FINC6014

Fixed Income Securities

Presented by
Dr James Cummings
Discipline of Finance

The University of Sydney Page 1

 Welcome to FINC6014

Lecturer
Dr James Cummings
– Office: Codrington Building H69 Room 420
– Consultation hour: Friday, 10:00-11:00 am
– Email: [email protected]

The University of Sydney Page 2

 Welcome to FINC6014

Tutors
Mr Salaar Bin Tassadaq
Mr Jun Wu (Andoreal) Chen
Dr Adam Corbett
Dr James Cummings
Dr Thanh Son (Alex) Luong
Mr Qian (Clement) Peng
Mr Ahasan Sarkar

The University of Sydney Page 3

 Assessment

Mid-semester test
Week 7
Due date: 14 Sep 2024 at 9:40

25%
Group assignment
Mid-semester test
50% Group assignment Week 11
Final exam
Due date: 18 Oct 2024 at 23:59
25%

Final exam
Formal exam period

Weightings

The University of Sydney Page 4

 Learning activities

Preparation for class

– Readings
– Homework problems

Required text
– Fabozzi, F.J. and Fabozzi, F.A. (2021), Bond Markets, Analysis, and
Strategies, 10th edition, MIT Press

Online support
– Canvas (https://canvas.sydney.edu.au)

The University of Sydney Page 5

Week 1
Introduction

Presented by
Dr James Cummings
Discipline of Finance

The University of Sydney Page 6

 Learning Objectives

After studying this topic, you will understand

– the fundamental features of bonds
– the types of issuers
– the importance of the term to maturity of a bond
– floating-rate and inverse-floating-rate securities
– what is meant by a bond with an embedded option and the effect of this
option on cash flow
– the various types of embedded options
– convertible bonds
– the types of risks faced by fixed-income investors

The University of Sydney Page 7

 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
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

The University of Sydney Page 8

 Sectors of the U.S. Bond Market

– Bond investors include retail investors and institutional investors.

– Bond investors have an opportunity to invest in a pooled investment vehicle
in lieu of constructing their own portfolio to obtain exposure to the broad
bond market and/or specific sectors of the bond market.
– For retail investors, the benefits of investing in pooled funds rather than the
direct purchase of individual bonds to create a portfolio are
1. better diversification in obtaining the desired exposure
2. better liquidity, and
3. professional management.

The University of Sydney Page 9

 Overview of Bond Features

1. Type of Issuer
2. Term to Maturity
3. Principal and Coupon Rate
4. Amortisation Feature
5. Embedded Options
6. Describing a Bond Issue

The University of Sydney Page 10

 Overview of Bond Features

1. Type of Issuer – there are three issuers of bonds

– the federal government and its agencies
– municipal governments
– corporations (domestic and foreign)
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.

The University of Sydney Page 11

 Overview of Bond Features

3. Principal and Coupon Rate

– Principal Value – 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 – is the 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

The University of Sydney Page 12

 Overview of Bond Features

3. Principal and Coupon Rate (continued)

– LIBOR (London Interbank Offered Rate) – rate at which the highest
credit quality banks borrow from each other in the London interbank
market. The rate is reported in 10 currencies
– Linkers – bonds whose interest rate is tied to the rate of inflation
– Inverse-floating-rate bonds – coupon interest rate moves in the
opposite direction from the change in interest rates

The University of Sydney Page 13

 Overview of Bond Features

4. Amortisation Feature – the principal repayment of a bond issue can call

for either the total principal to be repaid at maturity or the principal
repaid over the life of the bond
– In the latter case, there is a schedule of principal repayments called an
amortisation schedule.
– For amortising securities, a measure called the weighted average life or
simply average life of a security is computed.

The University of Sydney Page 14

 Overview of Bond Features

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

The University of Sydney Page 15

 Overview of Bond Features

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

The University of Sydney Page 16

 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

The University of Sydney Page 17

 Risks Associated with Investing in Bonds

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 realisation 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.

The University of Sydney Page 18

 Risks Associated with Investing in Bonds

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.

The University of Sydney Page 19

 Risks Associated with Investing in Bonds

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:
a) cash flow pattern cannot be known with certainty
b) investor is exposed to reinvestment risk
c) bond’s capital appreciation potential will be reduced

The University of Sydney Page 20

 Risks Associated with Investing in Bonds

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.

The University of Sydney Page 21

 Risks Associated with Investing in Bonds

5. Inflation Risk
– Inflation risk arises because of the variation in the value of cash flows
from a security due to declines in purchasing power.
– If investors purchase a bond on which they can realise 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.

The University of Sydney Page 22

 Risks Associated with Investing in Bonds

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.

The University of Sydney Page 23

 Risks Associated with Investing in Bonds

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.

The University of Sydney Page 24

 Risks Associated with Investing in Bonds

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.
• In the case of a bond that is callable, or a mortgage-backed
security, in which the investor has granted the borrower an option,
the price of the security falls because the investor has given away a
more valuable option.

The University of Sydney Page 25

 Risks Associated with Investing in Bonds

9. Risk Risk
– Risk risk refers to not knowing the risk of a security.
– Two ways to mitigate or eliminate risk risk are:
1) Keep up with the literature on the state-of-the-art methodologies
for analysing securities
2) Avoid securities that are not clearly understood

The University of Sydney Page 26

 Required reading

– Fabozzi, F.J. and Fabozzi, F.A. (2021), Bond Markets, Analysis, and
Strategies, 10th edition, MIT Press
– Chapter 1

The University of Sydney Page 27

 Homework problems

– Fabozzi and Fabozzi (2021)

– Chapter 1
• Questions 1, 2, 4, 5, 17, 19

The University of Sydney Page 28