Fixed Income Securities

Concepts and Valuation

Rustam Jamilov
State Committee of Securities
Capital Markets Training Center
jamilovrustam@gmail.com

April 9, 2015

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Table of Contents

Concepts

Valuation

Making Money

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Basic Features of FI Securities

Fixed income as an asset class

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Basic Features of FI Securities

Fixed income as an asset class

Bond as a fixed income instrument

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Basic Features of FI Securities

Fixed income as an asset class

Bond as a fixed income instrument
Bond as an asset/debt

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Basic Features of FI Securities

Fixed income as an asset class

Bond as a fixed income instrument
Bond as an asset/debt
Issuer of the bond

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Basic Features of FI Securities

Fixed income as an asset class

Bond as a fixed income instrument
Bond as an asset/debt
Issuer of the bond
Maturity date

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Basic Features of FI Securities

Fixed income as an asset class

Bond as a fixed income instrument
Bond as an asset/debt
Issuer of the bond
Maturity date
Principal value

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Basic Features of FI Securities

Fixed income as an asset class

Bond as a fixed income instrument
Bond as an asset/debt
Issuer of the bond
Maturity date
Principal value
Coupon rate

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Basic Features of FI Securities

Fixed income as an asset class

Bond as a fixed income instrument
Bond as an asset/debt
Issuer of the bond
Maturity date
Principal value
Coupon rate
Currency of denomination

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Fixed Income Market Size

Global fixed income market size in 2010 surpassed $150 trillion. The figure is closer to $200 trillion today.
This includes both pure loans and bond-style public/financial securities.
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Bonds as Debt/Asset

Liability

Asset

When a government or corporation

issues bonds in order to finance
operations, they become legal
debtors. They are mandated to repay
the par and all coupons (if any) to
those who buy the bonds. Bond is a
liability.

When an investor (pension fund,

wealth fund) buys a bond issued by a
corporation/government, the investor
becomes entitled to the par and all
coupons (if any). The investor owns
a stream of future payments. Bond is
an asset

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Issuers of Bonds

Corporations: financial and non-financial

Sovereign national governments

Local governments

Supranational entities

Companies

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Bond Maturity

The maturity date of a bond is the date on which the principal value is to
be repaid. For example, if a government issues a 10-year bond worth $1
billion USD, then exactly 10 years from now the principal value of $1
billion USD must be repaid in full amount.
Bonds that have no maturity are called perpetual bonds.
Bonds with maturities of one year or less are referred to as money market
securities.
Bonds with maturities of more than one year are capital market securities.

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Par Value

Principal value, or par value, of a bond is the amount that the issuer
agrees to repay the bondholders on the maturity date. For example,
assume the principal of a bond is $1000. If the bond is currently priced at
$1000 then we say it is at par. Above par - bond is trading at a premium.
Below par - at a discount. Par value could be any amount.

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Coupon Rates
Plain Vanilla (Fixed)
A plain vanilla bond pays a predetermined fixed rate of interest. This rate
can be paid annually/quarterly/monthly. For example, annual coupon rate
of 6% for a $1000 par value bond is $60.

Floating-rate Notes (FRN)

Floating rate notes pay non-fixed coupons that depend on a reference rate.
A widely used reference is the London interbank offered rate (LIBOR).
Usually, bonds are issued at LIBOR + Spread rate, where spread reflects
the credit risk of the issuer. For example, Apple issues a 10 year FRN
bond at LIBOR + 50 bps. Bps = basis points. 1 basis point = 0.01.
There are 100 bps in 1%. If LIBOR is 1.2% (120 bps) then Apple must
pay 1.7% (120 bps) in its next coupon installment.

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Coupon Rates 2

Zero-coupon Bonds (ZCB)

ZCBs pay no periodic payments via coupons. They just repay the par
value at maturity. ZCBs may be purchased at a price different from par.
For example, a bond purchased at price $95 pays back $100 at maturity
(in 1 year). This implies a 5% rate of interest. The interest is implied, i.e.
not actually paid via installments but embedded into the discounted price.

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Coupon Rates 3

Index-Linked Bonds
An index-linked bond pays its principal and coupon payments linked to a
specified index. The most popular type of indexed bonds is
inflation-linked. They provide protection against rising prices. For
example, the United Kingdom issues an 1.5% 10-year inflation-protected
bond. Inflation rate in the UK is 2%. If this bond was plain vanilla, then
the investor holding the bond would only earn negative 0.5% of real
interest. In general, the real rate of return is what we care about because
real purchasing power is our main goal.

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Currency Denomination

Bonds can be issued in any currency, although most bonds are issued in
either USD or EUR - these 2 are called hard currency. Any government,
corporation, agency can in principle issue bonds in USD or EUR. It makes
issuance easier, even if your local currency is not USD or EUR. Many
agents issue bonds in local currencies (GBP, JPY, KRW, TRY, RUB) to
finance expenditures in the local market. Demand for local currencies
varies across markets and on a cyclical basis.

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Global Bond Market - Bloomberg Terminal

Here we see bonds of different issuers, prices (bid and ask), yields (to be discussed further), and
historical performance.
Values swing dramatically over time; markets have high volatility and tens of millions worth of
sovereign debt move around every hour.
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Global Currency Market - Bloomberg Terminal

Bonds denominated in local currencies have billions in size. When deciding to purchase a bond
in a foreign (non-USD or non-EUR) currency, one must carefully study the FOREX market.

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Table of Contents

Concepts

Valuation

Making Money

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Time Value of Money

Definition
A dollar invested today is not the same as the dollar invested tomorrow.
You can earn interest i on 1 dollar invested today, and tomorrow your
wealth becomes 1$+i. The value of money grows over time. The skill of
finance is to develop and price instruments whose value grows over time.
The art of finance is knowing which instrument to buy/sell and at what
moment.

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Bond Pricing - No Coupons

Formula
Present Value =

Future Value
(1 + i)t

where i is the market discount rate, aka required yield of the bond
t is the maturity length of the bond.

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Example
Lets price a zero-coupon bond with maturity 7 years, paying $1000 at
maturity, and the required rate of return 5%.
Price =

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1000
= 710.68
(1 + 0.05)7

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Bond Pricing - With Coupons

Formula 2
Present Value =

t
X
Coupon
k=1

(1 + i)k

Future Value
(1 + i)t

where i is the market discount rate, aka required yield of the bond
t is the maturity length of the bond k is the current time period
Do not forget to add the future value to the stream of coupons!

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Example
The same bond with maturity 7 years, paying $1000 at maturity, and the required rate of return
5%, is now paying annual coupons of $20. The price is now:

Price =

20
20
20
20
20
+
+
+
+
+
2
3
4
(1 + 0.05) (1 + 0.05) (1 + 0.05) (1 + 0.05) (1 + 0.05)5
+

20
20
1000
+
+
= 826.41
6
7
(1 + 0.05)
(1 + 0.05)
(1 + 0.05)7

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Yield to Maturity
The problem can be solved in reversed order. If we have a known market
price for a bond, we can calculate its yield to maturity. YTM is the implied
market discount rate which makes the future discounted cash flows equal
to the todays market price. Market players may speculate on the price of
the bond, and the YTM will respond to price fluctuations. Suppose, a
4-year bond with 5% annual coupon payment is priced by traders at 105
per the par value of 100. The YTM can be solved numerically from:
105 =

5
5
5
100
5
+
+
+
+
(1 + i) (1 + i)2 (1 + i)3 (1 + i)4 (1 + i)4

Which gives i=3.634%. Notice how the yield is lower than the coupon rate,
which is normal for bonds priced above par. Also, negative relationship
between asset prices and yields is one of the major laws in finance.

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Pricing using Spot Rates

In the previous examples, we made a big assumption that drove the result.
We assumed that the required return is constant until bond maturity. A
more fundamental approach is to discount every cash flow using its spot
rate, i.e. the actual interest rate observed at the period. Spot rates are
not necessarily equal to assumed constant yields. This can generate
pricing distortions across the two approaches. For example, consider that
the one-year spot rate is 2%, 2-year is 3%, and 3-year is 4%. Coupon is
5%. Pricing is:
Price =

5
5
5
5
+
+
+
= 102.960
(1 + 0.02) (1 + 0.03)2 (1 + 0.04)3 (1 + 0.04)3

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Bond Pricing - Bloomberg Terminal

This is a 5-year corporate bond. Issuer is IBM. Coupon rate is 1.875%. Yield to maturity is
0.53%. Current market price is $107.4. Bond is priced above par. Currency of denomination is
EUR. Yes, interest rates (yields) are very low in Europe nowadays . . .
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Table of Contents

Concepts

Valuation

Making Money

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Yields Differential

There are plenty of reasons why yields on any two bonds are different. The
major drivers causing yield differentials include:
1

Currency

Credit risk

Liquidity

Tax Status

Periodicity

Another obvious driver is the maturity structure. Bonds with longer

tenures (maturity terms) have, in general, higher yields ceteris paribus.

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Term Structure of Interest Rates

This is the term structure for US Treasuries. Notice the 40bps drop in 10-year treasuries, just over the past 6 months . . .

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Forecasting Yields
Bond prices and yields are negatively related. When interest rates go
down, prices go up. If you can predict the right moment of the rate drop you can position yourself for the event by buying lots of the asset and then
selling it after interest rates fall. The market generally has a very good
understanding of which way the interest rates will go. Usually, even a
slight 5bps move (0.05%) can make a big difference. E.g.: multiply 0.05
by a $100 million investment and get $5 million in profit.
The best way to get an idea of future interest rate movement is the
forward rate matrix. Forward rate is the future yield on a bond calculated
using the yield curve. For example, the yield on a 3-month Treasury bill six
months from now is a 6-month - 3-month forward rate. By pricing a
forward rate for every maturity we construct a forward curve.

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Forward Curve
As of today, the spot 10-year rate is 1.95%. In 1 year, the expectation is that the 10-year becomes 2.2%. Most financial
contracts will be signed using this as a benchmark of expectations. BUT, if the future 10-year rate one year from now will in
fact be 2.0% (different from the forward rate), you can capture a profit by correctly positioning yourself on the curve. This is
how millions are made (or lost).

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Relative Value

This is the spread of a 5-year Deutsche-Telecom bond over the 5-year German Bund. Spread has been narrowing greatly for the
past 2 years.
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CMTC Trainings

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CMTC Trainings

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