CHAPTER 4

Fixed income securities

Definition: Fixed-income securities are financial claims with promised cash flows of fixed amount
paid at fixed dates.
Classification of Fixed-Income Securities:
1. Treasury Securities:
• U.S. Treasury securities (bills, notes, bonds). Bond characteristic.
2. Federal Agency Securities:
• Securities issued by federal agencies.
3. Corporate Securities:
 Commercial paper.
 Medium-term notes (MTNs).
 Corporate bonds.
4. Municipal Securities.
5. Mortgage-Backed Securities.
Organization of Fixed Income Market
ISSUERS:
1. Government
2. Corporations
3. Commercial banks
4. States and municipalities
5. Special purpose vehicles
6. Foreign institutions

INTERMEDIARIES:
1. Primary dealers
2. Other dealers
3. Investment banks
4. Credit rating agencies
5. Credit and liquidity enhancers

INVESTORS:
1. Governments
2. Pension funds
3. Insurance companies
4. Commercial banks
5. Mutual funds
6. Foreign institutions
7. Individual investors

Cash Flow and Valuation of Fixed-Income Securities

Cash flow:
1. Maturity
2. Principal
3. Coupon.

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Example. A 3-year bond with principal of $1,000 and annual coupon payment of 5% has the
following cash flow:

Valuation:
1. Time-value.
• Interest rates
 Risks:
 Inflation.
 Credit.
 Timing (call ability).
 Liquidity.
 Currency
2 Term Structure of Interest Rates
Our objective here is to value riskless cash flows. Given the rich set of fixed-income securities
traded in the market, their prices provide the information needed to value riskless cash flows at hand.
In the market, this information on the time value of money is given in several different forms:
 Spot interest rates.
 Prices of discount bonds (e.g., zero-coupon bonds and STRIPS).
 Prices of coupon bonds.
 Forward interest rates.
Spot Interest Rates
Definition: Spot interest rate, rt, is the (annualized) interest rate for maturity date t.
 rt is for payments only on date t.
 rt is the “average” rate of interest between now and date t.
 rt is different for each different date t.
Discount Bonds
Discount bonds (zero coupon bonds) are the simplest fixed-income securities.
Definition: A discount bond with maturity date t is a bond which pays
$1 only at t.
Example. STRIPS are traded at the following prices:

For the 5-year STRIPS, we have

Let Bt denote the current price (at date 0) of a discount bond maturing at t. Then

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 Coupon Bonds
A coupon bond pays a stream of regular coupon payments and a principal at maturity. Observation:
A coupon bond is a portfolio of discount bonds.
Example. A 3-year bond of $1,000 par and 5% annual coupon.

Suppose that the discount bond prices are as follows

What should the price of the coupon bond be?

Price = (50)(0.952) + (50)(0.898) + (1050)(0.863) = 998.65

What if not?
Thus, a bond with coupon payments {C1, C2, . . . , CT } and a principal P at maturity T is composed
of
 Ct units of discount bonds maturing at t, t = 1, . . . , T
 P units of discount bond maturing at T .
The price of a coupon bond must be

Example. Measuring term structure from coupon bond prices.

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What is a Bond?
A bond can be defined as fixed income security that represents a loan by an investor to a borrower.
Bonds are one of the three asset classes that investors are familiar with along with equity and cash
equivalents.
Bond Categories
There are four categories of bonds sold in the markets:
Corporate bonds are issued by companies that seek funding, rather than using loaning money from
a bank they issue bonds. Bonds offer more favorable terms and lower interest rates for the
companies.

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Municipal bonds are issued by the states and municipalities the bonds are offered with a tax-free
coupon income to investors.
Government bonds are issued by the government; the bonds issued by national governments are
referred to as sovereign debt.
Agency bonds are issued by government-affiliated organizations.
Characteristics of Bonds
Most bonds share some basic characteristics including:
Face Value
Face value is the amount that the bond will be worth at maturity. Bond issuers use the face value of
the bond to calculate the interest payments.
For example, if a bond has a face value of $1000 a buyer purchases the bond at a premium of $1050.
The same bond is bought by a different buyer a few months later at a discounted price of $950. At
the maturity of the bond, both investors will receive $1000 which is the face value of the bond.
Coupon Rate
The coupon rate is the interest rate of the bond; this interest is calculated on the face value of the
bond. The interest rate is expressed as a percentage.
For example, a $1000 face value bond with an 8% coupon rate is issued. What amount of interest
will the bondholders receive?

Coupon Date
Coupon dates are the dates on which interest payments will be made. Interest payments can be made
at different intervals, but the standard is semi-annual payments.
Maturity Date
The maturity date is the date at which the face value of the bond will be paid out to the bondholder.
Issue Price
The issue price is the price that the bond was originally sold for.

Bond price
A bond can be issued at a discount or premium price depending on the market interest rate. The
bondholder will pay the face value of the bond. The bond will then be paid back at maturity with
monthly, semi-annual, or annual interest payments.
A bond’s price will change daily a bondholder doesn’t have to keep their bond until maturity, the
bonds can be sold on the open market. The price of the bond will change due to a change in the
interest rate of the economy
Way of considering a bond’s price:
Inverse to Interest Rates – a bond’s price will vary inversely to the interest rate. When interest
rates decrease the bond prices will rise to have an equalizing For example – a 10% coupon rate, a
$1000 bond is issued, and the price goes down to $800. The yield will go up to 12.5% this is since
you are guaranteed $100 on an asset that is now worth $800.ffect on the interest rate of the bond.

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If the price of the bond goes up to $1200 the yield will decrease to 8.33%:

Bond Benefits
Bond financing has three benefits:
Bonds do not affect the ownership of a company whereas equity financing does. Issuing bonds will
not dilute company shares.
Interest expenses on a bond are tax-deductible meaning even though you are incurring interest
expenses in financing the bonds you can deduct the money from tax. Equity financing doesn’t
provide any tax advantages.

Financial leverage – when finance a bond and the bond earns you a return on equity it is financial
leverage. If a company invests the proceeds from the bond at a higher interest rate than the interest
payments on the bond, then the company will make money on issuing the bond.

Bond Conclusion
B A bond can be defined as fixed income security that represents a loan by an investor to a borrower.
There are four categories of bonds sold in the markets:
 Corporate bonds
 Municipal bonds
 Government bonds
 Agency bonds
Most bonds share some basic characteristics including:
 Face value
 The coupon rate 
 Coupon dates 
The market price of a bond depends on numerous factors:
 The credit quality of the issuer
 Time until expiration
 The coupon rate
Varieties of bonds
 Zero-coupon bonds
 Convertible bonds 
 Callable bonds 
 A Put table bond 
Way of considering a bond’s price:
 Inverse to Interest Rates
 Yield-to-Maturity (YTM)
 Duration
bond yield Yield-to-Maturity (YTM)
Definition: Yield-to-maturity of a bond, denoted by y, is given by

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Given its maturity, the principle and the coupon rate, there is a one to one mapping between the price
of a bond and its YTM.
Example. Current 1- and 2-year spot interest rates are 5% and 6%, respectively. The price of a 2-
year Treasury coupon bond with par value of $100 and a coupon rate of 6% is

Its YTM is 5.9706%:

Risks in bond
Measures of Interest Rate Risk
Assume flat term structure at rt = y.
A bond’s interest rate risk can be measured by its relative price change with respect to a change in
yield.

This is called a bond’s modified duration or volatility.

The term modified duration comes from its link to duration:
Definition: A bond’s duration is the weighted average of the maturity of individual cash flows, with
the weights being proportional to their present values:

Duration measures the average time taken by a bond, on a discounted basis, to pay back the original
investment.
Duration and MD satisfy the following relation:

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Example. Consider a 4-year T-note with face value $100 and 7% coupon, selling at $103.50,
yielding 6%.
For T-notes, coupons are paid semi-annually. Using 6-month intervals, the coupon rate is 3.5% and
the yield is 3%.

Duration (in 1/2 year units) is

D = (738.28)/103.50 = 7.13.
Modified duration (volatility) is
MD = D/ (1 + y) = 7.13/1.03 = 6.92.
If the semi-annual yield moves up by 0.1%, the bond price decreases roughly by 0.692%.
Rating of bonds
Credit Risk and Corporate Bonds
Fixed-income securities have promised payoffs of fixed amount at fixed times. Excluding
government bonds, other fixed-income securities, such as corporate bonds, carry the risk of failing to
payoff as promised.
Definition: Default risk (credit risk) refers to the risk that a debt issuer fails to make the promised
payments (interest or principal).
Default Premium and Risk Premium
Example. Suppose all bonds have par value $1,000 and
 10-year Treasury strip is selling at $463.19, yielding 8%
 10-year zero issued by XYZ Inc. is selling at $321.97
 Expected payoff from XYZ’s 10-year zero is $762.22.
For the 10-year zero issued by XYZ:

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And

Risk Premium = Expected YTM - Default-free YTM

= 9% - 8% = 1%
 Promised YTM is the yield if default does not occur.
 Expected YTM is the probability-weighted average of all possible yields
 Default premium is the difference between promised yield and expected yield.
 Bond risk premium is the difference between the expected yield on a risky bond and
the yield on a risk-free bond of similar maturity and coupon rate.

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