CHAPTER 6 Investing in Fixed Income Securities

OVERVIEW Fixed income securities represent borrowing by governments and corporations Ratings agencies assess the quality of various offerings Investing in fixed income securities involves some risk Prices of fixed income securities depend on the terms of the security and prevailing interest rates

Fixed Income Securities Fixed income securities are a group of investment products that offer a fixed periodic return Some forms offer contractually guaranteed returns while others have specified, but not guaranteed, returns. Because of their fixed returns, fixed income securities tend to be popular investments during periods of high interest rates when investors seek to lock in high returns

Fixed Income Securities The main forms of fixed income securities are: Bonds Hybrids, which have characteristics of both bonds and shares — preference shares, and — convertible securities

Characteristics of Bonds Bonds are the long-term debt instruments (that is, IOUs) of corporations and governments that offer a fixed periodic return. A bondholder has a contractual right to receive a fixed interest return (known as the coupon rate) plus the return of the bond’s face value (the stated value given on the certificate) at maturity (typically three to 10 years). Long-term debt instruments issued by corporations (the Corporate Bond Market) can be classified as debentures or unsecured notes.

Characteristics of Bonds Coupon payments are generally made semi-annually Once a bond is issued it can (usually) be traded in what is called the secondary market As interest rates change, the price of the bond changes, but in the opposite direction

Types of Bonds Main issuers — Commonwealth Government; Commonwealth Government Securities (CGS) mainly Treasury Bonds Fixed coupon Capital indexed — Semi-government; state government authorities — Corporate; debentures and unsecured notes

Yields The yield or internal rate of return of an investment is the compounded annual rate of return earned. It can also be viewed as the discount rate that produces a present value of benefits from the investment just equal to the cost of the investment. The current interest rate for a bond compared with its market value is known as the running yield on the bond.

Yields The total return from a bond over the whole of its remaining term, including both interest payments and capital gains or losses, is known as the yield to maturity (YTM). The term ‘yield’, used alone, usually refers to the yield to maturity.

Bond Ratings Both Moody’s and Standard and Poor’s (S&P) have ratings for the various bonds and preference shares on issue Both agencies have 9 categories, which are equivalent — Moodys: Aaa, Aa, A to Caa, Ca, C — S & P: AAA, AA, A to CCC, CC, C

Bond Risks Interest rate risk; values decline when interest rates rise Credit risk; the borrower might default on repayment Inflation risk; the real value of fixed interest payments may decline Liquidity risk; buyers might not be present on the secondary market when a sale is desired

Bond Risks Interest rate risk; values decline when interest rates rise Credit risk; the borrower might default on repayment Inflation risk; the real value of fixed interest payments may decline Liquidity risk; buyers might not be present on the secondary market when a sale is desired

Calculating Bond Prices Bond prices are calculated as the Present Value of the sum of the future interest payments and the redemption value at maturity PV = FV / (1+i) n PV is present value FV is future value i is the interest rate required n is the term

Calculating Bond Prices A single formula includes all these individual present value calculations that otherwise would need to be added together Price = C/i x {1-1/(1+i) n }+F/(1+i) n C = Coupon value F = Face value

Preference Shares Like ordinary shares, preference shares represent an ownership interest in a corporation and are a form of equity funding, though they have a number of features in common with debt. Like ordinary shares, preference shares represent an ownership interest in a corporation. Like debt securities, and unlike ordinary shares, preference shares have a stated dividend rate and payment of this dividend is given preference over other share dividends of the same firm.

Preference Shares Preference shares have no maturity date and holders of preference shares often have no voting rights. Preference shares are typically issued by companies which need money but don’t want to issue debt to get it. Investors typically purchase them for the dividends they pay, but preference shares may also provide capital gains. Companies like to issue preference shares because they don’t count as ordinary shares and so don’t affect earnings per share.

Convertible Securities Either a convertible note or a convertible preference share Key feature is that under stated conditions the convertible note or the convertible preference share can be ‘converted’ to ordinary shares The strategy is to invest in these more defensive assets when market conditions are unfavourable, and then covert to ordinary shares when the share market is expected to rise

Summary This chapter has covered: Characteristics of bonds and the markets in which they are traded The rating of bonds by the ratings agencies The risks involved in bond investment The calculation of bond prices, given the yield required Some types of hybrid securities