Investments & Securities Chapter 1 Overview Contents Introduces The Text S Set Forth The Basic Analytical

OVERVIEW OF CONTENTS

Chapter 1 introduces the text. Chapters 2–5 set forth the basic analytical framework necessary to

understand the pricing of bonds and their investment characteristics. Chapter 6 introduces

Treasury securities, Treasury derivative securities, and federal agency securities. Chapters 7–9

explain the investment characteristics and special features of U.S. corporate debt, municipal

securities, and non-U.S. bonds. Chapters 10–13 focus on residential mortgage-backed securities.

Chapter 14 covers commercial mortgage loans and commercial mortgage-backed securities.

CHAPTER 1

INTRODUCTION

CHAPTER SUMMARY

This introductory chapter will focus on the fundamental features of bond, the type of issuers, and

risk faced by investors in fixed-income securities. A bond is a debt instrument requiring the

issuer to repay to the lender the amount borrowed plus interest over a specified period of time.

A typical (“plain vanilla”) bond issued in the United States specifies (1) a fixed date when the

SECTORS OF THE U.S. BOND MARKET

The U.S. bond market is divided into six sectors: U.S. Treasury sector, agency sector, municipal

sector, corporate sector, asset-backed securities, and mortgage sector.

The Treasury Sector

The Agency Sector

The Municipal Sector

The municipal sector is where state and local governments and their authorities raise funds. This

sector is divided into two subsectors based on how the interest received by investors is taxed at

The Corporate Sector

The corporate sector includes (i) securities issued by U.S. corporations and (ii) securities issued

in the United States by foreign corporations. Issuers in the corporate sector issue bonds, medium–

term notes, structured notes, and commercial paper. The corporate sector is divided into the

investment grade and noninvestment grade sectors.

The Asset-Backed Securities Sector

The Mortgage Sector

The mortgage sector is the sector where securities are backed by mortgage loans. These are loans

OVERVIEW OF BOND FEATURES

A more detailed treatment of bond features is presented in later chapters.

Type of Issuer

There are three issuers of bonds: the federal government and its agencies, municipal

governments, and corporations (domestic and foreign).

Term to Maturity

The maturity of a bond refers to the date that the debt will cease to exist, at which time the issuer

Generally, bonds with a maturity of between one and five years are considered short-term.

Bonds with a maturity between 5 and 12 years are viewed as intermediate -term, and those with

Principal and Coupon Rate

The principal of a bond is the amount that the issuer agrees to repay the bondholder at the

maturity date. This amount is also referred to as the redemption value, maturity value, par

The holder of a zero-coupon bond realizes interest by buying the bond substantially below its

principal value. Interest is then paid at the maturity date, with the exact amount being the

difference between the principal value and the price paid for the bond.

Floating-rate bonds are issues where the coupon rate resets periodically (the coupon reset date)

based on a formula. The coupon reset formula has the following general form: reference rate +

An important non-interest rate index that has been used with increasing frequency is the rate of

inflation. Bonds whose interest rate is tied to the rate of inflation are referred to generically as

linkers.

The coupon on floating-rate bonds (which is dependent on an interest rate benchmark) typically

rises as the benchmark rises and falls as the benchmark falls. Exceptions are inverse floaters

whose coupon interest rate moves in the opposite direction from the change in interest rates. To

Amortization Feature

The principal repayment of a bond issue can call for either (1) the total principal to be repaid at

maturity or (2) the principal repaid over the life of the bond. In the latter case, there is a schedule

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the right to retire the debt, fully or partially, before the scheduled maturity date. An issue with a

put provision included in the indenture grants the bondholder the right to sell the issue back to

the issuer at par value on designated dates.

A convertible bond is an issue giving the bondholder the right to exchange the bond for a

specified number of shares of common stock. An exchangeable bond allows the bondholder to

Describing a Bond Issue

There are hundreds of thousands of bonds issues. Most securities are identified by a nine

character (letters and numbers) CUSIP number. CUSIP stands for Committee on Uniform

RISKS ASSOCIATED WITH INVESTING IN BONDS

Bonds may expose an investor to one or more of the following risks: (1) interest-rate risk,

(2) reinvestment risk, (3) call risk, (4) credit risk, (5) inflation risk, (6) exchange rate risk,

Interest-Rate Risk

Reinvestment Income or 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,

Call Risk

Call risk is the risk investors have 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. The issuer usually retains this right in order to have flexibility to

refinance the bond in the future if the market interest rate drops below the coupon rate.

For investors, there are three disadvantages to call provisions. First, the cash flow pattern cannot

be known with certainty. Second, the investor is exposed to reinvestment risk. Third, the capital

Credit Risk

Credit risk is the risk that the issuer of a bond will fail to satisfy the terms of the obligation with

respect to the timely payment of interest and repayment of the amount borrowed. This form of

do not exist in a Treasury issue—referred to as a spread. The part of the risk premium or spread

attributable to default risk is called the credit spread. The risk that a bond price will decline due

to an increase in the credit spread is called credit spread risk.

Inflation Risk

Inflation risk or purchasing-power risk arises because of the variation in the value of cash

flows from a security due to inflation, as measured in terms of purchasing power.

Exchange-Rate Risk

Liquidity Risk

Liquidity 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. Marking a

Volatility Risk

The value of an embedded option rises when expected interest-rate volatility increases. The risk

Risk Risk

There have been new and innovative structures introduced into the bond market. Risk risk is

defined as not knowing what the risk of a security is. There are two ways to mitigate or eliminate

ANSWERS TO QUESTIONS FOR CHAPTER 1

(Questions are in bold print followed by answers.)

1. What is the cash flow of a 8-year bond that pays coupon interest semiannually, has a

coupon rate of 6%, and has a par value of $100,000?

The principal or par value of a bond is the amount that the issuer agrees to repay the bondholder

at the maturity date. The coupon rate multiplied by the principal of the bond provides the dollar

amount of the coupon (or annual amount of the interest payment). An 8-year bond with a 6%

2. What is the cash flow of a 4-year bond that pays no coupon interest and has a par value

of $1,000?

There is no periodic cash flow as found in the previous problem. Thus, the only cash flow will be

the principal payment of $1,000 received at the end of six years. This type of cash flow

3. Give three reasons why the maturity of a bond is important.

There are three reasons why the maturity of a bond is important. First, the maturity gives the

time period over which the holder of the bond can expect to receive the coupon payments and the

4. Explain whether or not an investor can determine today what the cash flow of a floating–

rate bond will be.

Floating-rate bonds are issues where the coupon rate resets periodically based on a general

formula equal to the reference rate plus the quoted margin. The reference rate is some index

5. Suppose that coupon reset formula for a floating-rate bond is: 1-month LIBOR + 130

basis points.

(a) What is the reference rate?

(b) What is the quoted margin?

(c) Suppose that on coupon reset date that 1-month LIBOR is 2.4%. What will the coupon

rate be for the period?

6. What is a deferred coupon bond?

Deferred-coupon bonds are coupon bonds that let the issuer avoid using cash to make interest

7. What is meant by a linker?

8. Answer the below questions.

(a) What is meant by an amortizing security?

The principal repayment of a bond issue can be for either the total principal to be repaid at

maturity or for the principal to be repaid over the life of the bond. In the latter case, there is a

schedule of principal repayments. This schedule is called an amortization schedule. Loans that

(b) Why is the maturity of an amortizing security not a useful measure?

For amortizing securities, investors do not talk in terms of a bond’s maturity. This is because the

stated maturity of such bonds or securities only identifies when the final principal payment will

9. What is a bond with an embedded option?

A bond with an embedded option is a bond that contains a provision in the indenture that gives

either the bondholder and/or the issuer an option to take some action against the other party. For

10. What does the call provision for a bond entitle the issuer to do?

11. Answer the below questions.

(a) What is the advantage of a call feature for an issuer?

Inclusion of a call feature benefits bond issuers by allowing them to replace an old bond issue

with a lower-interest cost issue if interest rates in the market decline. A call provision effectively

(b) What are the disadvantages of a call feature for the bondholder?

From the bondholder’s perspective, there are three disadvantages to call provisions. First, the

cash flow pattern of a callable bond is not known with certainty. Second, because the issuer will

call the bonds when interest rates have dropped, the investor is exposed to reinvestment risk (i.e.,

12. What does the put provision for a bond entitle the bondholder to do?

An issue with a put provision included in the indenture grants the bondholder the right to sell the

issue back to the issuer at par value on designated dates. The advantage to the bondholder is

13. The Export Development Canada issued a bond on March 17, 2009. The terms were as

follows:

Currency of denomination: Japanese yen (JPY)

Denomination: JPY100,000,000

Maturity date: March 18, 2019, or an optional redemption date

Redemption/payment basis: Redemption at par value

Interest rate:

Fixed rate for the first three years up to but excluding March 18, 2012: 1.5%

March 18, 2012-September 18, 2012 1.75% − 6 month JPY LIBORBBA

September 18, 2012-March 18, 2013 1.75% − 6 month JPY LIBORBBA

March 18, 2014-September 18, 2014 2.25% − 6 month JPY LIBORBBA

September 18, 2014-March 18, 2015 2.25% − 6 month JPY LIBORBBA

March 18, 2015-September 18, 2015 2.50% − 6 month JPY LIBORBBA

September 18, 2015-March 18, 2016 2.50% − 6 month JPY LIBORBBA

Answer the below questions.

(a) What is meant by JPY LIBORBBA?

The reference rate for most floating-rate securities is an interest rate or an interest rate index. The

mostly widely used reference rate throughout the world is the London Interbank Offered Rate

(b) Describe the coupon interest characteristics of this bond.

The characteristics are based on the floating-rate bonds, which are issues where the coupon rate

resets periodically (the coupon reset date) based on a formula. The formula, referred to as the

coupon reset formula, has the following general form:

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1-month LIBOR + 150 basis points = 3.5% + 1.5% = 5.0%

If the 1-month LIBOR on the coupon reset date is 3.5%, the coupon rate is reset for that period at

5.0% .

(c) What are the risks associated with investing in this bond if the investor’s home currency

is not in Japanese yen.

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

14. What are a convertible bond and an exchangeable bond?

A convertible bond is an issue giving the bondholder the right to exchange the bond for a

specified number of shares of common stock. Such a feature allows the bondholder to take

15. How do market participants gauge the default risk of a bond issue?

It is common to define credit risk as the risk that the issuer of a bond will fail to satisfy the terms

of the obligation with respect to the timely payment of interest and repayment of the amount

16. Comment on the following statement: Credit risk is more than the risk that an issuer

will default.

There are risks other than default that are associated with investment bonds that are also

components of credit risk. Even in the absence of default, an investor is concerned that the

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“widened”—the market price of the bond issue will decline. The risk that a bond issue will

decline due to an increase in the credit spread is called credit spread risk. This risk exists for an

individual bond issue, bond issues in a particular industry or economic sector, and for all bond

issues in the economy not issued by the U.S. Treasury.

17. Explain whether you agree or disagree with the following statement: “Because my bond

is guaranteed by an insurance company, I have eliminated credit risk.”

Credit risk consists of three types of risk: default risk, credit spread risk, and downgrade risk.

18. Answer the below questions.

(a) What is counterparty risk?

Counterparty risk is a form of credit risk that involves transactions between two parties in a

(b) Give two examples of transactions where one faces counterparty risk.

For a first example of counterparty risk, consider the strategy of a borrower using the borrowed

funds from a lender to purchase another asset such as a bond. In this transaction, the lender is

19. Does an investor who purchases a zero-coupon bond face reinvestment risk?

The calculation of the yield of a coupon paying bond assumes that the cash flows received are

reinvested at the prevailing rate when the coupon payment is received. Because this rate is not

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For zero-coupon bonds, unlike bonds that pay a stream of coupon payments over time, the

payment is reinvested at the same rate as the coupon rate. This eliminates any risk associated

with the possibility that coupon payments will be reinvested at a lower rate. However, if rates go

up, then the zero coupon bond will fall in value because its “locked–in” rate is below the higher

market rate.

20. What is meant by marking a position to market?

Marking a position to market means that periodically the market value of a portfolio must be

determined. Thus, it can refer to the practice of reporting the value of assets on a market rather

21. What is meant by a CUSIP number, and why is it important?

By a CUSIP number, we mean a unique number assigned to a firm’s security to identify it. Thus,

its importance lies in its ability to singularly identify each security. Most securities are identified