that country’s largest
debt issuer
Corporate sector for Japan, Italy and
Germany is relatively small compared
to their overall bond markets
– Due to custom of borrowing from a bank
vs. issuing bonds
6
International Bonds
Represent a rapidly growing category
– Reflects willingness of borrowers to borrow
across borders
International bond investors face two types
of political risk
– Repatriation-of-funds risk
• A government may block payments of principal or
interest
– Sovereign risk
• A government may refuse to honor its debts
7
International Bonds
Can be organized into the following
categories
– Domestic bonds
• Issued by a local borrower and denominated in local
currency
– Foreign bonds
• Issued in one country and denominated in that
country’s currency by a bond issuer from another
country
– Eurobonds
• Any bond not issued in a domestic market regardless of
its currency denomination and the issuer’s nationality
8
Bearer Bonds Vs. Registered Bonds
Registered bonds—send coupon
checks to registered bond owners
Bearer bonds—have no list of
registered owners
– Investor must submit a dated coupon to a
bank to receive coupon payments
• Many Eurodollar bonds are of this type
• Owner’s identity is unknown
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Accrued Interest
Market price of bond (or its clean price) is:
Price bond 
Coupon  Coupon
1 k  1 k 
1
1
2
2


Present Value of Coupon Payments
Coupon
1 k 
T
T

Par
1 k 
T
T
Present Value of Par
Bonds pay coupon payments periodically
 Annually, semi-annually, quarterly, etc.
When a bond is purchased on a day between
its scheduled interest payment, buyer must
pay seller for accrued interest
 Interest that has been earned but not yet paid by
issuer
10
Compounding Conventions
The length of time between coupon
payments impacts bonds’ yields and prices
11
Bonds Pricing
Bond Price = Coupon X PVIFA
+
Par Value X PVIF
12
Yield-to-Maturity (YTM): A First Look
 A simple approximation of yield-to-maturity is:
Par - Current Price
Years until maturity
Non  compounded YTM  Coupon Rate 
Current Price
Rate of Cash Flow
Rate of price appreciation or depreciation
13
Bond Basics, II.
Two basic yield measures for a bond are its
coupon rate and its current yield.
Annual coupon
Coupon rate 
Par value
Annual coupon
Current yield 
Bond price
Compounded YTM
YTM defined as the discount rate
equating the present value of a bond’s
future cash flows to its current market
price
– For bonds paying coupon payments semiannually, the correct formula is:
Present
Coupon1  2
Coupon 2  2



1
2
Value
1  YTM  2  1  YTM  2 

Coupon 2T  2
1  YTM  2 
T

Par
2T
1  YTM  2 
• The YTM is identical to IRR
15
Example: Comparing a Bond’s
Conventional and Effective YTM
Given information
–
–
–
–
Par value: $100
Coupon rate: 10% (semi-annual)
Time to maturity: 10 years
Purchase price: $106.59
Using the conventional YTM formula, we
calculate a YTM of 8.89%
$106.59 
$10  2

$10  2
1  0.089873  2  1  0.089873  2 
1
2


$10  2  $100
1  0.089873  2 
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16
Conditions Required to Earn a
Bond’s Expected YTM
A bond’s computed YTM will only
actually be earned if:
– The bond is held to maturity
– The bond issuer does not default in the
timing or amount of scheduled payments
– All the cash flows are immediately
reinvested to earn the bond’s YTM
17
Inverse Relationship Between a
Bond’s Price and YTM
 The price and YTM of a bond move inversely
NOTE:
Price-yield
curves are
convex to
the origin.
18
Interest Rate Risk
The value of the 5% bond falls as interest
rates
1,200 rise
Bond price ($)
1,100
1,000
900
800
700
0
2
4
6
8
10
Interest rate (%)
12
14
16
Interest Rate Risk and Time to
Maturity
Bond values ($)
2,000
$1,768.62
30-year bond
Time to Maturity
1,500
Interest rate
5%
$1,047.62
1,000
1-year bond
$916.67
500
$1,768.62
10
1,000.00
1,000.00
15
956.52
671.70
20
916.67
502.11
Interest rates (%)
10
15
30 years
$1,047.62
$502.11
5
1 year
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Value of a Bond with a 10% Coupon Rate for Different Interest Rates and Maturities
Other Measures of Bonds’ Yields
Yield-to-call (YTC)
– A bond issuer may call a bond before its
original maturity date
• Need to calculate the bond’s YTC
– Similar to YTM, except replace T as the time-tocall rather than time-to-maturity
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International Bond Index Statistics
U.S. $
Return
No single
bond
investment
appears to be
the most or
least risky.
U.K. Pound
SD
Return
SD
Hong Kong $
Return
SD
German Mark
Return
SD
Australia
8.5%
15.5%
9.9%
18.3%
9.5%
16.4%
5.0%
20.2%
Belgium
11.6
17.2
13.0
14.7
12.7
16.2
8.1
8.6
Canada
9.3
10.4
10.7
19.3
10.3
13.2
5.8
17.0
France
10.8
15.6
12.2
15.3
11.8
15.6
7.2
12.2
Germany
12.0
14.9
13.4
16.7
13.0
13.4
8.4
8.4
Japan
12.2
17.5
13.7
18.4
13.3
18.3
8.7
17.3
Netherlands
11.7
14.2
13.1
15.8
12.7
14.0
8.1
8.2
Switzerland
10.2
17.1
11.6
16.8
11.2
16.0
6.7
9.8
U.K.
10.2
22.3
11.6
17.2
11.6
17.2
11.3
23.4
U.S.
9.3
12.2
10.6
21.3
10.3
14.7
5.8
16.8
22
Actively Managing International
Bond Investments
 Active international bond investors can use different
approaches:
– Political analysts begin with a top-down approach and
analyze sovereign risks, etc.
– Macro-economists study macro factors (income,
employment, etc.) to determine which nations are
economically strong
– Monetary economists forecast a nation’s level and structure
of market interest rates by analyzing central bank and their
policies, etc.
– Industry analysts analyze financial data from different
industries
– Security analysts have a bottom-up approach—focus on
bond issuer’s financial conditions, protective provisions,
etc.
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The Bottom Line
 Governments are the largest borrowers in the world
 Most rapid growth occurring in Eurobond market
– Unregulated and untaxed
 Some countries publish clean bond prices while
others publish dirty prices which includes accrued
interest
 Day counting conventions differ across countries
 YTM calculations methods also differ across
countries
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Bond Risk Hierarchy
Common Stock
Preferred Stock
More
Risk
Subordinated Debentures
Senior Debentures
2nd Mortgage Bonds
1st Mortgage Bonds
Less
Risk
Higher
Priority of Claim
Lower
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The Bottom Line
If a bond’s cash flows are not invested
at the bond’s YTM the investor will not
earn the YTM
Other yield measures exist
– Holding period return
– Current yield
– Yield to call
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