Chapter 1

Introduction

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 Learning Objectives
After reading this chapter, you will understand
1) the fundamental features of bonds
2) the types of issuers
3) the importance of the term to maturity of a bond
4) floating-rate and inverse-floating-rate securities
5) what is meant by a bond with an embedded
option and the effect of this option on cash flow

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 Learning Objectives
(continued)
After reading this chapter, you will understand
6) the various types of embedded options
7) convertible bonds
8) the types of risks faced by fixed-income
investors
9) the secondary market for bonds
10) ways of classifying financial innovation

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Sectors of the U.S. Bond Market
1. Treasury sector – securities issued by
the U.S. government
2. Agency sector – securities issued by
federally related institutions and
government-sponsored enterprises
3. Municipal sector – securities issued by
state and local governments bonds

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Sectors of the U.S. Bond Market
(continued)

4. Corporate sector – securities issued in

the U.S. by U.S. corporations and foreign
corporations
5. Asset-backed sector – securities
backed by a pool of assets
6. Mortgage sector – securities backed by
mortgage loans

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 Bond Indenture
The bond indenture is the
contract between the issuer and
the bondholder, which sets forth
all the obligations of the issuer.

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 Overview of
Bond Features
1. Type of Issuer
2. Term to Maturity
3. Principal and Coupon Rate
4. Amortization Feature
5. Embedded Options
6. Describing a Bond Issue

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 The Bond Features
1. Type of Issuer – there are three issuers of bonds
the federal government and its agencies
municipal governments
corporations
2. Term to Maturity – refers to the date that the
issuer will redeem the bond by paying the principal
There may be provisions in the indenture that allow either
the issuer or bondholder to alter a bond’s term to maturity.

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 Bond Features (continued)
3. Principal and Coupon Rate
 Bond Principal – amount that the issuer agrees to repay
the bondholder at the maturity date
 Zero-Coupon Bond – interest is paid at the maturity with
the exact amount being the difference between the principal
value and the price paid for the bond
Coupon Rate – the nominal or interest rate that the issuer
agrees to pay each year; the annual amount of the interest
payment is called the coupon
 Floating-rate bonds – issues where the coupon rate resets
periodically (the coupon reset date) based on the coupon
reset formula given by:
reference rate + quoted margin

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 Bond Features (continued)
4. Amortization Feature – the principal
repayment of a bond issue can call for either
i. the total principal to be repaid at maturity or
ii. the principal repaid over the life of the bond
 In the latter case, there is a schedule of
principal repayments called an amortization
schedule.
 For amortizing securities, a measure called
the weighted average life or simply average life
of a security is computed.

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 Bond Features (continued)
5. Embedded Options – it is common for a bond issue
to include a provision in the indenture that gives either the
bondholder and/or the issuer an option
 Call provision - grants the issuer the right to retire the
debt, fully or partially, before the scheduled maturity date
 Put provision - gives the bondholder the right to sell the
issue back to the issuer at par value on designated dates
 Convertible bond - provides the bondholder the right to
exchange the bond for shares of common stock
 Exchangeable bond - allows the bondholder to exchange
the issue for a specified number of common stock shares of a
corporation different from the issuer of the bond

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 Bond Features (continued)
6. Describing a Bond Issue –most securities are
identified by a nine character CUSIP number
 CUSIP stands for Committee on Uniform Security
Identification Procedures
 First six characters of CUSIP identify the issuer
 The next two characters identify whether the issue is
debt or equity and the issuer of the issue
 The last character is a check character that allows for
accuracy checking
 The CUSIP International Numbering System (CINS)
identifies foreign securities and includes 12 characters

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 Risks Associated with
Investing in Bonds
1. Interest-rate Risk
2. Reinvestment Risk
3. Call Risk
4. Credit Risk
5. Inflation Risk
6. Exchange Rate Risk
7. Liquidity Risk
8. Volatility Risk
9. Risk Risk

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 Risks Associated with Investing in
Bonds (continued)
1. Interest-Rate Risk
Interest-rate risk or market risk refers to an
investor having to sell a bond prior to the maturity
date.
An increase in interest rates will mean the
realization of a capital loss because the bond sells
below the purchase price.
Interest-rate risk is by far the major risk faced by
an investor in the bond market.

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 Risks Associated with Investing in
Bonds (continued)
2. 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, early, cash
flows, such as high-coupon bonds.
It should be noted that interest-rate risk and
reinvestment risk have offsetting effects.

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 Risks Associated with Investing in
Bonds (continued)
3. Call Risk
Call risk is the risk 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; for investors, there are three disadvantages
to call provisions:
i.cash flow pattern cannot be known with certainty
ii.investor is exposed to reinvestment risk
iii.bond’s capital appreciation potential will be reduced

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Risks Associated with Investing in
Bonds (continued)
4. Credit Risk
 Credit risk is the default risk that the bond issuer
will fail to satisfy the terms of the obligation with
respect to the timely payment of interest and
principal.
 Credit spread is the part of the risk premium or
spread attributable to default risk.
 Credit spread risk is the risk that a bond price will
decline due to an increase in the credit spread.

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 Risks Associated with Investing in
Bonds (continued)
5. Inflation Risk
Inflation risk arises because of the variation in the value
of cash flows from a security due to rises in purchasing
power.
If investors purchase a bond on which they can realize a
coupon rate of 7% but the rate of inflation is 8%, the
purchasing power of the cash flow falls.
For all but floating-rate bonds, an investor is exposed to
inflation risk because the interest rate the issuer promises to
make is fixed for the life of the issue.

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 Risks Associated with Investing in
Bonds (continued)
6. Exchange-Rate Risk
Exchange-rate risk refers to the unexpected change in one
currency compared to another currency.
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 flows are dependent on the exchange rate
at the time the payments are received.
The risk of the exchange rate causing smaller cash flows is
the exchange rate risk or currency risk.

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 Risks Associated with Investing in
Bonds (continued)
7. Liquidity Risk
 Liquidity risk 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.

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 Risks Associated with Investing in
Bonds (continued)
8. Volatility Risk
Volatility risk is the risk that a change in volatility will
adversely affect the price of a bond.
The value of an option rises when expected interest-rate
volatility increases.
For example, consider the case of a callable bond where
the borrower has an embedded option, the price of the
bond falls when interest rates fall due to increased
downward volatility in interest rates.

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 Risks Associated with Investing in
Bonds (continued)

9. Risk Risk
Risk risk refers to not knowing the risk of a
security.
Two ways to mitigate or eliminate risk risk are:
i.Keep up with the literature on the state-of-the-art
methodologies for analyzing securities
ii.avoid securities that are not clearly understood

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Secondary Market for Bonds
The secondary market is the market where
securities that have been issued previously
are traded.
Secondary trading of common stock
occurs at several trading locations in the
United States: centralized exchanges and
the over-the-counter (OTC) market.

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Secondary Market for Bonds
(continued)
The secondary markets in bonds
throughout the world are quite different
from those in stocks.
The secondary markets in bonds are not
centralized exchanges but are OTC
markets, which are a network of
noncentralized market makers.

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 Financial Innovation
and the Bond Market
 Since the 1960s, there has been a surge of
significant financial innovations.
 The Economic Council of Canada classifies
financial innovations into three broad categories:
i.Market-broadening instruments
ii.Risk-management instruments
iii.Arbitraging instruments and processes

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 Financial Innovation
and the Bond Market
(continued)

 Market-broadening instruments
Market-broadening instruments augment the
liquidity of markets and the availability of
funds by attracting new investors and offering
new opportunities for borrowers.

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 Financial Innovation
and the Bond Market
(continued)

 Risk-management instruments
Risk-management instruments reallocate
financial risks to those who are less averse
to them or have offsetting exposure.

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 Financial Innovation
and the Bond Market
(continued)

 Arbitraging instruments and processes

Arbitraging instruments and processes enable
investors and borrowers to take advantage of
differences in costs and returns between
markets.

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 Financial Innovation
and the Bond Market
(continued)

1. Price-Risk Transferring Innovations

2. Credit-Risk-Transferring Instruments
3. Liquidity-Generating Innovations
4. Credit- and Equity Generating
Instruments

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 Financial Innovation
and the Bond Market
(continued)

1. Price-Risk Transferring Innovations

Price-risk-transferring innovations are
those that provide market participants with
more efficient means for dealing with price
or exchange rate risk.

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 Financial Innovation
and the Bond Market
(continued)
2. Credit-Risk Transferring Innovations
Credit-risk-transferring instruments reallocate default
risk.
3. Liquidity-Generating Innovations
Liquidity-generating innovations increase the liquidity
of the market, allow borrowers to draw upon new
sources of funds, and permit market participants to
circumvent capital constraints imposed by regulations.

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 Financial Innovation
and the Bond Market
(continued)

4. Credit- and Equity-Risk

Generating Innovations
Credit- and equity-generating innovations increase
the amount of debt funds available to borrowers
and increase the capital base of financial and
nonfinancial institutions, respectively.

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