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M10 Gitman5097010 11 FI C10
M10 Gitman5097010 11 FI C10
Fixed-Income Securities
Fixed-Income Securities
Learning Goals
1. Explain the basic investment attributes of bonds and their use as investment vehicles.
2. Describe the essential features of a bond, note the role that bond ratings play in the market, and distinguish among different types of call, refunding, and sinking-fund provisions. 3. Explain how bonds are priced in the market and why some bonds are more volatile than others.
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Fixed-Income Securities
Learning Goals (contd)
4. Identify the different types of bonds and the kinds of investment objectives these securities can fulfill.
5. Discuss the global nature of the bond market and the difference between dollar-denominated and nondollar- denominated foreign bonds. 6. Describe the basic features and characteristics of convertible securities, and measure the value of a convertible.
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Also called fixed income securities since payments are fixed amounts
Borrower agrees to pay a fixed amount of interest over a specified period of time Borrower agrees to repay a fixed amount of principal at a predetermined maturity date
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Current Yield is a measure of the annual interest income a bond provides relative to its current market price
Principal (par value) is the amount of capital that must be repaid at maturity Maturity Date is the date when a bond matures and the principal must be repaid Term Bond is a bond that has a single maturity date Serial Bond is a bond that has a series of different maturity dates Note is a debt security originally issued with a maturity from 2 to 10 years
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Call premium is the amount added to bonds par value and paid upon call to compensate bondholders Call price is the bonds par value plus call premium Refunding provision prohibits the premature retirement of an issue from proceeds of a lower-coupon refunding bond
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Essential Features of a Bond (contd) Sinking fund stipulates how a bond will be paid off over time
Applies only to term bonds Issuer is obligated to pay off the bond systematically over time
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Junior bonds are backed only by promise and good faith of the issuer to pay
Debenture is an unsecured (junior) bond
Subordinated debentures are unsecured bonds whose claim is secondary to other claims
Income bond requires interest to be paid only after a specific amount of income has been earned
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Bond Ratings
Bond ratings are letter grades that designate investment quality Private bond rating agencies assign ratings based upon financial analysis of the bond issuer Investment grade ratings are received by financially strong companies Junk bond ratings are received by companies making payments, but default risk is high Split ratings occur when a bond issue is given different ratings by major rating agencies Higher rated bonds have less default risk and pay lower interest rates
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Treasury Bonds
Considered risk freeno risk of default Interest is exempt from state and local taxes Sold in $1,000 denominations Types of Treasury Bonds
Treasury notes: maturities of 2, 3, 5, 7, and 10 years Treasury bonds: mature in 30 years
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Agency Bonds
Issued by U.S. government agencies
Federal Home Loan Bank Federal National Mortgage Association Small Business Administration
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Municipal Bonds
Issued by states, counties, cities and any other political subdivision Issued to fund public projects Two basic types
General obligation bonds are paid from general fund of the issuer Revenue bonds are paid from revenues from the project being financed
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Municipal Bonds
Interest is tax-exempt for Federal taxes
Interest can be tax-exempt from state taxes if you live in the state where the bond was issued
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Corporate Bonds
Issued by corporations from four major segments
Industrials Public utilities Rail and transportation bonds Financial issues
Provide higher returns than government bonds due to higher risk of default Wide variety of bond quality and bond types available
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Zero-Coupon Bonds
Do not pay interest
Treasury strips are zero-coupon bonds created from U.S. Treasury securities.
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Mortgage-Backed Securities
Bond backed by pool of residential mortgages
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Collateralized Mortgage Securities Mortgage-back bond pool that is divided into tranches, or classes of investors All principal payments go first to the shortest tranche until it is fully retired, then the next in sequence is paid Allows investors to choose short-term, mediumterm or long-term investment Potentially complex; interest rate fluctuations may have significant impact upon bond prices
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Asset-Backed Securities
Issued by corporations and backed by pools of loans
Auto loans Credit card loans Home equity loans
Provide relatively high yields Short maturities, typically 3 to 5 years Interest and principal payments are monthly High credit quality
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Global Bonds
Potentially higher returns than U.S. bonds
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Dollar-Denominated Bonds
Bonds issued by foreign governments or corporations and denominated in dollars Based on U.S. dollars Yankee bonds are registered with the SEC and issued and traded in U.S. Eurodollar bonds are not registered with the SEC and are issued and traded outside of the U.S.
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Foreign-Pay Bonds
Bonds issued by foreign governments or corporations Based on currency other than U.S. dollars Not registered with the SEC and issued and traded outside of the U.S. Subject to currency exchange rate risk
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Convertible Securities
Fixed-income security that allows holder to convert the security into a specified number of shares of the issuing companys common stock Two major types of convertible securities:
Convertible bonds Convertible preferred stock
Equity kicker: another name for the conversion feature that allows holder to convert the security into a specified number of shares of common stock
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Special Types of Convertible Securities (contd) LYON (Liquid Yield Option Note)
Zero coupon bond with both a conversion feature and a put option
No current income, but no limit on potential capital appreciation Put option allows security to be sold back to issuer at prespecified prices, providing downside protection
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Sources of Value
Value of convertibles is based in both the stock and the bond dimensions of the security
Convertibles trade much like common stock as the market price of the stock starts getting close to (or exceeds) the stated conversion price
Convertibles trade much like a bond when the market price of the stock is well below the conversion price
Bond price sets a price floor in case the stock price goes into a freefall
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Measuring the Value of a Convertible Conversion Value: indication of what a convertible issue would trade for if it were priced to sell on the basis of its stock value
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Measuring the Value of a Convertible (contd) Conversion Equivalent: the price at which the common stock would have to sell in order to make the convertible security worth its present market price
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Measuring the Value of a Convertible (contd) Payback Period: the length of time it takes for the buyer of a convertible to recover the conversion premium from the extra current income earned on the convertible
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Chapter 10 Review
Learning Goals
1. Explain the basic investment attributes of bonds and their use as investment vehicles.
2. Describe the essential features of a bond, note the role that bond ratings play in the market, and distinguish among different types of call, refunding, and sinking-fund provisions. 3. Explain how bonds are priced in the market and why some bonds are more volatile than others.
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Chapter 10
Table 10.1 Historical Annual Yields and Total Rates of Return for Treasury Bonds
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