Lecture 3

Introduction to
Fixed Income Securities

References: Villalobos, Luenberger, Faerber

 What is a fixed income security?
• The original concept was a fixed income (definite) cash flow
stream would be paid to whoever purchased the security.
– The only risk would be if the issuer of the security would
default (such as going bankrupt)
• Today, some fixed income securities cash flows are aligned or
tied with contingencies such as some of the financial indices.
– Adjustable rate mortgage tied to interest rate index.
– These contingencies are well defined.
• Common types of fixed income securities include:
– Mortgages
– Savings deposits
– Money Market Instruments
– US Government Securities
– Bonds
– Annuities
 Savings Deposits
• Interest bearing bank deposits include:
– Demand deposit (savings account) which pays interest
that varies with the market conditions.
– Time deposit which pays a fixed interest; money must be
deposited for a specified amount of time or a penalty
would be imposed for early withdrawal.
– Certificate of Deposit (CD) which is issued in defined
denominations such as $10,000 and can be sold in a
market.
 Money Market Instruments
• Short term, less than or equal to one year, loans by
corporations or financial intermediaries (banks).
– Commercial paper refers to an unsecured loan to a
corporation (no collateral).
– Banker’s acceptance is typically used for international
business transactions such that a bank will back the
payment by company A to company B.
– Eurodollars are deposits in US dollars that are held in a
bank outside of the US, most commonly in Europe.
 US Government Securities
• These are loans made to the US government to cover debt
– They are generally considered to be the highest quality, risk free,
because it is highly unlikely that the US government will default.
– Income from these securities are exempt from state and local
taxes.
• Common US government securities include:
– US Treasury Bills: Issued in multiples of $1,000 with short term
maturities of 4, 13, 26, and 52 weeks. Sold at discounts through
auctions. No coupons; the interest is the difference between
purchased and face value.
– US Treasury Notes: Issued in multiples of $1,000 or higher and
have maturities of 2, 5, and 10 years. Fixed interest (coupon) paid
twice per year with the face value of the note paid with the last
coupon. Sold through auctions.
– US Treasury Bonds: Issued with maturities over 10 years, with
semi-annual coupon payments. Some are callable (can be called
by the Treasury before the maturity date).
 Bonds
• Issued by the federal government, local governments, and
corporations.
• A loan that is backed by the property of the issuer with a
specified collateral.
• Include a face value and pay defined periodic coupons
through to the maturity.
• Interest is generally based on the face value.
• At maturity, the face value is paid along with the last
coupon.
• A zero coupon bond will have a face value that will be paid
on maturity, but will not issue coupons. The entire interest
is based on the difference between paid and face values.
 Types of Bonds
• Municipal bonds are issued by state and local governments.
– Tax free (no federal state or local taxes)
– Lower risk
– As a result of being tax free and lower risk, also have lower
interest rates.
– Backed by general government revenues or by the revenue of
the project (such as a football stadium) that the bond was
issued against.
– Read the next general election ballot carefully for bond related
propositions.
• Corporate bonds are issued by corporations to finance projects
and new ventures.
– Vary in quality.
– Mostly traded over the counter.
– Not very “liquid”.
 Other Terminology
• Indenture is a contract of terms associated with a bond
which can include:
– Callable: The issuer has the right to repurchase the
bond at a specified price. The date after which the
bond can be called is usually defined.
– Sinking Funds: Spreads the face value payment of the
bond out over a period of time rather than lump it at the
date of maturity.
– Debt Subordination: Limits the amount of future
borrowing that can be made by the issuer.
 Bond Summary
Type of Face Value Maturity Tax Status Callable Characteristics
Bond Period
Corporate $1,000 1 to 5 years Taxable Callable Can be risky
Bonds 5 to 10 years High yields
10 to 20 years Large minimum
investment
Municipal ≥$5,000 1 month to Exempt from Can be Low interest
Bonds 40 years federal tax callable Tax exemption
T-Bonds $1,000 > 10 years Usually Maximum safety
T-Notes $1,000 2 to 10 years Exempt from not Low interest
state and callable
T-Bills $1,000 3 months local tax Not Short term
6 months callable No coupons
1 year
 Bonds
• For our purposes, the bond is:
– A contract in which the buyer pays a fixed amount and
receives a fixed payment at the end of each defined period.
– A zero coupon or T-bill will have a zero payment.
– A final payment of the face value of the bond will be made on
the maturity date.
– There are primary markets for bonds when they are first
issued.
– There are secondary markets for bonds where they can be
traded during their life.

• Our interests are in determining the value of bonds at various

points in time.
 Bonds
1 2 3 4 5 1. Bond issuer, company, state,
Issuer Name Coupon Maturity Bid Yield %
local government.
2. Coupon is the fixed interest
GENERAL 2.63% Dec-22 101.25 1.336
rate.
JPMORGAN 2.13% Dec-22 101.99 0.081 3. Maturity date is when the
issuer will pay the face value
SOUTHERN 5.30% Jan-22 100.13 0.464
back to the investor.
CITIGROUP 2.25% Dec-22 100.13 2.112
4. Bid price is the price for the
AT&T 5.35% Sep-50 113.57 4.502 bond and is based on 100.
AT&T actual price is $1,135.70
GENERAL 2.20% Jun-22 100.89 0.111
5. Yield is the annual return until
HSBC 6.38% Nov-22 103.27 2.643
the bond matures; usually this
is the Yield to Maturity, YTM,
and not the current yield.
63.80
Current Yield for HSBC = = 6.178%
1032.70
Bonds from WSJ
 Bond Quality Ratings
Moody’s S&P Fitch Grade Risk
Aaa AAA AAA Investment Highest Grade
Aa AA AA Investment High Grade
A A A Investment Strong
Baa BBB BBB Investment Medium Grade
Ba, B BB, B BB, B Junk Speculative
Caa, Ca, C CCC, CC, C CCC, CC, C Junk Highly Speculative
Default Danger
 Recent Treasury Note Auctions
Security Issue Maturity Interest Yield Price
CUSIP
Term Date Date Rate % % Per $100

7-Year 8/31/2021 8/31/2028 1.38% 1.42% 99.681269 9128282D1

5-Year 8/31/2021 8/31/2026 1.13% 1.13% 100.000000 9128282F6
2-Year 8/31/2021 8/31/2023 0.75% 0.76% 99.980189 9128282C3
10-Year 8/15/2021 8/15/2031 1.50% 1.50% 99.972242 9128282A7
3-Year 8/15/2021 8/15/2024 0.75% 0.85% 99.704412 9128282B5

7-Year 8/1/2021 7/31/2028 1.25% 1.34% 99.400756 912828S92

5-Year 8/1/2021 7/31/2026 1.13% 1.18% 99.733839 912828S76

2-Year 8/1/2021 7/31/2023 0.75% 0.76% 99.980208 912828S68
10-Year 7/15/2021 7/15/2031 2.00% 2.03 99.729725 912828RR3
3-Year 7/15/2021 7/15/2024 0.75% 0.77% 99.955960 912828S43
 Treasury Example
From the highlighted line on the previous slide:
10 year note
Issue date of July 15, 2021
Maturity date of July 15, 2031
Interest = 2%
Yield (YTM) = 2.03%
Price per $100 = 99.729725

Verify the quoted YTM?

P = 99.729725 x 10 = $997.29725 (negative in the cash flow)

F = $1,000 on July 15, 2031
Coupon = (2% x $1,000) / 2 coupons per year = $10
20 payments over 10 years made on January 15 and July 15
 Treasury Example
Cash flow: 1000

10 10 10 10 10 10 10 10

1 2 3 4 5 18 19 20

$997.29725

10 10 10 1010
0 = −997.29725 + + 2
+ 3
+ ⋯+
1 + 𝑖𝑖 1 + 𝑖𝑖 1 + 𝑖𝑖 1 + 𝑖𝑖 20

Solving for i gives us i = 1.015%

Multiplying by 2 gives us the YTM of 2.030%

 Bond Price
Luenberger shows λ as yield to maturity in the price equation:
 
F C  1


+ −
P=  1 
  λ 
n
λ n
  λ  
1+     1+   
  m    m  
Where:
n = Remaining coupon periods
λ = Yield to Maturity
F = Face Value
C = Annual coupon payment
m = Number of coupon payments per year

This is equivalent to our previous IRR function adjusted to m

periods per year such that i = λ /m:
 GE Capital Example
OVERVIEW
Price: 112
Coupon (%): 5.25
Maturity Date: 6-Dec-22
Yield to Maturity (%): 3.219
Current Yield (%): 4.688
Fitch Ratings: AA
Coupon Payment Frequency: Semi-Annual
First Coupon Date: 6-Jun-13
Type: Corporate
Callable: No

OFFERING INFORMATION
Quantity Available: 100
Minimum Trade Qty: 25
Dated Date: 6-Dec-12
Settlement Date: 28-Apr-16
 GE Capital Example
• See the example in Excel
– Iterative method 1000
– Excel functions
26.25 26.25 26.25 26.25 26.25

4/28/16

6/6/16 12/6/16 6/6/17 6/6/22 12/6/22

1120    
   
F C 1  F C 1 
P= + 1 − n 
⇒0=
−P + + 1 − n 
  λ 
n
λ    λ     λ 
n
λ    λ  
1 +
   1 +
     1 +
    1 +    
  m     m     m     m  
 
 
1000 52.5  1 
0=−1120 + 14
+ 1 − ⇒λ =3.315%
  λ  λ    λ  14 
1 +  2    1 +  2    Wasn’t the YTM = 3.219%
        
 GE Capital Example
We purchased this bond in between coupon dates, so what does
this do to our bond price and YTM calculation? 1000

26.25 26.25 26.25 26.25 26.25

4/28/16

6/6/16 12/6/16 6/6/17 6/6/22 12/6/22

12/6/15

1120

The price must be adjusted for the “accrued interest”:

 Days into period 

P ( adjusted )= P + Coupon  
 Total days of period 
 Days into period   143 
P + Coupon 
=  1120
= + 26.25  =1140.63
 Total days of period   182  Dirty Price
 GE Capital Example
So, if we apply 1140.63 to the YTM calculations, we get:

YTM = 3.004%

which is still not the same as the Yahoo table value of 3.219%

However, if we apply the PV equation to the adjusted price to

a start date of December 6, 2015, we will get the correct value.
1000

26.25 26.25 26.25 26.25 26.25

4/28/16
6/6/16 12/6/16 6/6/13 6/6/22 12/6/22
12/6/15

1140.63
 Bond YTM Summary
• So, there were two reasons why the YTM value we calculated was different than
the quoted value in Yahoo Finance:
– We needed to add the accrued interest due to the fact that we purchased the
bond in between the normal period dates. (Dirty rather than Clean price).
– We needed to align the actual payment with a normal period date by either
pushing forward or pulling backward.

• I highly recommend that you:

– Download a couple of bond profiles from the US TreasuryDirect
– Create your own spreadsheet or calculator that does both:
• Iterative method
• Excel functions
– Verify your answers
– Check out one of the many online bond calculators!
http://www.quantwolf.com/calculators/bondyieldcalc.html
– Do you get the same answers? Do the calculators make the same
assumptions?
 Assignments
• Work your own bond YTM examples; try out other excel
financial functions and see what you get!
• Continue reading Faerber.
• Recommend you complete problems 2.3, 2.7, 2.10, 2.11, 2.12
in Luenberger; these will not be turned in or graded.