Type:
Solution Manual
Resource:
Bond Markets, Analysis, and Strategies
Edition:
7th Edition
Author(s):
Frank J. Fabozzi
OVERVIEW OF CONTENTS Chapter 1 introduces the text. Chapters 2-5 set forth the basic analytical framework necessary to understand the pricing of bonds and their investment characteristics. Chapter 6 describes the treasury market. Chapters 7-9 explain the investment characteristics and special features of U.S. corporate debt, municipal securities, and non-U.S. bonds. Chapters 10-13 focus on residential mortgage-backed securities. Chapter 14 covers commercial mortgage loans and commercial mortgage-backed securities. Chapters 15-16 look at asset-backed securities and collateralized debt obligations. Chapters 17-20 describe methodologies for valuing bonds. Chapters 21 and 22 deals with corporate bond credit risk. Chapters 23-26 discuss portfolio strategies. Chapters 27-30 explain the various instruments that can be used to control portfolio risk.
CHAPTER 1 INTRODUCTION CHAPTER SUMMARY This introductory chapter will focus on the fundamental features of bond, the type of issuers, and risk faced by investors in fixed-income securities. A bond is a debt instrument requiring the issuer to repay to the lender the amount borrowed plus interest over a specified period of time. A typical (“plain vanilla”) bond issued in the United States specifies (1) a fixed date when the amount borrowed (the principal) is due, and (2) the contractual amount of interest, which typically is paid every six months. The date on which the principal is required to be repaid is called the maturity date. Assuming that the issuer does not default or redeem the issue prior to the maturity date, an investor holding this bond until the maturity date is assured of a known cash flow pattern. SECTORS OF THE U.S. BOND MARKET The U.S. bond market is divided into six sectors: U.S. Treasury sector, agency sector, municipal sector, corporate sector, asset-backed securities, and mortgage sector. The Treasury Sector The Treasury sector includes securities issued by the U.S. government. These securities include Treasury bills, notes, and bonds. This sector plays a key role in the valuation of securities and the determination of interest rates throughout the world. The Agency Sector The agency sector includes securities issued by federally related institutions and governmentsponsored enterprises. The securities issued are not backed by any collateral and are referred to as agency debenture securities.
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The Municipal Sector The municipal sector is where state and local governments and their authorities raise funds. Bonds issued in this sector typically are exempt from federal income taxes. The Corporate Sector The corporate sector includes (i) securities issued by U.S. corporations and (ii) securities issued in the United States by foreign corporations. Issuers in the corporate sector issue bonds, mediumterm notes, structured notes, and commercial paper. The corporate sector is divided into the investment grade and noninvestment grade sectors. The Asset-Backed Securities Sector In the asset-backed securities sector, a corporate issuer pools loans or receivables and uses the pool of assets as collateral for the issuance of a security. The Mortgage Sector The mortgage sector is the sector where securities are backed by mortgage loans. These are loans obtained by borrowers in order to purchase residential property or an entity to purchase commercial property (i.e., income-producing property). The mortgage sector is then divided into the residential mortgage sector and the commercial mortgage sector. OVERVIEW OF BOND FEATURES The bond indenture is the contract between the issuer and the bondholder, which sets forth all the obligations of the issuer. Type of Issuer There are three issuers of bonds: the federal government and its agencies, municipal governments, and corporations (domestic and foreign). Term to Maturity The maturity of a bond refers to the date that the debt will cease to exist, at which time 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. Generally, bonds with a maturity of between one and five years are considered short-term. Bonds with a maturity between 5 and 12 years are viewed as intermediate -term, and those with a maturity of more than 12 years are called long-term. With all other factors constant, the longer the maturity of a bond, the greater the price volatility resulting from a change in market yields.
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Principal and Coupon Rate The principal of a bond is the amount that the issuer agrees to repay the bondholder at the maturity date. This amount is also referred to as the redemption value, maturity value, par value, or face value. The coupon rate, also called the nominal rate, is the interest rate that the issuer agrees to pay each year. The annual amount of the interest payment made to owners during the term of the bond is called the coupon. The holder of a zero-coupon bond realizes interest by buying the bond substantially below its principal value. Interest is then paid at the maturity date, with the exact amount being the difference between the principal value and the price paid for the bond. Floating-rate bonds are issues where the coupon rate resets periodically (the coupon reset date) based on a formula. The coupon reset formula has the following general form: reference rate + quoted margin. The reference rate for floating-rate securities can be an interest rate or an interest rate index or a financial index or a nonfinancial index. The quoted margin is the additional amount that the issuer agrees to pay above the reference rate. The coupon on floating-rate bonds (which is dependent on an interest rate benchmark) typically rises as the benchmark rises and falls as the benchmark falls. Exceptions are inverse floaters whose coupon interest rate moves in the opposite direction from the change in interest rates. To reduce the burden of interest payments, firms involved in LBOs and recapitalizations, have issued deferred-coupon bonds that let the issuer avoid using cash to make interest payments for a specified number of years. Amortization Feature The principal repayment of a bond issue can call for either (1) the total principal to be repaid at maturity or (2) the principal repaid over the life of the bond. In the latter case, there is a schedule of principal repayments. This schedule is called an amortization schedule. For amortizing securities, a measure called the weighted average life or simply average life of a security is computed. 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 to take some action against the other party. The most common type of option embedded in a bond is a call provision. This provision grants the issuer the right to retire the debt, fully or partially, before the scheduled maturity date. An issue with a put provision included in the indenture grants the bondholder the right to sell the issue back to the issuer at par value on designated dates. A convertible bond is an issue giving the bondholder the right to exchange the bond for a specified number of shares of common stock. An exchangeable bond allows the bondholder to
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exchange the issue for a specified number of common stock shares of a corporation different from the issuer of the bond. Describing a Bond Issue There are hundreds of thousands of bonds issues. Most securities are identified by a nine character (letters and numbers) CUSIP number. CUSIP stands for Committee on Uniform Security Identification Procedures. The first six characters identify the issuer: the corporation, government agency, or municipality. The next two characters identify whether the issue is debt or equity and the issuer of the issue. The last character is simply a check character that allows for accuracy checking and is sometimes truncated or ignored. The CUSIP International Numbering System (CINS) is used to identify foreign securities and includes 12 characters. RISKS ASSOCIATED WITH INVESTING IN BONDS Bonds may expose an investor to one or more of the following risks: (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, and (9) risk risk. In later chapters, other risks, such as yield curve risk, event risk, and tax risk, are also introduced. Interest-Rate Risk If an investor has to sell a bond prior to the maturity date, an increase in interest rates will mean the realization of a capital loss (i.e., selling the bond below the purchase price). This risk is referred to as interest-rate risk or market risk. This risk is by far the major risk faced by an investor in the bond market. Reinvestment Income or 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. That is, interest-rate risk is the risk that interest rates will rise, thereby reducing a bond’s price. In contrast, reinvestment risk is the risk that interest rates will fall. Call Risk Call risk is the risk investors have 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. The issuer usually retains this right in order to have flexibility to refinance the bond in the future if the market interest rate drops below the coupon rate. For investors, there are three disadvantages to call provisions. First, the cash flow pattern cannot be known with certainty. Second, the investor is exposed to reinvestment risk. Third, the capital appreciation potential of a bond will be reduced. Even though the investor is usually
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