Fixed Income Securities

What are fixed Income Securities?

Financial claims issued by government, government

agencies, state governments, corporations, municipalities, and banks and other financial institutions The cash flows promised to the buyer of fixed income securities represent contractual obligations of the respective issuers. Typically, when such contractual obligations are not met, the buyers of fixed income securities will have the right to take control of the firm that issued such debt securities

A fixed income security is a financial

obligation of an entity that promises to pay a specified sum of money at specified future dates. The entity promising the payment is called the issuer of the security Two categories:
Debt obligationsBond Markets Preferred Stock

Participants
Issuers/sellers
government, government agencies, state governments, corporations, municipalities, and banks and other financial institutions

To receive a fair value for their securities Be able to issue securities that best fit their needs

Investors
Large institutions such as pension funds, insurance companies, commercial banks, corporations, mutual funds, and central banks Smaller institutions Individual investors

Participants
Objective is to buy/sell at a fair market price and at narrow bid/offer spread.

Intermediaries
Help issuers in the initial offering of the security, assist in pricing and distribution of the securities, make a secondary market, provide liquidity, and engage in proprietary trading activities Produce information about credit quality of different issuers Provide liquidity and credit enhancement for a fee

Bond Markets
Global Bond Markets U.S. Bond Markets

Meaning of a Bond
A debt instrument requiring the issuer also called

the debtor or borrower to repay to the lender/investor the amount borrowed plus interest over some specified period of time A typical plain vanilla bond issued in the U.S. specifies
A fixed date when the amount borrowed is due The contractual amount of interest, which is typically paid every six months

Cash flow pattern is know assuming no default

What is a Bond?
A bond is a tradable instrument that

represents a debt owed to the owner by the issuer. Most commonly, bonds pay interest periodically (usually semiannually) and then return the principal at maturity.

A Bond Certificate

Advantages of Bonds over Stocks

Bonds, while a more conservative

investment than stocks, can offer certain investors some very attractive features:
Safety Reliable income Potential for capital gains Diversification (especially for an otherwise allequity portfolio) Tax advantages

Safety of Bonds
The safety of bonds derives mainly from

two things:
Bondholders are in line ahead of both preferred and common stockholders for payment. Thus, if a firm falls on hard times, it must first pay its bondholders while stockholders may see dividends cut. In the event that a company skips a payment or violates covenants of the indenture, the creditors may force it into bankruptcy to protect

Reliability of Income
Most bonds are fixed-income securities.

As such, they promise a fixed set of interest payments and the return of the principal at maturity. Investors can count on receiving their interest payments in full and on time, except in the event of severe financial distress. Common stockholders can never be sure of the exact amount (and sometimes the exact timing) of dividends. Bonds that are callable (most corporates and some Treasuries issued before 1985)

Potential for Capital Gains

Investors who do not hold a bond to maturity may enjoy

capital gains or suffer capital losses:

When interest rates fall, bond prices rise. Thus an investor who buys when rates are high, and sells after rates fall will earn a capital gain. The rate decrease may be due to general market conditions or improvement in the companys creditworthiness. When interest rates rise, bond prices fall. Thus an investor who buys when rates are low, and sells after rates rise will suffer a capital loss. The rate increase may be due to general market conditions or a decrease in the companys creditworthiness. All other things being equal, as the bond moves through time to maturity, the price must move towards its face value. Thus, bonds purchased at a discount will rise in price, and those purchased at a premium will decline in price.

Derivatives An easy way to think of derivatives is as a

side bet on interest rates, exchange rates, commodity prices, and practically ANYTHING that you can think of.

Why Derivatives? Not to raise capital Buy or sell to protect against adverse

changes in external factors