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 introduces
Treasury securities, Treasury derivative securities, and federal agency securities. 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.
Chapter 15 covers asset-backed securities. Chapter 16 provides the basics of interest rate
modeling. Chapter 17 explains the lattice method for valuing bonds with embedded. Chapter 18
discusses the Monte Carlo simulation model for mortgage-backed securities and asset-backed
securities backed by residential loans. Chapter 19 covers the analysis of convertible bonds.
Chapter 20 describes traditional credit analysis and Chapter 21 provides the basics of credit risk
modeling. Chapters 22–25 discuss portfolio management. Chapter 26 covers interest-rate futures
contracts while Chapter 27 covers interest-rate options. Chapter 28 examines interest-rate swaps,
caps, and floors while Chapter 29 looks at credit derivatives.
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. since the early 1980s a wide range of bond structures has been introduced into the
bond market.
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.
© 2013 Pearson Education, Inc. 1
, The Agency Sector
The agency sector includes securities issued by federally related institutions and government-
sponsored enterprises. The securities issued are not backed by any collateral and are referred to
as agency debenture securities.
The Municipal Sector
The municipal sector is where state and local governments and their authorities raise funds. This
sector is divided into two subsectors based on how the interest received by investors is taxed at
the federal income tax level: the tax-exempt and taxable sectors. The municipal bond market
includes two types of structures: tax-backed and revenue bonds.
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, medium-
term 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
A more detailed treatment of bond features is presented in later chapters.
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.
© 2013 Pearson Education, Inc. 2
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 introduces
Treasury securities, Treasury derivative securities, and federal agency securities. 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.
Chapter 15 covers asset-backed securities. Chapter 16 provides the basics of interest rate
modeling. Chapter 17 explains the lattice method for valuing bonds with embedded. Chapter 18
discusses the Monte Carlo simulation model for mortgage-backed securities and asset-backed
securities backed by residential loans. Chapter 19 covers the analysis of convertible bonds.
Chapter 20 describes traditional credit analysis and Chapter 21 provides the basics of credit risk
modeling. Chapters 22–25 discuss portfolio management. Chapter 26 covers interest-rate futures
contracts while Chapter 27 covers interest-rate options. Chapter 28 examines interest-rate swaps,
caps, and floors while Chapter 29 looks at credit derivatives.
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. since the early 1980s a wide range of bond structures has been introduced into the
bond market.
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.
© 2013 Pearson Education, Inc. 1
, The Agency Sector
The agency sector includes securities issued by federally related institutions and government-
sponsored enterprises. The securities issued are not backed by any collateral and are referred to
as agency debenture securities.
The Municipal Sector
The municipal sector is where state and local governments and their authorities raise funds. This
sector is divided into two subsectors based on how the interest received by investors is taxed at
the federal income tax level: the tax-exempt and taxable sectors. The municipal bond market
includes two types of structures: tax-backed and revenue bonds.
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, medium-
term 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
A more detailed treatment of bond features is presented in later chapters.
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.
© 2013 Pearson Education, Inc. 2
