1. Fixed Income Securities
Bonds & Its Diversified Dimensions

2. Real vs. Financial Assets
Real Assets have physical characteristics that determine the value of the asset
Size, Shape, Material, Color, etc.
Price based on the benefits of the physical characteristics
Financial Assets physical characteristics are inconsequential
Value based on claim to promised or anticipated cash flows
TVM concepts used to price financial assets

3. The U.S. Bond Market
U.S. Treasury is the world’s single largest borrower—also has the most liquid market—an informal OTC market.

4. Corporate Bonds in the U.S.
Market for corporate bonds is less liquid than market for U.S. Treasuries
IPOs for bonds are underwritten by investment banking firms
Largest organized secondary bond market is NYSE
Uses matrix prices for most of the bonds listed on its Automated Bond System (ABS)
Based on price quotes for similar bonds (in terms of coupon rate, maturity, quality rating, call provisions)

5. Bond Markets
Debt Issuers
Underwriter
Investors
U.S. government
U.S. Treasury
Governments, pensions, commercial banks, insurance companies, mutual funds, foreigners, households
Federal government agencies
Investment banks
Municipalities
Commercial and investment banks
Governments, commercial banks, insurance companies, mutual funds, foreigners, households
Corporations
Pensions, commercial banks, insurance companies, mutual funds, foreigners, households
Home buyers, commercial real estate developers
Mortgage banks & pool operators
Pensions, commercial banks, insurance companies, REITs
Foreign governments
Pensions, mutual funds, foreigners, households
Foreign corporations
U.S. government conducts regularly scheduled auctions for Treasury securities.

6. Sectors of the Industrialized World’s Bond Markets
In almost every country, the federal government is that country’s largest debt issuer
Corporate sector for Japan, Italy and Germany is relatively small compared to their overall bond markets
Due to custom of borrowing from a bank vs. issuing bonds

7. International Bonds Represent a rapidly growing category
Reflects willingness of borrowers to borrow across borders
International bond investors face two types of political risk
Repatriation-of-funds risk
A government may block payments of principal or interest
Sovereign risk
A government may refuse to honor its debts

8. International Bonds Can be organized into the following categories
Domestic bonds
Issued by a local borrower and denominated in local currency
Foreign bonds
Issued in one country and denominated in that country’s currency by a bond issuer from another country
Eurobonds
Any bond not issued in a domestic market regardless of its currency denomination and the issuer’s nationality

9. Bearer Bonds Vs. Registered Bonds
Registered bonds—send coupon checks to registered bond owners
Bearer bonds—have no list of registered owners
Investor must submit a dated coupon to a bank to receive coupon payments
Many Eurodollar bonds are of this type
Owner’s identity is unknown

10. Accrued Interest Market price of bond (or its clean price) is:
Bonds pay coupon payments periodically
Annually, semi-annually, quarterly, etc.
When a bond is purchased on a day between its scheduled interest payment, buyer must pay seller for accrued interest
Interest that has been earned but not yet paid by issuer

11. Compounding Conventions
The length of time between coupon payments impacts bonds’ yields and prices

12. Bonds Pricing
Bond Price = Coupon X PVIFA + Par Value X PVIF

13. Yield-to-Maturity (YTM): A First Look
A simple approximation of yield-to-maturity is:

14. Bond Basics, II.
Two basic yield measures for a bond are its coupon rate and its current yield.

15. Compounded YTM
YTM defined as the discount rate equating the present value of a bond’s future cash flows to its current market price
For bonds paying coupon payments semi-annually, the correct formula is:
The YTM is identical to IRR

16. Example: Comparing a Bond’s Conventional and Effective YTM
Given information
Par value: $100
Coupon rate: 10% (semi-annual)
Time to maturity: 10 years
Purchase price: $106.59
Using the conventional YTM formula, we calculate a YTM of 8.89%

17. Conditions Required to Earn a Bond’s Expected YTM
A bond’s computed YTM will only actually be earned if:
The bond is held to maturity
The bond issuer does not default in the timing or amount of scheduled payments
All the cash flows are immediately reinvested to earn the bond’s YTM

18. Inverse Relationship Between a Bond’s Price and YTM
The price and YTM of a bond move inversely
NOTE: Price-yield curves are convex to the origin.

19. Interest Rate Risk
The value of the 5% bond falls as interest rates rise

20. Interest Rate Risk and Time to Maturity
Bond values ($)
2,000
$1,768.62
30-year bond
Interest rate year years
5% $1, $1,768.62
10 1, ,000.00
Time to Maturity
1,500
$1,047.62
1-year bond
1,000
$916.67
500
$502.11
Interest rates (%) 5 10 15 20
Value of a Bond with a 10% Coupon Rate for Different Interest Rates and Maturities

21. Other Measures of Bonds’ Yields
Yield-to-call (YTC)
A bond issuer may call a bond before its original maturity date
Need to calculate the bond’s YTC
Similar to YTM, except replace T as the time-to-call rather than time-to-maturity

22. International Bond Index Statistics
U.S. $
U.K. Pound
Hong Kong $
German Mark
Return SD
Australia
8.5%
15.5%
9.9%
18.3%
9.5%
16.4%
5.0%
20.2%
Belgium
11.6
17.2
13.0
14.7
12.7
16.2
8.1
8.6
Canada
9.3
10.4
10.7
19.3
10.3
13.2
5.8
17.0
France
10.8
15.6
12.2
15.3
11.8
7.2
Germany
12.0
14.9
13.4
16.7
8.4
Japan
17.5
13.7
18.4
13.3
18.3
8.7
17.3
Netherlands
11.7
14.2
13.1
15.8
14.0
8.2
Switzerland
10.2
17.1
16.8
11.2
16.0
6.7
9.8
U.K.
22.3
11.3
23.4
U.S.
10.6
21.3
No single bond investment appears to be the most or least risky.

23. Actively Managing International Bond Investments
Active international bond investors can use different approaches:
Political analysts begin with a top-down approach and analyze sovereign risks, etc.
Macro-economists study macro factors (income, employment, etc.) to determine which nations are economically strong
Monetary economists forecast a nation’s level and structure of market interest rates by analyzing central bank and their policies, etc.
Industry analysts analyze financial data from different industries
Security analysts have a bottom-up approach—focus on bond issuer’s financial conditions, protective provisions, etc.

24. The Bottom Line Governments are the largest borrowers in the world
Most rapid growth occurring in Eurobond market
Unregulated and untaxed
Some countries publish clean bond prices while others publish dirty prices which includes accrued interest
Day counting conventions differ across countries
YTM calculations methods also differ across countries

25. Bond Risk Hierarchy More Risk Less Risk Higher Lower Priority of Claim
Common Stock
Preferred Stock
Subordinated Debentures
Senior Debentures
2nd Mortgage Bonds
1st Mortgage Bonds
Less
Risk
Higher Lower
Priority of Claim

26. The Bottom Line
If a bond’s cash flows are not invested at the bond’s YTM the investor will not earn the YTM
Other yield measures exist
Holding period return
Current yield
Yield to call