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Chapter 2 Securities Markets and Transactions 15
Chapter 10
Fixed-Income Securities
Outline
Learning Goals
I. Why Invest in Bonds?
A. A Brief History of Bond Prices, Returns and Interest Rates
1. Historical Returns
2. Bonds versus Stocks
B. Exposure to Risk
1. Interest Rate Risk
2. Purchasing Power Risk
3. Business/Financial Risk
4. Liquidity Risk
5. Call Risk
Concepts in Review
II. Essential Features of a Bond
A. Bond Interest and Principal
B. Maturity Date
C. Principles of Bond Price Behavior
D. Quoting Bond Prices
E. Call Features—Let the Buyer Beware!
F. Sinking Funds
G. Secured or Unsecured Debt
H. Bond Ratings
1. How Ratings Work
2. What Ratings Mean
Concepts in Review
III. The Market for Debt Securities
A. Major Market Segments
1. Treasury Bonds
a. Inflation-Protected Securities
2. Agency Bonds
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16 Smart/Gitman/Joehnk • Fundamentals of Investing, Thirteenth Edition
3. Municipal Bonds
a. Tax Advantages
b. Taxable Equivalent Yields
4. Corporate Bonds
B. Specialty Issues
1. Zero-Coupon Bonds
2. Mortgage-Backed Securities
3. Collateralized Mortgage Obligations
4. Asset-Backed Securities
5. Junk Bonds
C. A Global View of the Bond Market
1. U.S.-Pay versus Foreign-Pay Bonds
a. Dollar-Denominated Bonds
b. Foreign-Pay Bonds
Concepts in Review
IV. Convertible Securities
A. Convertibles as Investment Outlets
1. Convertible Notes and Bonds
2. Conversion Privilege
3. LYONS
B. Sources of Value
C. Measuring the Value of a Convertible
1. Conversion Value
a. Conversion Premium
b. Payback Period
2. Investment Value
Concepts in Review
Summary
Key Terms
Discussion Questions
Problems
Case Problems
10.1 Max and Veronica Develop a Bond Investment Program
10.2 The Case of the Missing Bond Ratings
Excel@Investing
Chapter-Opening Problem
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Chapter 2 Securities Markets and Transactions 17
Key Concepts
1. Historical returns in the bond market and comparison to stock returns
2. Current income and capital gains components of bond returns, including the fixed nature of
coupon payments and inverse relationship between bond returns and interest rates
3. The types of risks to which bond investors are exposed; call features may result in the early
exercise of bonds with relatively high coupon payment streams
4. The basic features of bonds and the principles of bond price behavior, including the impact of
coupon payments and bond maturity on the inverse relationship between interest rates and bond
prices
5. The many types of bonds currently available and the wide array of investment objectives they can
fulfill; Treasury bonds, agency bonds, municipal bonds, and corporate bonds are examined
6. A global view of the bond market, including dollar-denominated and foreign-pay bonds
7. Bond ratings and the way they work
8. Basic features and characteristics of convertible securities are presented; comparison of
conversion values and investment values
Overview
Bonds are an important type of investment due to the attractive investment opportunities they offer to
investors and the size of the bond market. This chapter examines various features of bonds and bond
ratings.
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18 Smart/Gitman/Joehnk • Fundamentals of Investing, Thirteenth Edition
1. Why invest in bonds? Investors choose bonds because they provide interest income and an
opportunity for capital gains. The instructor should indicate to the class that, due to the certainty of
2. To put bond returns into perspective (and to clear up possible misconceptions along the way),
some time should be spent reviewing the historical performance of bond yields and bond returns;
3. Fixed-income securities are also exposed to various types of risks. The instructor should outline
the five major types of risks to which bonds are exposed: interest rate risk, purchasing power risk,
4. Features that characterize bonds include principal, interest, maturity date, and call and sinking
fund provisions. It might be helpful to make the following distinction between bonds and stocks in
5. An interesting difference between corporate and Treasury bonds is that the former is traded as a
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Chapter 2 Securities Markets and Transactions 19
6. Bond ratings are presented next. Different bond ratings should be mentioned. A detailed
7. Bond trading takes place mainly in the OTC market. Bonds issued by the U.S. Treasury, agencies
8. Like the stock market, the bond market is also globalized. This helps U.S. investors increase the
9. Convertibles possess features of both fixed-income securities and equity. Students should be made
10. Investment strategies related to convertibles are discussed next. Students should understand that
convertibles provide good upside potential through their equity feature and downside protection
Answers to Concepts in Review
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20 Smart/Gitman/Joehnk • Fundamentals of Investing, Thirteenth Edition
10.1.Bonds are appealing to investors because they provide a reliable stream of current income, and they
Bonds make an attractive investment outlet because of their versatility. They can provide a
10.2 Table 10.1 shows that over the past 52 years, bond returns have fluctuated a great deal. The years
with the highest (lowest) bond returns correspond to years in which interest rates fell (rose). For
Swings in market interest rates have a definite impact on annual bond returns, as shown in Table
10.3 Bonds are exposed to the following five major types of risk:
(1) Interest rate risk: This affects the market as a whole and therefore translates into market risk.
(2) Purchasing power risk: This is the risk caused by inflation. When inflation rises unexpectedly,
(3) Business/financial risk: Also known as default risk, this refers to the risk that the issuer will
(4) Liquidity risk: This is the risk that a bond will be difficult to sell at a reasonable price if the
(5) Call risk: This refers to the risk that a bond will be retired before its scheduled maturity date.
The most important source of risk for bonds in general is interest rate risk. It is the major cause of
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Chapter 2 Securities Markets and Transactions 21
10.4 Issue characteristics (such as call and coupon features) do indeed affect the yield and price behavior
10.5 With a call feature, the issuer pays a call premium that may be as much as one year’s interest at the
The three different types of call features are:
A bond can be freely callable but nonrefundable for a certain number of years. In this case, a
10.6 The difference between a premium bond and a discount bond illustrates the inverse relationship
The three main factors that affect a bond’s price volatility are interest rates, coupon, and maturity
10.7 A percent of par quotation indicates that the issue is trading at the quoted percent of the par value of
Corporate bond quotes are in thousandths of a percentage, which essentially results in corporate
Government bonds are quoted in 32nds of a point, which is 1% of par value. Hence, a bond quoted
10.8 Bond ratings are grades that are assigned to bond issues on the basis of extensive, professionally
conducted financial analysis to designate investment quality. Ratings basically point to the default
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22 Smart/Gitman/Joehnk • Fundamentals of Investing, Thirteenth Edition
For a particular bond issue, if Moody’s and S&P assign different ratings (called split ratings), the
10.9 From an individual investor perspective, bond ratings relieve the drudgery of evaluating the quality of
the bond. Individuals depend on agency ratings as a viable measure of the creditworthiness of the
Bond ratings are intended to only measure an issuer’s default risk, and as such, ratings provide no
10.10 Bonds are securities that promise to pay a stated amount of annual interest over the life of an issue,
a. Treasury bonds are debt securities issued by the U.S. federal government to meet the
ever-increasing needs of the federal budget. Advantages: Highest quality with essentially no
b. Agency bonds are debt securities issued by various agencies and organizations of the U.S.
government—like the Student Loan Marketing Association (Sallie Mae) and Government
c. Municipal bonds are debt securities issued by states, counties, cities, and other political
subdivisions like school districts and water and sewer districts. Advantages: Interest on most
d. Corporate bonds are debt securities issued by corporations. The corporate bond market is
customarily subdivided into the industrial, public utility, transportation, and financial bond
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Chapter 2 Securities Markets and Transactions 23
10.11 a. Zero-coupon bonds have no interest or coupon payments. They are sold at a deep discount
from their par values, and then they increase in value over time at a compound rate of return so
b. CMOs, or collateralized mortgage obligations, are obligations designed to reduce the problems
caused by the pass-through of principal payments on mortgage-backed bonds. Normally, all
c. Junk bonds are low-rated, high-yielding, speculative securities issued primarily by corporations
(there’s also a smaller, but still sizable, market for “high-yield” junk municipals). In the past,
d. Yankee bonds are bonds issued by foreign governments or corporations or by so-called
10.12 The tax implications of various government bonds differ. Treasury issues are subject to federal
income tax but exempt from state and local taxes. Agency issues are all subject to federal tax. Some,
10.13 Asset-backed securities (ABS) are debt issues secured by a pool of bank loans, leases, and other
assets. These other assets include credit card bills, computer leases, truck rentals, and royalty fees.
Securitization (i.e., forming MBS and ABS) is the process whereby many lending vehicles are
transformed into marketable securities. An individual credit card loan might be very risky, but a pool
10.14 Dollar-denominated bonds have their cash flows (interest payment and principal repayments)
The two major types of foreign, U.S.-pay bonds are Yankee bonds and Eurodollar bonds:
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24 Smart/Gitman/Joehnk • Fundamentals of Investing, Thirteenth Edition
Yankee bonds are issued by foreign governments or corporations, registered with the SEC, and
Eurodollar bonds are issued and traded outside the United States. They are dollar-denominated,
Because U.S.-pay bonds are dollar-denominated, there is no currency exchange risk for an
U.S. investor. But foreign-pay bonds are denominated in some currency other than dollars, traded
10.15 A convertible debenture is a long-term, unsecured corporate bond carrying the provision that
within
a stipulated time period, the bond may be converted into a certain number of shares of the issuing
corporation’s common stock. A convertible preferred is very similar to a convertible bond except
10.16 The equity kicker feature of a convertible security gives the investor an opportunity to participate
in the potential price performance of the underlying common stock. When the market price of the
common is equal to or greater than the stated conversion price, the equity kicker has value to the
10.17 The convertible receives value from both its bond and stock properties. At the minimum, the
security is worth what it earns as a fixed-income security (present value of interest and face value at
maturity). This is its bond (or investment) value, and it sets the price floor for the convertible. In
10.18 Conversion value is an indication of what a convertible issue would trade for if its price were
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Chapter 2 Securities Markets and Transactions 25
Payback period is a good tool to assess the conversion premium on convertibles. The payback
The bond investment value of a convertible is a price at which the bond would trade if it were
©2017 Pearson Education, Inc.
