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.
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.
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.
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 quoted margin is the additional amount that the issuer
agrees to pay above the reference rate.
An important non-interest rate index that has been used with increasing frequency is the
rate of inflation. Bonds whose interest rate is tied to the rate of inflation are referred to
generically as linkers.
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
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.
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.
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.
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 quoted margin is the additional amount that the issuer
agrees to pay above the reference rate.
An important non-interest rate index that has been used with increasing frequency is the
rate of inflation. Bonds whose interest rate is tied to the rate of inflation are referred to
generically as linkers.
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
