Chapter 12 Supplement A: Fixed-Income Securities Chapter 12 Supplement A Fixed-Income Securities

 2005 Kaplan Financial 2 Chapter 12 Supplement A: Fixed-Income Securities Basic Concepts of Lending Securities Fixed-income securities are securities with specified payment dates and amounts, primarily bonds Lending securities are securities where an investor of bonds lends funds to the issuer in exchange for a promise to a stream of periodic interest payments and a repayment of the loaned principal at the maturity of the bond

 2005 Kaplan Financial 3 Chapter 12 Supplement A: Fixed-Income Securities Basic Concepts of Lending Securities (cont.) Coupon payments are interest payments paid to the bondholder on a semiannual basis and based on a percentage of the face value, or par value, of the bond Maturity is the period of time through which the issuer has control over the bond proceeds and the period of time it must continue to pay coupon payments

 2005 Kaplan Financial 4 Chapter 12 Supplement A: Fixed-Income Securities Valuation of Fixed-Income Securities The value of a bond is equal to the present value of the expected future cash flows Cash flows Discount rate Zero-coupon bonds

 2005 Kaplan Financial 5 Chapter 12 Supplement A: Fixed-Income Securities Measures of Return Current Yield = Annual Coupon Market Price Yield to Maturity = IRR Yield to Call Maturity Call Price

 2005 Kaplan Financial 6 Chapter 12 Supplement A: Fixed-Income Securities Corporate Returns vs. Municipal Returns Tax-exempt yield 1 – marginal tax rate Pretax yield =

 2005 Kaplan Financial 7 Chapter 12 Supplement A: Fixed-Income Securities Types of Fixed-Income Securities The Money Market Treasury Bills Commercial Paper Certificates of Deposit Banker’s Acceptances Repurchase Agreements Treasury Notes and Bonds Inflation indexed STRIPS

 2005 Kaplan Financial 8 Chapter 12 Supplement A: Fixed-Income Securities Types of Fixed-Income Securities (cont.) U.S. Savings Bonds Federal Agency Securities Municipal Bonds Corporate Bonds Convertible Bonds Mortgage-Backed Securities and Collateralized Mortgage Obligations

 2005 Kaplan Financial 9 Chapter 12 Supplement A: Fixed-Income Securities Rating Agencies Standard & Poor’s Moody’s

 2005 Kaplan Financial 10 Chapter 12 Supplement A: Fixed-Income Securities Standard Credit Rating System Investment Grade:  High Grade AAA - AAAaa - Aa  Medium Grade A - BBBA - Baa Non-Investment Grade:  Speculative BB - BBa - B  Default CCC - DCaa - C BondsStandard & Poor’sMoody’s Overall RangeAAA - DAaa - C

 2005 Kaplan Financial 11 Chapter 12 Supplement A: Fixed-Income Securities Risks of Fixed-Income Securities Systematic Risks Interest Rate Risk Reinvestment Risk Purchasing Power Risk Exchange Rate Risk Unsystematic Risks Default (Credit) Risk Call Risk Liquidity Risk

 2005 Kaplan Financial 12 Chapter 12 Supplement A: Fixed-Income Securities Volatility of Fixed-Income Securities Two key factors that influence volatility are: Coupon rate – the volatility in price for a bond is inversely related to the bond’s coupon payment when interest rates change Maturity – bonds with longer terms are subject to more volatility with changing interest rates than bonds with shorter terms

 2005 Kaplan Financial 13 Chapter 12 Supplement A: Fixed-Income Securities Term Structure of Interest Rates Yield Curves Yield Curve Theories Pure Expectations Theory Liquidity Preference Theory Preferred Habitat Theory Market Segmentation Theory

 2005 Kaplan Financial 14 Chapter 12 Supplement A: Fixed-Income Securities Duration & Immunization Duration – a concept developed by Fred Macaulay in 1938 that provides a time- weighted measure of a security’s cash flows in terms of payback Immunization – the concept of minimizing the impact of changes in interest rates on the value of investments

 2005 Kaplan Financial 15 Chapter 12 Supplement A: Fixed-Income Securities Uses for Duration Measuring a bond’s volatility Estimating the change in the price of a bond based on changes in interest rates Immunizing a bond or bond portfolio against interest rate risk

 2005 Kaplan Financial 16 Chapter 12 Supplement A: Fixed-Income Securities Traditional Methods of Immunizing Bond Portfolios The Ladder Strategy The Barbell Strategy The Bullet Strategy