fabozzi bmas8 ppt ch01

Chapter 1

Introduction

2013 Pearson Education, Inc. 1-2

Learning Objectives

After reading this chapter, you will understand

the fundamental features of bonds the types of issuers the importance of the term to maturity of a

bond

floating-rate and inverse-floating-rate securities

what is meant by a bond with an embedded option and the effect of this option on cash flow


After reading this chapter, you will understand

the various types of embedded options convertible bonds the types of risks faced by fixed-income

investors

Learning Objectives (continued)


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

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

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


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


The Bond Features

1. Type of Issuer there are three issuers of bonds the federal government and its agencies municipal governments corporations (domestic and foreign)

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 bonds term to maturity.


The Bond Features (continued)

3. Principal and Coupon Rate Principal Value 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


3. Principal and Coupon Rate LIBOR (London Interbank Offered Rate) rate at

which the highest credit quality banks borrow from each other in the London interbank market. The rate is reported in 10 currencies

Linkers bonds whose interest rate is tied to the rate of inflation

Inverse-floating-rate bonds coupon interest rate moves in the opposite direction from the change in interest rates



4. Amortization Feature the principal repayment of a bond issue can call for either

i. the total principal to be repaid at maturity orii. 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.



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



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



Risks Associated with Investing in Bonds (continued)

1. Interest-rate Risk2. Reinvestment Risk3. Call Risk4. Credit Risk5. Inflation Risk6. Exchange Rate Risk7. Liquidity Risk8. Volatility Risk9. Risk Risk


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.




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.


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

certaintyii. investor is exposed to reinvestment riskiii. bonds capital appreciation potential will be

reduced



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.



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.



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.



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.



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.



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


fabozzi bmas8 ppt ch01

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