CHAPTER THREE

FIXED INCOME SECURITIES

 Are securities that promise to make fixed payments according to

some preset schedule.

 Are therefore debt obligations.

 Issued by corporations and governments.

 Unlike money market instruments, fixed-income securities have

lives that exceed 12 months at time they are issued.

 It is longer-term debt obligations, often of corporations &

governments, that promise to make fixed payments according to

 Potential gains from owning a fixed-income security come in two forms.

 First, there are fixed payments promised

 final payment at maturity.

 Prices of most fixed income securities rise when interest rates fall, so there is

possibility of a gain from a favorable movement in rates.

 An unfavorable change in interest rates will produce a loss.

 Risk for many fixed-income securities is possibility that issuer will not make

promised payments.

 It doesn't exist for gov’t bonds, but for many other issuers possibility is very

real.

 Fixed-income securities are often quite illiquid, again depending on issuer &

specific type.
 Bond Characteristics
A bond is loan issued by corporation or gov’t entity.

Issuer pays bondholder specified amount of interest

for specified time, usually several years & then
repays bondholder face amount of bond.
A bond can be characterized based on

 Its intrinsic features

 Its type

 Its indenture provisions, or

 Intrinsic Features: coupon, maturity, principal value, & type of
ownership are important intrinsic features of a bond.
 The coupon of a bond indicates income that bond investor will
receive over life (or holding period) of issue. This is known as
interest income, coupon income, or nominal yield.
 Sometimes, however, zero-coupon bonds are issued that make no
coupon payments. In this case, investors receive par value at
maturity date, but receive no interest payments and the bond has
a coupon rate of zero.
 These bonds are issued at prices considerably below par value, &
investor’s return comes solely from difference between issue price
& payment of par value at maturity.
 Term to maturity specifies date or number of years

before bond matures (or expires).

 There are two different types of maturity.

Term bond, which has a single maturity date.

Serial obligation bond issue has a series of maturity

dates, perhaps 20 or 25.

Municipalities issue most serial bonds.

 Types of Issues: Bonds can have different types of collateral & be senior, unsecured,

or subordinated (junior) securities.

 Secured (senior) bonds: are backed by legal claim on some specified property of

issuer in case of default.

 For example, mortgage bonds are secured by real estate assets; equipment trust

certificates, which are used by railroads and airlines, provide a senior claim on the

firm’s equipment.

 Unsecured bonds (debentures): are backed only by promise of issuer to pay interest

& principal on timely basis. As such, they are secured by the general credit of issuer.

 Subordinate (junior) debentures: possess claim on income & assets that is

subordinated to other debentures.

 Income issues are most junior type because interest on them is paid only if it is

earned.
 Bond Price
 A bond’s coupon & principal repayments all occur months
or years in future, price investor would be willing to pay
for claim to those payments depends on value of dollars to
be received in future compared to dollars in hand today.
 This “present value” calculation depends in turn on
market interest rates.
 The nominal risk-free interest rate equals sum;

1. Real risk-free rate of return

2. Premium above real rate to compensate for expected

inflation.
 To value security, discount its expected cash flows by
appropriate discount rate.
 The cash flows from bond consist of coupon payments
until maturity date plus final payment of par value.
 Bond value = Present value of coupons + Present value of par
value

 If call maturity date T and call discount rate r,

 Bond value can be written as

 Example, XYZ Company issues 8% coupon, 30-year maturity
bond with par value of Birr 1,000 paying semiannual coupon
payments. Suppose that the interest rate is 8% annually, and ABC
Company wants to purchase this asset, by how much birr should
ABC purchase the financial assets? Given r= 8%, semiannually
8%/2 =4%
T= 30 year, the coupon paid twice in year, 30*2 = 60
Coupon= 1000*0.04= 40
Principal = 1000

= = 95.06 + 904.94= 1000

 Effect of interest rate changes on bond prices will vary from
bond to bond & will depend upon number of characteristics of
bond.
 The maturity of bond - Holding coupon rates & default risk
constant, increasing maturity of a straight bond will increase
its sensitivity to interest rate changes.
 The coupon rate of the bond - Holding maturity and default
risk constant, increasing coupon rate of straight bond will
decrease its sensitivity to interest rate changes.
 Since higher coupons result in more cash flows earlier in
bond's life, present value will change less as interest rates
 Bond Yields: current yield of bond measures only cash
income provided by bond as a percentage of bond
prices and ignores any prospective capital gains or
losses.
 Yield to maturity (YTM) is defined as discount rate
that makes present value of bond’s payments equal to
its price.
 This rate is often viewed as a measure of the average
rate of return that will be earned on a bond if it is
bought now and held until maturity.
• Yield to Call: Callable bonds, some corporate bonds are
issued with call provisions, allowing issuer to repurchase
bond at specified call price before maturity date.
• For example, if a company issues a bond with a high coupon
rate when market interest rates are high, and interest rates
later fall, the firm might like to retire the high-coupon debt
and issue new bonds at a lower coupon rate to reduce
interest payments.
• Proceeds from new bond issue are used to pay for
repurchase of existing higher coupon bonds at call price.
• Puttable bonds while callable bond gives issuer option
to extend or retire bond at call date, extendable or put
bond gives this option to bondholder.
• Floating-rate bonds make interest payments that are
tied to some measure of current market rates.
• For example, rate might be adjusted annually to
current T-bill rate plus 2%. If the one-year T-bill rate
at adjustment date is 4%, bond’s coupon rate over
next year would then be 6%.
 • Horizon Yield
• This measures expected rate of return of bond that you
expect to sell prior to its maturity.
• It is therefore a total return measure which, allows
portfolio manager to project the performance of a bond on
the basis of a planned investment horizon, his expectations
concerning reinvestment rates and future market yields.
• This allows the portfolio manager to evaluate which of
several potential bonds considered for investment will
perform best over the planned investment horizon.
 Risks in bond
• Credit risk: occurs when issuer default on payment of coupon, and

even principal amount

• Interest Rate risk: The value of bond is affected by interest rate

changes.

• This makes it particularly important for investors to consider interest

rate risk when they purchase bonds in a low-interest rate environment.

• Bond prices and yields are inversely related:

• As yields increase, bond prices fall; as yields fall, bond prices rise.

• An increase in a bond’s yield to maturity results in smaller price change

than a decrease in yield of equal magnitude.

• Prices of long-term bonds tend to be more sensitive to interest
rate changes than prices of short-term bonds.
• The sensitivity of bond prices to changes in yields increases at
a decreasing rate as maturity increases. In other words,
interest rate risk is less than proportional to bond maturity.
• Interest rate risk is inversely related to the bond’s coupon
rate. Prices of low-coupon bonds are more sensitive to
changes in interest rates than prices of high-coupon bonds.
• The sensitivity of a bond’s price to a change in its yield is
inversely related to the yield to maturity at which the bond
• Market Risk: The value of the bond is also subject to demand
and supply forces. Should the bond market as a whole decline,
the value of individual bonds may be brought down by market
sentiments regardless of their fundamental characteristics.
• As such, this market risk is relevant if the investor decides to
sell the bond and not hold it to maturity.
• Inflation risk

• Liquidity Risk

• Foreign exchange risk

• Call risk
 Rating of bonds
 These credit ratings usually appear in form of alphabetical letter
grades (for example, ‘AAA’ & ‘BBB’) & are intended to give
estimation of relative level of credit risk of bond or a company
or government as whole.

 Credit ratings can be useful item of information to consider

when evaluating an investment along with other information.

 But if you use credit ratings, you should understand their

limitations.

 You should not base your investment decision solely on a credit

• A bond rating is a grade given to bonds that indicates their credit

quality. Private independent rating services such as Standard &

Poor's, Moody's and Fitch provide these evaluations of a bond issuer's
financial strength, or it’s the ability to pay a bond's principal and
interest in a timely fashion.

• A credit rating is assessment of entity’s ability to pay its financial

obligations. The ability to pay financial obligations is referred to as

“creditworthiness.”

• Credit ratings apply to debt securities like bonds, notes, and other

debt instruments (such as certain asset-backed securities) and do not

apply to equity securities like common stock. Credit ratings also are
assigned to companies and governments.
• A typical credit rating scale,, has a top rating of ‘AAA’
and may have a lowest rating of ‘D’ (indicating default).
• some credit rating agencies’ scales distinguish between
investment grade and non-investment grade (i.e.,
“speculative” or “high yield”) ratings and they draw this
distinction between the ‘BBB’ and ‘BB’ rating
categories (in other words, a rating that is ‘BBB-minus’
or higher is investment grade and a rating that is lower
than ‘BBB-minus’ is non-investment grade).
What a credit rating is not

• A credit rating does not reflect other types of risk, such as market or

liquidity risks, which may also affect the value of a security.

• Nor does a credit rating consider the price at which an investor purchased

a security, or the price at which the security may be sold.

• You should not interpret a credit rating as investment advice and should

not view it as a recommendation to buy, sell, or hold securities. A credit

rating is not a guarantee that a financial obligation will be repaid.

• For example, an ‘AAA’ credit rating on a debt instrument does not mean the

investor will always be paid with absolute certainty—instruments rated at

this level sometimes default.

Determinants of Bond Safety

• Bond rating agencies base their quality ratings largely on an analysis of the

level and trend of some of the issuer’s financial ratios. The key ratios used
to evaluate safety are:

• Coverage ratios. Ratios of company earnings to fixed costs.

 For example, the times interest- earned ratio is the ratio of earnings before

interest payments and taxes to interest obligations. The fixed-charge

coverage ratio includes lease payments and sinking fund payments with
interest obligations to arrive at the ratio of earnings to all fixed cash
obligations.

• Leverage ratio. Debt-to-equity ratio. A too-high leverage ratio indicates

excessive indebtedness, signaling possibility firm will be unable to earn

• Liquidity ratios These ratios measure the firm’s ability to pay bills
coming due with its most liquid assets.
• Profitability ratios. Measures of rates of return on assets or equity.
Profitability ratios are indicators of a firm’s overall performance.
• The return on assets (earnings before interest and taxes divided by
total assets) or return on equity (net income/equity) are the most
popular of these measures.
• Firms with higher return on assets or equity should be better able to
raise money in security markets because they offer prospects for
better returns on the firm’s investments.
• Cash flow-to-debt ratio. This is the ratio of total cash flow to
outstanding debt.
Analysis of convertible bonds
• Convertible bonds give bondholders option to exchange each
bond for a specified number of shares of common stock of firm.
• The conversion ratio gives number of shares for which each
bond may be exchanged.
• Suppose a convertible bond is issued at par value of $1,000 and
is convertible into 40 shares of a firm’s stock.
• The current stock price is $20 per share, so the option to
convert is not profitable now. Should the stock price later rise to
$30, however, each bond may be converted profitably into
• The market conversion value is the current value of the shares for which the

bonds may be exchanged.

• At the $20 stock price, for example, the bond’s conversion value is $800.

• The conversion premium is the excess of the bond price over its conversion

value. If the bond were selling currently for $950, its premium would be

$150.

• Convertible bondholders benefit from price appreciation of the company’s

stock. Not surprisingly, this benefit comes at a price; convertible bonds offer

lower coupon rates and stated or promised yields to maturity than

nonconvertible bonds.

• At the same time, the actual return on the convertible bond may exceed the
 Quiz(5%)

1. What is difference b/n term bond and serial obligation

bond?(1%)
2. What is difference b/n secured and unsecured bond?
(1.5%)
3. List at least five features of bond (2.5%)