CHAPTER THREE

FIXED INCOME SECURITIES

• Fixed-income securities are exactly what the name suggests:
securities that promise to make fixed payments according to
some preset schedule.
• The other key characteristic of a fixed-income security is that,
like a money market instrument, it begins life as a loan of
some sort.
• Fixed-income securities are therefore debt obligations. They
are typically issued by corporations and governments. Unlike
money market instruments, fixed-income securities have lives
that exceed 12 months at the time they are issued. (marg. def.
• fixed-income securities Longer-term debt obligations, often of
corporations and governments, that promise to make fixed
payments according to a preset schedule.)
• The potential gains from owning a fixed-income security come
in two forms. First, there are the fixed payments promised and
the final payment at maturity.
• In addition, the prices of most fixed income securities rise
when interest rates fall, so there is the possibility of a gain
from a favorable movement in rates. An unfavorable change in
interest rates will produce a loss.
• Another significant risk for many fixed-income securities is the
possibility that the issuer will not make the promised
payments. This risk depends on the issuer. It doesn't exist for
government bonds, but for many other issuers the possibility
is very real.
• Finally, unlike most money market instruments, fixed-income
securities are often quite illiquid, again depending on the
issuer and the specific type.
 Bond Characteristics
• A bond is basically a loan issued by a
corporation or government entity. The issuer
pays the bondholder a specified amount of
interest for a specified time, usually several
years, and then repays the bondholder the face
amount of the bond.
• A bond can be characterized based on (1) its
intrinsic features, (2) its type, (3) its indenture
provisions, or (4) the features that affect its
cash flows and/or its maturity.
• Intrinsic Features; The coupon, maturity, principal value,
and the type of ownership are important intrinsic
features of a bond. The coupon of a bond indicates the
income that the bond investor will receive over the life
(or holding period) of the issue. This is known as interest
income, coupon income, or nominal yield.
• Sometimes, however, zero-coupon bonds are issued
that make no coupon payments. In this case, investors
receive par value at the maturity date, but receive no
interest payments until then: The bond has a coupon
rate of zero.
• These bonds are issued at prices considerably below par
value, and the investor’s return comes solely from the
difference between issue price and the payment of par
value at maturity. We will return to these bonds below.
• The term to maturity specifies the date or the number of years before a
bond matures (or expires). There are two different types of maturity. The
most common is a term bond, which has a single maturity date.
Alternatively, a serial obligation bond issue has a series of maturity dates,
perhaps 20 or 25. Each maturity, although a subset of the total issue, is
really a small bond issue with generally a different coupon. Municipalities
issue most serial bonds.
• The principal, or par value, of an issue represents the original value of the
obligation. This is generally stated in $1,000 increments from $1,000 to
$25,000 or more. Principal value is not the same as the bond’s market
value.
• The market prices of many issues rise above or fall below their principal
values because of differences between their coupons and the prevailing
market rate of interest.
• Finally, bonds differ in terms of ownership. With a bearer bond, the
holder, or bearer, is the owner, so the issuer keeps no record of
ownership. Interest from a bearer bond is obtained by clipping coupons
attached to the bonds and sending them to the issuer for payment. In
contrast, the issuers of registered bonds maintain records of owners and
pay the interest directly to them.
• Types of Issues: In contrast to common stock, companies can
have many different bond issues outstanding at the same time.
Bonds can have different types of collateral and be senior,
unsecured, or subordinated (junior) securities.
• Secured (senior) bonds are backed by a legal claim on some
specified property of the issuer in the case of default. For
example, mortgage bonds are secured by real estate assets;
equipment trust certificates, which are used by railroads and
airlines, provide a senior claim on the firm’s equipment.
• Unsecured bonds (debentures) are backed only by the promise
of the issuer to pay interest and principal on a timely basis. As
such, they are secured by the general credit of the issuer.
• Subordinate (junior) debentures possess a claim on income
and assets that is subordinated to other debentures. Income
issues are the most junior type because interest on them is paid
only if it is earned.
 Bond Price
• A bond’s coupon and principal repayments all
occur months or years in the future, the price
an investor would be willing to pay for a claim
to those payments depends on the value of
dollars to be received in the future compared to
dollars in hand today.
• This “present value” calculation depends in turn
on market interest rates. The nominal risk-free
interest rate equals the sum of (1) a real risk-
free rate of return and (2) a premium above the
real rate to compensate for expected inflation.
• To value a security, we discount its expected cash
flows by the appropriate discount rate. The cash
flows from a bond consist of coupon payments
until the maturity date plus the final payment of
par value. Therefore,
• Bond value = Present value of coupons + Present
value of par value
• If we call the maturity date T and call the discount
rate r, the bond value can be written as
• Example, XYZ Company issues 8% coupon, 30-year
maturity bond with par value of Birr 1,000 paying
semiannual coupon payments. Suppose that the
interest rate is 8% annually, and ABC Company wants to
purchase this asset, by how much birr should ABC
purchase the financial assets?
• Solution:
Given r= 8%, semiannually 8%/2 =4%
T= 30 year, the coupon paid twice in year, 30*2 = 60
Coupon= 1000*0.04= 40
Principal = 1000

= 95.06 + 904.94= 1000

• In this example, the coupon rate equals the
market interest rate, and the bond price
equals par value. If the interest rate were not
equal to the bond’s coupon rate, the bond
would not sell at par value.
• For example, if the interest rate were to rise to
10% (5% per six months), the bond’s price
would fall by 189.29, to 810.71, as follows
• 40 * Annuity factor (5%, 60) + 1,000 * PV
factor (5%, 60)
• = $757.17 + $53.54 = $810.71
• The effect of interest rate changes on bond prices will
vary from bond to bond and will depend upon a
number of characteristics of the bond.
• The maturity of the bond - Holding coupon rates and
default risk constant, increasing the maturity of a
straight bond will increase its sensitivity to interest
rate changes.
• The coupon rate of the bond - Holding maturity and
default risk constant, increasing the coupon rate of a
straight bond will decrease its sensitivity to interest
rate changes.
• Since higher coupons result in more cash flows earlier
in the bond's life, the present value will change less as
interest rates change.
• Bond Yields: the current yield of a bond
measures only the cash income provided by
the bond as a percentage of bond prices and
ignores any prospective capital gains or losses.
• The yield to maturity (YTM) is defined as the
discount rate that makes the present value of
a bond’s payments equal to its price. This rate
is often viewed as a measure of the average
rate of return that will be earned on a bond if
it is bought now and held until maturity.
• Yield to Call: Callable bonds, some corporate bonds
are issued with call provisions, allowing the issuer to
repurchase the bond at a specified call price before
the maturity date.
• For example, if a company issues a bond with a high
coupon rate when market interest rates are high,
and interest rates later fall, the firm might like to
retire the high-coupon debt and issue new bonds at
a lower coupon rate to reduce interest payments.
• The proceeds from the new bond issue are used to
pay for the repurchase of the existing higher coupon
bonds at the call price. This is called refunding.
• Puttable bonds while the callable bond gives
the issuer the option to extend or retire the
bond at the call date, the extendable or put
bond gives this option to the bondholder.
• Floating-rate bonds Floating-rate bonds make
interest payments that are tied to some
measure of current market rates.
• For example, the rate might be adjusted
annually to the current T-bill rate plus 2%. If the
one-year T-bill rate at the adjustment date is
4%, the bond’s coupon rate over the next year
would then be 6%.
• Horizon Yield
• This measures the expected rate of return of a
bond that you expect to sell prior to its maturity.
• It is therefore a total return measure which,
allows the portfolio manager to project the
performance of a bond on the basis of a planned
investment horizon, his expectations concerning
reinvestment rates and future market yields.
• This allows the portfolio manager to evaluate
which of several potential bonds considered for
investment will perform best over the planned
investment horizon.
 Risks in bond
• Credit risk: Credit risk occurs when the issuer default on the
payment of the coupon, and even the principal amount
• Interest Rate risk: The value of the bond is affected by
interest rate changes.
• This makes it particularly important for investors to consider
interest rate risk when they purchase bonds in a low-interest
rate environment. We can summarize the observations
about interest rate change in the following propositions:
• Bond prices and yields are inversely related: As yields
increase, bond prices fall; as yields fall, bond prices rise.
• An increase in a bond’s yield to maturity results in a smaller
price change than a decrease in yield of equal magnitude.
• Prices of long-term bonds tend to be more sensitive to
interest rate changes than prices of short-term bonds.
• The sensitivity of bond prices to changes in yields
increases at a decreasing rate as maturity increases. In
other words, interest rate risk is less than proportional
to bond maturity.
• Interest rate risk is inversely related to the bond’s
coupon rate. Prices of low-coupon bonds are more
sensitive to changes in interest rates than prices of
high-coupon bonds.
• The sensitivity of a bond’s price to a change in its yield
is inversely related to the yield to maturity at which the
bond currently is selling.
• Market Risk: The value of the bond is also
subject to demand and supply forces. Should
the bond market as a whole decline, the value
of individual bonds may be brought down by
market sentiments regardless of their
fundamental characteristics. As such, this
market risk is relevant if the investor decides to
sell the bond and not hold it to maturity.
• Inflation risk
• Liquidity Risk
• Foreign exchange risk
• Call risk
 Rating of bonds
• If you invest in bonds, notes, or other debt instruments,
you have probably come across credit ratings. These credit
ratings usually appear in the form of alphabetical letter
grades (for example, ‘AAA’ and ‘BBB’) and are intended to
give you an estimation of the relative level of credit risk of
a bond or a company or government as a whole.
• Credit ratings can be a useful item of information to
consider when evaluating an investment along with other
information.
• But if you use credit ratings, you should understand their
limitations. You should not base your investment decision
solely on a credit rating or treat a credit rating as if it were
investment advice.
• A bond rating is a grade given to bonds that indicates
their credit quality. Private independent rating
services such as Standard & Poor's, Moody's and Fitch
provide these evaluations of a bond issuer's financial
strength, or it’s the ability to pay a bond's principal
and interest in a timely fashion.
• A credit rating is an assessment of an entity’s ability to
pay its financial obligations. The ability to pay financial
obligations is referred to as “creditworthiness.” Credit
ratings apply to debt securities like bonds, notes, and
other debt instruments (such as certain asset-backed
securities) and do not apply to equity securities like
common stock. Credit ratings also are assigned to
companies and governments.
• A typical credit rating scale, as shown in the
table below, has a top rating of ‘AAA’ and may
have a lowest rating of ‘D’ (indicating default).
• some credit rating agencies’ scales distinguish
between investment grade and non-investment
grade (i.e., “speculative” or “high yield”) ratings
and they draw this distinction between the
‘BBB’ and ‘BB’ rating categories (in other words,
a rating that is ‘BBB-minus’ or higher is
investment grade and a rating that is lower than
‘BBB-minus’ is non-investment grade).
What a credit rating is not
• A credit rating does not reflect other types of risk, such as
market or liquidity risks, which may also affect the value of
a security.
• Nor does a credit rating consider the price at which an
investor purchased a security, or the price at which the
security may be sold.
• You should not interpret a credit rating as investment
advice and should not view it as a recommendation to buy,
sell, or hold securities. A credit rating is not a guarantee
that a financial obligation will be repaid.
• For example, an ‘AAA’ credit rating on a debt instrument
does not mean the investor will always be paid with
absolute certainty—instruments rated at this level
sometimes default.
Determinants of Bond Safety
• Bond rating agencies base their quality ratings largely on
an analysis of the level and trend of some of the issuer’s
financial ratios. The key ratios used to evaluate safety are:
• Coverage ratios. Ratios of company earnings to fixed
costs. For example, the times interest- earned ratio is the
ratio of earnings before interest payments and taxes to
interest obligations. The fixed-charge coverage ratio
includes lease payments and sinking fund payments with
interest obligations to arrive at the ratio of earnings to all
fixed cash obligations.
• Leverage ratio. Debt-to-equity ratio. A too-high leverage
ratio indicates excessive indebtedness, signaling the
possibility the firm will be unable to earn enough to
satisfy the obligations on its bonds.
• Liquidity ratios These ratios measure the firm’s ability to
pay bills coming due with its most liquid assets.
• Profitability ratios. Measures of rates of return on
assets or equity. Profitability ratios are indicators of a
firm’s overall performance.
• The return on assets (earnings before interest and taxes
divided by total assets) or return on equity (net
income/equity) are the most popular of these measures.
• Firms with higher return on assets or equity should be
better able to raise money in security markets because
they offer prospects for better returns on the firm’s
investments.
• Cash flow-to-debt ratio. This is the ratio of total cash
flow to outstanding debt.
Analysis of convertible bonds
• Convertible bonds Convertible bonds give
bondholders an option to exchange each bond for a
specified number of shares of common stock of the
firm. The conversion ratio gives the number of shares
for which each bond may be exchanged.
• Suppose a convertible bond is issued at par value of
$1,000 and is convertible into 40 shares of a firm’s
stock.
• The current stock price is $20 per share, so the
option to convert is not profitable now. Should the
stock price later rise to $30, however, each bond may
be converted profitably into $1,200 worth of stock.
• The market conversion value is the current value of the
shares for which the bonds may be exchanged. At the $20
stock price, for example, the bond’s conversion value is
$800.
• The conversion premium is the excess of the bond price
over its conversion value. If the bond were selling currently
for $950, its premium would be $150.
• Convertible bondholders benefit from price appreciation of
the company’s stock. Not surprisingly, this benefit comes at
a price; convertible bonds offer lower coupon rates and
stated or promised yields to maturity than nonconvertible
bonds.
• At the same time, the actual return on the convertible
bond may exceed the stated yield to maturity if the option
to convert becomes profitable.