Lecture Note One: Introduction to

Fixed Income Securities

FINA3323 Fixed Income Securities

HKU Business School
University of Hong Kong

Dr. Huiyan Qiu

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 Outline
1. What is fixed income securities?
2. Fixed income market: players
3. Fixed income securities: types
4. Fixed income terminology
5. Risks in investing in bond
6. Bond market in Hong Kong

Reference: Fabozzi’s chapter 1, Tuckman’s Overview

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1. What is Fixed Income Security?
Fixed income securities are debt instruments that
provide a return in the form of periodic interest
payments and the eventual return of principal at
maturity.
• Many fixed income securities have cash flows that are not
fixed. E.g., callable bonds; floaters.
• Fixed income market means the market for debt, and
debt-related instrument.
• The best known type of fixed income security is bond.

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Why Study Fixed Income Securities?
Fixed income securities are important and relevant in the
financial economic domain.
• Borrowing/lending is essential for efficient economic
development.
• Domestically and internationally, pension and mutual
funds, among others, have largely been specializing in
bond investing.
• Much of the most successful and unsuccessful investment
strategies have involved fixed income instruments.

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 Why Study Fixed Income Securities?
(cont’d)
• It’s essential to have fixed income derivatives to
effectively manage interest rate risk and credit risk.
• More than 90% of the world's largest 500 companies use
fixed income derivatives to manage interest rate and credit
risk exposures.
• Further more, financial engineers keep inventing new fixed
income derivatives to help firms transfer risk more
effectively and selectively.

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 Why Study Fixed Income Securities?
(cont’d)
• About two‐thirds of the market value of all securities
outstanding in the world can be classified as fixed income
securities.
• By recent estimates, the worldwide bond market’s total
value exceeds US$100 trillion, while the worldwide stock
market value is about $69 trillion.
It is therefore critical for anyone involved in corporate
finance or financial risk management to have deep-
rooted understanding of interest rate risk and fixed
income securities.
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 2. Fixed Income Market: Players
Issuers
• Governments and agencies, corporations, commercial
banks, states and municipals, special-purpose vehicles
Financial Intermediaries
• Primary dealers, investment banks, credit rating agencies,
credit and liquidity enhancers
Investors
• Governments, pension funds, insurance companies,
mutual funds, commercial banks, retail investors

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 Issues for Issuers
To issue debt securities that best suit their needs
To sell securities at a fair value (valuation)
To have liquid secondary markets in their securities
To have flexibility in modifying their securities after
issuance

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 Issues for Financial Intermediaries
To carry out market‐making activities in the primary
market: auction, underwriting, and distribution
To provide liquid secondary market
Risk management and asset liability management
• How much interest rate risk they are taking on
• What is the credit risk exposure

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 Issues for Investors
Valuation of the security
Buy securities with a risk‐return profile that best fits
their needs (diversification, investment, hedging, …)
• Understand well the risk and return characteristics of the
portfolio
Get information on credit rating

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3. Fixed Income Securities: Types
Publically traded
• Issued by governments
• Issued by corporations

Not publically traded: loans; mortgages

Fixed income derivatives

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 Fixed Income Securities
– issued by Governments
Bonds and notes:
• Bonds have time to maturity more than 10 years and notes
have time to maturity up to 10 years
• Bonds and notes pay a regular coupon
• Bond and notes are sometimes “callable” – they can be
repurchased, usually at par by the issuer
Bills
• Short maturity, ≤ 1 year, and no coupon
• Essentially short dated bonds
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 U.S. Treasury Market

Source: http://www.treasurydirect.gov 1-13

U.S Treasury Market

Source: Wikipedia.
US national debt from 1940
to 2016.
The difference between the debt
held by the public and the total
national debt or gross debt is the
"intragovernmental debt," which
includes obligations to
government programs such as
Social Security Trust Fund.

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 Government Debt: US
Besides Treasury bills, notes, and bonds, US states and
districts have a large amount of Municipal Bonds
outstanding.
• General Obligation Bonds (GOBs)
• Revenue Bonds
There are also debts issued by Government Sponsored
Enterprises (GSEs), e.g., Fannie Mae and Freddie Mac.
• These agencies issue regular debt as well as securities
backed by mortgages (or assets).

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 Government Debt: China
Government bonds: issued by the Ministry of Finance
in a range of maturities to finance government spending.
Local governments also issue bonds, similar to
municipal bonds in US.
Central Bank bills: short-term securities issued by the
People’s Bank of China as a tool for implementing
monetary policy.
Some financial or non-financial corporate bonds may
also be considered as government debt based on the type
of the issuer.
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 Government Debt: Hong Kong
Government bonds: to promote the development of the
local bond market. Weblink
Exchange Fund Bills and Notes (EFBNs): to provide
benchmark yields that guide private debt pricing, i.e., to
set a foundation for HK$ bonds.
Bonds issued by statutory bodies (e.g., Hong Kong
Housing Authority).
Bonds issued by government-related corporations (e.g.,
Hong Kong Mortgage Corporation, Hong Kong Link
2004 Limited, etc.)
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 Government Debt: UK
Gilts: (gilt-edged securities)
• Conventional / standard gilts: nominal bonds that
promise to pay a fixed coupon rate every six months;
representing the majority of government debt.
• Inflation-linked gilts: coupon rates adjusted to reflect
changes in the U.K. retail prices index, a proxy for
inflation.
British consols: perpetual bonds; fully redeemed in
2015

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 Government Debt: Eurozone

Source: Fixed Income Securities: Tools for Today’s Markets, Tuckman

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 Fixed Income Securities
– issued by Corporations
Three primary categories:
• Money market instruments – less than 1 year maturity,
such as commercial papers.
• Medium Term Notes – maturity ranging from 1 year to
30 years, flexible issuance schedule as they are shelf‐
registered.
• Corporate bonds/notes – usually longer than 5 years
maturity.
Corporate debt is much more complicated in structure
and design than government securities.
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 Fixed Income Securities
– issued by Corporations
Following is description of one corporate bond issued by
Hysan Development Co. Ltd.
HYSAN MTN N2301 (4590 )
Company/Securities
Hysan (MTN) Ltd. 3.5% Guaranteed Notes 2023
Name:
Description: Hysan (MTN) Ltd. 3.5% Guaranteed Notes 2023
Amount Outstanding: USD 300,000,000
Board Lot Nominal: USD 200,000 nom.
Date Raised: 17/1/2013
Maturity Date: 16/1/2023
Interest (%): 3.500
Payable (Month/Day): 01/16
07/16
Listing Date : 17/1/2013
Trading Currency: USD
http://www.hkex.com.hk/eng/invest/company/profile_page_e.asp?WidCoID=045
90&WidCoAbbName=&Month=&langcode=e
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 Fixed Income Securities
– Not Publically Traded
Loans:
• A loan is just like a bond or note, except that it is an
agreement between the lender and the borrower, and is not
publicly traded.
Mortgages:
• Technically, a mortgage is a loan, which is secured against
the thing which it is being used to purchase.
• Residential mortgages can have fixed or floating interest
payments.

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 Fixed Income Derivatives
Plain vanilla interest rate derivatives:
• Forward rate agreement (FRA)
• Eurodollar futures – settle against 3 month LIBOR
• Bond forward and bond futures
• Interest rate swaps – LIBOR for fixed
• Options on bonds, on bond futures, on interest rate swaps
• Interest rate options

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Fixed Income Derivatives (cont’d)
Exotic interest rate derivatives, examples:
• CMT (Constant Maturity Treasury) swaps
• Variable amortization rate swaps.
• Structured notes (e.g. range accrual notes).
Recent developments – “Credit derivatives”:
• CDS (Credit Default Swaps) – essentially insurance
against default of a bond.
• CDOs (Collateralized Debt Obligations) – structured
hierarchy of claims on a portfolio of debt contracts.

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 4. Fixed Income Terminology
Indenture: the contract that set forth the promises of a
bond issuer and the rights of the investors, usually
specifying the coupon rate, maturity date, options,
covenants, provisions, and other terms.
Bond covenants: a legally binding term of agreement
between a bond issuer and a bondholder, specifying the
exact contractual rules and restrictions.
• Bond covenants are designed to protect the interests of
both parties.

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 Term to Maturity
Term to maturity: the number of years over which the
issuer has promised to meet the conditions of the
obligation.
• Short-term: maturity of between 1 and 5 years
• Intermediate-term: maturity of between 5 and 12 years
• Long-term: maturity of more than 12 years
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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 Par Value and Coupon Rate
Par value (also called the principal of bond, maturity
value, face value): the amount that the issuer agrees to
repay the bondholder at the maturity date
Coupon rate: the interest rate that the issuer agrees to
pay each year. The annual amount of the interest
payment is called the coupon.
• Most bonds pay interest on an annual, semi-annual or
quarterly basis. Many mortgage-related bonds, however,
pay interest on a monthly basis.

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 More on Coupon Rate
Some bonds have their coupon rates reset according to pre-
determined benchmark.
• Floating-rate bonds: coupon rate reset periodically
according to: reference rate + quoted margin
• Inverse-floating-rate bonds: coupon rate moves in the
opposite direction from the change in interest rates.
• Linkers: bonds whose interest rate is tied to the inflation
rate.
• TIPS: Treasury Inflation Protected Securities in US.

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 Fixed Income Terminology
Amortization feature: the principal of a bond issue to
be repaid over the life of the bond
• Amortization schedule: the schedule of principal
repayments.
Sinking fund provision is similar. Sinking fund
provision requires the bond issuers periodically retire a
specified portion of the bond issuance.
Mortgage-related bonds usually have amortization
feature.

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 Fixed Income Terminology
Embedded options: 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

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 5. Risks Inherent in Bonds
Bonds may expose an investor to one or more of the
following risks:

Interest Rate Risk Exchange Rate Risk

Reinvestment Risk Liquidity Risk
Call Risk Volatility Risk
Default Risk Risk Risk
Inflation Risk

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 Interest Rate Risk
If investor must sell bond prior to maturity date, current
value of the bond depends upon current interest rates.
• If rates rise, bond prices will fall, and investor will lose
money
• If rates fall, bond prices will rise, and investor will make
money
Interest rate risk (or market risk) is by far the major
risk faced by an investor in the bond market.

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 Reinvestment Risk
If investor receives CF’s earlier than desired holding
period, the rate at which she will be able to reinvest her
CF’s is unknown today.
• If rates fall in the interim, then the rate she can reinvest at
will be below today’s prevailing rates.
• Note that this risk moves in the opposite direction of
interest rate risk.
Reinvestment risk is greater for longer holding periods,
as well as bonds with large, early, cash flows, such as
high-coupon bonds.
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 Call Risk
Many bonds include a call provision that allows issuer to
retire debt before maturity date. Issuer will take
advantage of this when firm can reissue debt at lower
interest.
There are three disadvantages to call provisions for
investors:
• cash flow pattern cannot be known with certainty
• investor is exposed to reinvestment risk
• bond’s capital appreciation potential will be reduced

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 Credit Risk and Inflation Risk
Credit risk is the risk that the bond issuer will fail to
satisfy the term of the obligation with respect to the
timely payment of interest and principal.

Inflation risk (purchasing power risk) arises because

even if promised future cash flows are ‘risk-free’, the
purchasing power of these cash flows is not guaranteed.

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 Exchange Rate Risk
Exchange rate risk (or currency 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 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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 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.
To get prices that reflect market value, the bonds must
trade with enough frequency.

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 Volatility Risk and Risk Risk
Volatility risk is the risk that a change in volatility
might adversely affect the price of a bond.
Risk risk refers to not knowing what the risk of a
security is (due to a new and innovative structure). Two
ways to mitigate or eliminate risk risk are:
• Keep up with the literature on the state-of-the-art
methodologies for analyzing securities
• Avoid securities that are not clearly understood

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 6. Bond Market in Hong Kong
The bond market in Hong Kong is one of the most
liberal debt markets.
• The range of product offerings, in both domestic and
foreign currencies,
• the open access for issuers and investors, both domestic
and international, and
• the significance of offshore RMB bond issuances
make Hong Kong one of the most frequented
international bond markets in Asia.

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 Government Bond Market
Public Sector Bonds come in the form of
• Government bonds
• Exchange Fund Bills and Notes (EFBNs) issued and
managed by the Hong Kong Monetary Authority
(HKMA).
• Bonds issued by statutory bodies (e.g., Hong Kong
Housing Authority)
• Bonds issued by government-related corporations (e.g.,
Hong Kong Mortgage Corporation, Hong Kong Link
2004 Limited, etc.)

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 Corporate Bond Market
Corporate bond market is very active and liquid in Hong
Kong, accounting for around 40-50% of Hong Kong
dollar debt instruments.

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Foreign Currency-Denominated Bond
Hong Kong has developed into a multi-currency capital
market and a major debt market.
• US dollar Clearing System was introduced in August
2000.
• Euro Clearing System was implemented in April 2003.
• Renminbi (RMB) real-time gross settlement (RTGS)
interbank payment system was implemented in June 2007.

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 Bond Market Size
Hong Kong bond market is still small.
Summary of debt securities outstanding at end-June 2019
By sector of issuer, in billions of US dollars
Financial Non-financial General
Total Corporations corporations government
United States 40,177 14,532 6,499 18,933
   Japan 12,767 2,547 725 9,495
  China 13,810 5,171 3,284 5,356
   United Kingdom 5,834 2,577 503 2,750
  France 4,693 1,673 704 2,316
   Germany 3,600 1,592 202 1,806
     Hong Kong SAR 510 313 44 153
Source: Bank for International Settlements
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 Bond Market Size
Summary of debt securities outstanding at end-June 2020
By sector of issuer, in billions of US dollars
Financial Non-financial General
Total Corporations corporations government
United States 45,608 15,289 7,126 22,986
China 15,770 5,590 4,061 6,119
Japan 13,472 2,627 845 9,999
   United Kingdom 6,451 2,737 564 3,145
  France 5,076 1,736 777 2,563
   Germany 3,796 1,606 241 1,950
     Hong Kong SAR 527 333 43 151
Source: Bank for International Settlements
*: The reported data includes both the domestic debt securities and international
debt securities.
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End of the Notes!

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