Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall 1-1 Chapter 1 Introduction

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall 1-2 Learning Objectives After reading this chapter, you will understand 1)the fundamental features of bonds 2)the types of issuers 3)the importance of the term to maturity of a bond 4)floating-rate and inverse-floating-rate securities 5)what is meant by a bond with an embedded option and the effect of this option on cash flow

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall 1-3 Learning Objectives (continued) After reading this chapter, you will understand 6)the various types of embedded options 7)convertible bonds 8)the types of risks faced by fixed-income investors 9)the secondary market for bonds 10)ways of classifying financial innovation

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall 1-4 Sectors of the U.S. Bond Market 1.Treasury sector – securities issued by the U.S. government 2.Agency sector – securities issued by federally related institutions and government-sponsored enterprises 3.Municipal sector – securities issued by state and local governments bonds

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall 1-5 Sectors of the U.S. Bond Market (continued) 4.Corporate sector – securities issued in the U.S. by U.S. corporations and foreign corporations 5. Asset-backed sector – securities backed by a pool of assets 6. Mortgage sector – securities backed by mortgage loans

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall 1-6 Bond Indenture The bond indenture is the contract between the issuer and the bondholder, which sets forth all the obligations of the issuer.

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall 1-7 Overview of Bond Features 1. Type of Issuer 2. Term to Maturity 3. Principal and Coupon Rate 4. Amortization Feature 5. Embedded Options 6. Describing a Bond Issue

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall 1-8 The Bond Features 1. Type of Issuer – there are three issuers of bonds the federal government and its agencies municipal governments corporations 2. Term to Maturity – refers to the date that the issuer will redeem the bond by paying the principal There may be provisions in the indenture that allow either the issuer or bondholder to alter a bond’s term to maturity.

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall 1-9 Bond Features (continued) 3. Principal and Coupon Rate Bond Principal – amount that the issuer agrees to repay the bondholder at the maturity date Zero-Coupon Bond – interest is paid at the maturity with the exact amount being the difference between the principal value and the price paid for the bond Coupon Rate – the nominal or interest rate that the issuer agrees to pay each year; the annual amount of the interest payment is called the coupon Floating-rate bonds – issues where the coupon rate resets periodically (the coupon reset date) based on the coupon reset formula given by: reference rate + quoted margin

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall 1-10 Bond Features (continued) 4. Amortization Feature – the principal repayment of a bond issue can call for either i.the total principal to be repaid at maturity or ii.the principal repaid over the life of the bond In the latter case, there is a schedule of principal repayments called an amortization schedule. For amortizing securities, a measure called the weighted average life or simply average life of a security is computed.

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall 1-11 Bond Features (continued) 5. Embedded Options – it is common for a bond issue to include a 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 Exchangeable bond - allows the bondholder to exchange the issue for a specified number of common stock shares of a corporation different from the issuer of the bond

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall 1-12 Bond Features (continued) 6. Describing a Bond Issue –most securities are identified by a nine character CUSIP number CUSIP stands for Committee on Uniform Security Identification Procedures First six characters of CUSIP identify the issuer The next two characters identify whether the issue is debt or equity and the issuer of the issue The last character is a check character that allows for accuracy checking The CUSIP International Numbering System (CINS) identifies foreign securities and includes 12 characters

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall 1-13 Risks Associated with Investing in Bonds 1.Interest-rate Risk 2.Reinvestment Risk 3.Call Risk 4.Credit Risk 5.Inflation Risk 6.Exchange Rate Risk 7.Liquidity Risk 8.Volatility Risk 9.Risk Risk

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall 1-14 Risks Associated with Investing in Bonds (continued) 1. Interest-Rate Risk  Interest-rate risk or market risk refers to an investor having to sell a bond prior to the maturity date.  An increase in interest rates will mean the realization of a capital loss because the bond sells below the purchase price.  Interest-rate risk is by far the major risk faced by an investor in the bond market.

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall 1-15 Risks Associated with Investing in Bonds (continued) 2. Reinvestment Risk  Reinvestment risk is the risk that the interest rate at which interim cash flows can be reinvested will fall.  Reinvestment risk is greater for longer holding periods, as well as for bonds with large, early, cash flows, such as high-coupon bonds.  It should be noted that interest-rate risk and reinvestment risk have offsetting effects.

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall 1-16 Risks Associated with Investing in Bonds (continued) 3. Call Risk  Call risk is the risk that a callable bond will be called when interest rates fall.  Many bonds include a provision that allows the issuer to retire or “call” all or part of the issue before the maturity date; for investors, there are three disadvantages to call provisions: i.cash flow pattern cannot be known with certainty ii.investor is exposed to reinvestment risk iii.bond’s capital appreciation potential will be reduced

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall 1-17 Risks Associated with Investing in Bonds (continued) 4. Credit Risk  Credit risk is the default risk that the bond issuer will fail to satisfy the terms of the obligation with respect to the timely payment of interest and principal.  Credit spread is the part of the risk premium or spread attributable to default risk.  Credit spread risk is the risk that a bond price will decline due to an increase in the credit spread.

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall 1-18 Risks Associated with Investing in Bonds (continued) 5. Inflation Risk  Inflation risk arises because of the variation in the value of cash flows from a security due to rises in purchasing power.  If investors purchase a bond on which they can realize a coupon rate of 7% but the rate of inflation is 8%, the purchasing power of the cash flow falls.  For all but floating-rate bonds, an investor is exposed to inflation risk because the interest rate the issuer promises to make is fixed for the life of the issue.

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall 1-19 Risks Associated with Investing in Bonds (continued) 6. Exchange-Rate Risk  Exchange-rate 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 (i.e., a bond whose payments occur in a foreign currency) 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.

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall 1-20 Risks Associated with Investing in Bonds (continued) 7. 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.

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall 1-21 Risks Associated with Investing in Bonds (continued) 8. Volatility Risk  Volatility risk is the risk that a change in volatility will adversely affect the price of a bond.  The value of an option rises when expected interest- rate volatility increases. For example, consider the case of a callable bond where the borrower has an embedded option, the price of the bond falls when interest rates fall due to increased downward volatility in interest rates.

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall 1-22 Risks Associated with Investing in Bonds (continued) 9. Risk Risk  Risk risk refers to not knowing the risk of a security.  Two ways to mitigate or eliminate risk risk are: i.Keep up with the literature on the state-of-the-art methodologies for analyzing securities ii.avoid securities that are not clearly understood

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall 1-23 Secondary Market for Bonds  The secondary market is the market where securities that have been issued previously are traded.  Secondary trading of common stock occurs at several trading locations in the United States: centralized exchanges and the over- the-counter (OTC) market.

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall 1-24 Secondary Market for Bonds (continued)  The secondary markets in bonds throughout the world are quite different from those in stocks.  The secondary markets in bonds are not centralized exchanges but are OTC markets, which are a network of noncentralized market makers.

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall 1-25 Financial Innovation and the Bond Market  Since the 1960s, there has been a surge of significant financial innovations.  The Economic Council of Canada classifies financial innovations into three broad categories: i.Market-broadening instruments ii.Risk-management instruments iii.Arbitraging instruments and processes

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall 1-26 Financial Innovation and the Bond Market (continued)  Market-broadening instruments Market-broadening instruments augment the liquidity of markets and the availability of funds by attracting new investors and offering new opportunities for borrowers.

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall 1-27 Financial Innovation and the Bond Market (continued)  Risk-management instruments Risk-management instruments reallocate financial risks to those who are less averse to them or have offsetting exposure.

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall 1-28 Financial Innovation and the Bond Market (continued)  Arbitraging instruments and processes Arbitraging instruments and processes enable investors and borrowers to take advantage of differences in costs and returns between markets.

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall 1-29 Financial Innovation and the Bond Market (continued) 1.Price-Risk Transferring Innovations 2.Credit-Risk-Transferring Instruments 3.Liquidity-Generating Innovations 4.Credit- and Equity Generating Instruments

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall 1-30 Financial Innovation and the Bond Market (continued) 1. Price-Risk Transferring Innovations Price-risk-transferring innovations are those that provide market participants with more efficient means for dealing with price or exchange rate risk.

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall 1-31 Financial Innovation and the Bond Market (continued) 2. Credit-Risk Transferring Innovations Credit-risk-transferring instruments reallocate default risk. 3. Liquidity-Generating Innovations Liquidity-generating innovations increase the liquidity of the market, allow borrowers to draw upon new sources of funds, and permit market participants to circumvent capital constraints imposed by regulations.

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall 1-32 Financial Innovation and the Bond Market (continued) 4. Credit- and Equity-Risk Generating Innovations Credit- and equity-generating innovations increase the amount of debt funds available to borrowers and increase the capital base of financial and nonfinancial institutions, respectively.

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall 1-33 All rights reserved. No part of this publication may be reproduced, stored in a retrieval system, or transmitted, in any form or by any means, electronic, mechanical, photocopying, recording, or otherwise, without the prior written permission of the publisher. Printed in the United States of America.