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Chapter 12 Supplement A. Fixed-Income Securities. Basic Concepts of Lending Securities (1 of 2). Fixed-income securities Specified payment dates and amounts Lending securities

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chapter 12 supplement a
Chapter 12Supplement A
  • Fixed-Income Securities
basic concepts of lending securities 1 of 2
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
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
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
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
Corporate Returns Vs. Municipal Returns
  • Taxable equivalent yield
    • Method used to compare yield on municipal bonds with yield on taxable bonds
types of fixed income securities 1 of 3
Treasury bills

Zero-coupon bonds

Commercial paper

Certificates of deposit

Banker’s acceptances

Repurchase agreements


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
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
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)
risks of fixed income securities

Interest rate risk

Reinvestment risk

Purchasing power risk


Default risk

Call risk

Risks of Fixed-Income Securities
volatility of fixed income securities
Volatility 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
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 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
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
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