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Chapter 12Supplement A

- Fixed-Income Securities

Basic Concepts of Lending Securities (1 of 2)

- Fixed-income securities
- Specified payment dates and amounts
- Lending securities
- An investor in bonds lends funds to issuer in exchange for a promise of a stream of periodic interest payments and a repayment of principal at maturity

Basic Concepts of Lending Securities (2 of 2)

- Coupon payments
- Interest payments paid to bondholder on semiannual basis
- Based on percentage of par value of bond
- Maturity
- Period of time through which issuer has control over bond proceeds
- Period of time required to pay coupon payments

Valuation of Fixed-Income Securities

- Value of a bond is equal to the present value of expected future cash flows
- Cash flows are discounted at appropriate discount rate (determined in same manner as an annuity)

Measures of Return

- Current yield (CY)
- Indication of income or cash flow an investor will receive on basis of coupon payment and current price
- Yield to maturity (YTM)
- Compounded rate of return on bond purchased at current market price and held to maturity
- Yield to call (YTC)
- Expected return on bond from purchase date to first call date

Corporate Returns Vs. Municipal Returns

- Taxable equivalent yield
- Method used to compare yield on municipal bonds with yield on taxable bonds

Treasury bills

Zero-coupon bonds

Commercial paper

Certificates of deposit

Banker’s acceptances

Repurchase agreements

Eurodollars

Promissory notes

Treasury notes and bonds

Treasury Inflation-Protected Securities (TIPS)

Treasury STRIPS

Types of Fixed-Income Securities (1 of 3)Types of Fixed-Income Securities (2 of 3)

- US savings bonds
- Series EE
- Series HH
- Series I
- Municipal bonds
- General obligation
- Backed by full faith and credit
- Revenue
- Finance specific revenue-producing projects

Types of Fixed-Income Securities (3 of 3)

- Corporate bonds
- Call provision
- Unsecured or secured
- Convertible bonds
- Acquire stock by exchanging bonds under specific formula
- Asset-backed securities
- Mortgage-backed securities (MBSs)
- Prepayment risk
- Collateralized mortgage obligations (CMOs)

Systematic

Interest rate risk

Reinvestment risk

Purchasing power risk

Unsystematic

Default risk

Call risk

Risks of Fixed-Income SecuritiesVolatility of Fixed-Income Securities

- Two key factors influencing volatility
- Coupon rate: 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

Term Structure of Interest Rates

- Yield curves
- Normal (upward sloping)
- Flat
- Downward sloping
- Yield curve theories
- Pure expectations theory
- Liquidity preference theory
- Preferred habitat theory
- Market segmentation theory

Duration and Immunization

- Duration: Provides a time-weighted measure of a security’s cash flows in terms of payback
- Factors impacting duration
- Coupon rate
- Maturity
- Yield to maturity
- Immunization: Concept of minimizing the impact of changes in interest rates on the value of investments

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

Traditional Methods of Immunizing Bond Portfolios

- Ladder strategy
- Portfolio of bonds with staggered maturities
- Barbell strategy
- One-half of portfolio is invested in short-term bonds, the other-half in long-term bonds
- Bullet strategy
- Purchasing a series of bonds with similar maturities, focused around a single point in time

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