Partielo | FIXED INCOME INSTRUMENTS

Fixed Income Instruments

A retenir :

Features of Debt Securities:

Definition: Bonds are loans made by investors to governments or companies.
Key Features:
Face value (amount repaid at the end)
Coupon (interest paid regularly)
Maturity date (when the loan ends and money is repaid)

Risks Associated with Investing in Bonds:

Interest rate risk: If interest rates rise, bond prices fall.
Credit risk: The risk the issuer cannot repay.
Inflation risk: Inflation reduces the value of payments.
Liquidity risk: Risk of not being able to sell the bond easily.

Overview of Bond Sectors and Instruments:

Government bonds (e.g. treasury bonds)
Corporate bonds (issued by companies)
Municipal bonds (issued by cities or regions)
Asset-backed securities (backed by things like mortgages)

Understanding Yield Spreads:

Definition: The difference in yields between two bonds (usually one is safer, one is riskier).
Why important: Shows how much extra return investors want for taking more risk.

Bond Characteristics

A retenir :

Bonds are debt:

The issuer borrows money (borrower).
The holder lends money (creditor).

Indenture:

The contract between issuer and bondholder.
It states:
Coupon rate (interest rate)
Maturity date (when money is repaid)
Par value (amount repaid at maturity)

Face or Par Value:

Usually $1000.
This is the amount repaid at maturity.

Coupon Rate and Payments:

The coupon rate decides how much interest is paid.
Interest is usually paid every 6 months (semiannually).
If coupon rate = 0, the bond is called a zero-coupon bond.
Interest payments are called coupon payments.

Models of Equity Valuation

Balance Sheet Models:

Value the company based on its assets minus liabilities (its net worth).
Example: Book value per share.

Dividend Discount Models (DDM):

Value the stock based on the present value of expected future dividends.
If a company pays regular dividends, this model is useful.

DDM Implications (Constant-Growth Dividend Discount Model)

Stock value is higher when:
Expected dividend per share is bigger.
Market capitalisation rate (k) is lower (lower required return).
Expected dividend growth rate is higher.
Stock price grows at the same rate as dividends.

Price/Earnings Ratios (P/E):

Compares the stock price to earnings per share (EPS).
A higher P/E means investors expect higher future growth.

Free Cash Flow Models:

Value the company based on the cash it generates after expenses and investments.
Useful for companies that do not pay dividends but generate strong cash flow.

Intrinsic Value vs. Market Price

Stock Return:
Comes from dividends (payments to shareholders) + capital gains/losses (price change).
Holding Period Return (HPR):
Total return from holding a stock over a period (dividends + price change).
Simple and key measure of investment performance.
Expected HPR vs. Required Return:
Expected HPR: What the investor thinks they will earn.
Required return: The return needed based on the stock’s risk.
If expected HPR > required return → stock may be undervalued.
If expected HPR < required return → stock may be overvalued.

Required Return

CAPM gives the required return, k:

•If the stock is priced correctly, k should equal expected return.

•E(rm) – rf =market premium/ risk premium

Constant Growth DDM

Estimating Dividend Growth Rates

Pitfalls in P/E Analysis!!

A retenir :

Use of Accounting Earnings:

P/E relies on reported earnings, which are based on accounting rules — not always on actual cash flow or business strength.

Earnings Management:

Companies can “adjust” earnings (legally or not) to make profits look better or smoother than they really are.

Choices on GAAP:

Different accounting methods (allowed under GAAP) can affect earnings — so comparing companies is tricky if they use different rules.

Inflation:

Inflation can distort earnings and make them look higher (just because prices rose, not because the company improved).

Cyclicality:

Earnings move up and down with the business cycle.
So P/E can be high when earnings are low (recession) or low when earnings are high (boom) — making it misleading sometimes.

Relative Measure:

P/E compares stocks to each other, but if all stocks are overvalued or undervalued, it does not show the true value clearly.

2007

Other Comparative Value Approaches

Price-to-Book Ratio (P/B):

Compares stock price to book value (assets minus liabilities).
Useful for valuing companies with lots of tangible assets (like banks).

Price-to-Cash-Flow Ratio (P/CF):

Compares stock price to cash flow (money generated by operations).
Less affected by accounting tricks than earnings.

Price-to-Sales Ratio (P/S):

Compares stock price to revenue (sales).
Useful for companies with no profits yet (like start-ups).

Ke = required return

g = dividend growth rate

If (Ke – g) is big → stock value falls

If (Ke – g) is small → stock value rises

Small changes in Ke or g → big impact on stock value

Important assumptions of DDM:

Stock pays dividends
Dividends grow at a constant rate forever
Ke > g (required return must be higher than growth rate)

U.S. Treasury Bonds vs Notes

Notes: Maturity = 1 to 10 years

Bonds: Maturity = 10 to 30 years

Both:

Can be bought directly from the U.S. Treasury
Minimum purchase = $100 (but $1,000 is common)
Bid price 100:08 → means 100 + 8/32 = $1002.50

Main difference = Maturity length

Notes = shorter-term
Bonds = longer-term

U.S. Treasury – Bills, Notes, Bonds

T-Bills (Treasury Bills)

Maturity < 1 year (4 weeks, 3 months, 6 months)
No coupon → sold at discount (you get full value at maturity)

T-Notes (Treasury Notes)

Maturity = 2, 5, 10 years
Non-callable
Pays explicit coupon (regular interest)

T-Bonds (Treasury Bonds)

Maturity > 10 years
Pays coupon

Main difference = Maturity + how interest is paid

Corporate Bonds!!

A retenir :

Callable Bonds

Company can repurchase (call back) the bond before maturity, usually at a set call price.
Often done if interest rates fall (company can refinance cheaper).
Riskier for investor → higher yield to compensate.

Convertible Bonds

Bondholder can convert bond into shares of the company’s stock at a set conversion ratio.
Benefit: upside if stock price rises.
Usually offers lower coupon (because of conversion option).

Puttable Bonds

Bondholder can sell back (put) the bond to the issuer before maturity or extend it.
Benefit: protection if interest rates rise or credit risk increases.
Typically offers lower yield (because of investor protection).

Floating Rate Bonds (Floaters)

Coupon rate adjusts based on a benchmark rate (e.g., LIBOR, SOFR) + a spread.
Benefit: protects investor from rising interest rates (payments increase).
Coupon resets at regular intervals (e.g., every 6 months).

Preferred Stock vs Common Stock

Both = ownership (equity)

Preferred Stock
Pays fixed dividend (like a regular payment)
Dividend lasts forever
Paid before common stock
Company does not go bankrupt if it skips dividend
No tax advantage for company
Common Stock
No fixed dividend (can change or be zero)
Paid after preferred
Voting rights in the company

Innovation in the Bond Market!!

A retenir :

Asset-Backed Bonds

Payments come from pools of assets (e.g. mortgages, car loans, credit card debt)
Investors get cash flows from the underlying loans
Diversifies risk (spread across many loans)

Catastrophe Bonds (Cat Bonds)

Issued by insurers
Payments delayed or cancelled if a disaster happens (e.g. earthquake, hurricane)
Investors get high returns for taking on this risk
Helps insurance companies transfer risk

TIPS (Treasury Inflation-Protected Securities)

US government bonds linked to inflation (CPI)
Principal and interest increase with inflation
Offers a “real” return (protects against inflation)
Low correlation with other investments → good for portfolio diversification
Government guarantees investors get at least the face value at maturity (even if deflation)
Tax advantages for US investors
Not corolated to other assets à good for portfolio

Indexed Bonds

Payments linked to a price index (like inflation)

Inverse Floaters

Coupon falls when interest rates rise (opposite of normal)
Riskier → bigger changes in payments

Principal and Interest Payments for a Treasury Inflation Protected Security

Bond Pricing

Yield to Maturity

Premium and Discounts

YTM vs Current Yield

YTM (Yield to Maturity)

The total return if bond is held to maturity
Makes present value of payments = bond price
Assumes coupons are reinvested at the YTM rate

Current Yield

Annual coupon ÷ bond price
Shows income now (does not include future gains/losses)

Relationships

Premium bond (price > face value):
Coupon rate > Current yield > YTM
Discount bond (price < face value):
YTM > Current yield > Coupon rate

Yield to Call (YTC)!!

A retenir :

Callable bond = can be bought back early by issuer

If interest rates fall

Straight bond price rises a lot
Callable bond price flattens (issuer likely to call it → limits price rise)

If interest rates are high

Low risk of call
Callable bond ≈ Straight bond (prices are similar)

A retenir :

When interest rates go down, the price of a straight bond goes up a lot.
The price of a callable bond goes up much less and flattens out, because the company can buy it back early.
When interest rates are high, both bonds have similar prices, because the company is not likely to call (buy back) the bond.

Default Risk and Bond Pricing

Rating Companies

Moody’s Investor Service
Standard & Poor’s (S&P)
Fitch

Rating Categories

Highest Rating

AAA (S&P, Fitch) or Aaa (Moody’s)

Investment Grade Bonds

BBB or Baa and above (safe bonds)

Speculative Grade/Junk Bonds

Below BBB or Baa (riskier bonds)

Factors Used by Rating Companies!!

A retenir :

Coverage Ratios

What it is: These ratios show how well a company can cover its debt obligations, particularly interest payments.
Why it matters: A higher coverage ratio means the company is more capable of paying off interest and is seen as less risky.
Example: Interest Coverage Ratio = EBIT (Earnings Before Interest and Taxes) ÷ Interest Expense.

Leverage Ratios

What it is: These ratios measure how much debt a company is using compared to its equity.
Why it matters: A company with high debt relative to its equity is riskier since it may have trouble meeting its debt obligations, especially in tough economic times.
Example: Debt-to-Equity Ratio = Total Debt ÷ Total Equity.

Liquidity Ratios

What it is: These ratios show a company's ability to meet its short-term obligations using its most liquid assets.
Why it matters: High liquidity suggests the company can easily pay off short-term debt, which lowers the risk for bondholders.
Example: Current Ratio = Current Assets ÷ Current Liabilities.

Profitability Ratios

What it is: These ratios indicate how effectively a company is generating profit from its resources.
Why it matters: A profitable company is more likely to pay its debts and perform well in the long run.
Example: Return on Equity (ROE) = Net Income ÷ Shareholder Equity.

Cash Flow to Debt

What it is: This ratio measures how well a company’s operating cash flow covers its total debt.
Why it matters: Strong cash flow relative to debt shows a company can comfortably meet its debt payments, reducing default risk.
Example: Cash Flow to Debt Ratio = Operating Cash Flow ÷ Total Debt.

Protection Against Default!!

A retenir :

Sinking Funds

What it is: A sinking fund is a fund set up by the company to buy back or pay off bonds before maturity.
Why it matters: It reduces the risk of the company defaulting by ensuring it has enough money to pay bondholders early or over time.

Subordination of Future Debt

What it is: This means any new debt issued after the bond is sold is ranked lower in priority for repayment in case of bankruptcy.
Why it matters: It helps protect existing bondholders by ensuring they get paid first if the company faces financial trouble.

Dividend Restrictions

What it is: The company is restricted from paying dividends to shareholders if it does not meet certain financial obligations or if it needs to retain earnings.
Why it matters: This ensures that the company keeps enough funds to meet its bond payments and reduces the risk of default.

Collateral

What it is: Collateral refers to specific assets pledged by the company to bondholders as security in case of default.
Why it matters: If the company defaults, the bondholders can seize the collateral (e.g., property or equipment) to recover their investment.

Credit Default Swaps!!

Définition

Credit Default Swaps

A credit default swap (CDS) is a type of insurance for bondholders or lenders against the risk that a borrower (like a corporation) will default on its debt. The buyer of the CDS pays annual premiums to the seller, who promises to cover the loss if the borrower defaults.

A retenir :

How it works

If the borrower defaults on a bond or loan, the CDS issuer pays the buyer the difference between the bond’s par value (original value) and the market value (current value).
For example, if the bond is worth $1,000 but drops to $700 because of default, the CDS seller would pay the buyer $300.

Who uses CDS

Institutional bondholders, like banks, use CDS to enhance the creditworthiness of their loan portfolios.
They may use CDS to create AAA-rated debt from riskier loans by buying CDS protection.

Speculation

CDS can also be used for speculation: buyers may purchase CDS contracts if they believe bond prices will fall or if they think a company will default.
Essentially, they’re betting on the creditworthiness of the borrower.

Potential Risks

Since CDS contracts can exist for more bonds than are actually issued (because of speculation), it can lead to more CDS outstanding than there are bonds to insure, creating a systemic risk if defaults happen on a large scale.

Fixed Income Instruments

A retenir :

Features of Debt Securities:

Definition: Bonds are loans made by investors to governments or companies.
Key Features:
Face value (amount repaid at the end)
Coupon (interest paid regularly)
Maturity date (when the loan ends and money is repaid)

Risks Associated with Investing in Bonds:

Interest rate risk: If interest rates rise, bond prices fall.
Credit risk: The risk the issuer cannot repay.
Inflation risk: Inflation reduces the value of payments.
Liquidity risk: Risk of not being able to sell the bond easily.

Overview of Bond Sectors and Instruments:

Government bonds (e.g. treasury bonds)
Corporate bonds (issued by companies)
Municipal bonds (issued by cities or regions)
Asset-backed securities (backed by things like mortgages)

Understanding Yield Spreads:

Definition: The difference in yields between two bonds (usually one is safer, one is riskier).
Why important: Shows how much extra return investors want for taking more risk.

Bond Characteristics

A retenir :

Bonds are debt:

The issuer borrows money (borrower).
The holder lends money (creditor).

Indenture:

The contract between issuer and bondholder.
It states:
Coupon rate (interest rate)
Maturity date (when money is repaid)
Par value (amount repaid at maturity)

Face or Par Value:

Usually $1000.
This is the amount repaid at maturity.

Coupon Rate and Payments:

The coupon rate decides how much interest is paid.
Interest is usually paid every 6 months (semiannually).
If coupon rate = 0, the bond is called a zero-coupon bond.
Interest payments are called coupon payments.

Models of Equity Valuation

Balance Sheet Models:

Value the company based on its assets minus liabilities (its net worth).
Example: Book value per share.

Dividend Discount Models (DDM):

Value the stock based on the present value of expected future dividends.
If a company pays regular dividends, this model is useful.

DDM Implications (Constant-Growth Dividend Discount Model)

Stock value is higher when:
Expected dividend per share is bigger.
Market capitalisation rate (k) is lower (lower required return).
Expected dividend growth rate is higher.
Stock price grows at the same rate as dividends.

Price/Earnings Ratios (P/E):

Compares the stock price to earnings per share (EPS).
A higher P/E means investors expect higher future growth.

Free Cash Flow Models:

Value the company based on the cash it generates after expenses and investments.
Useful for companies that do not pay dividends but generate strong cash flow.

Intrinsic Value vs. Market Price

Stock Return:
Comes from dividends (payments to shareholders) + capital gains/losses (price change).
Holding Period Return (HPR):
Total return from holding a stock over a period (dividends + price change).
Simple and key measure of investment performance.
Expected HPR vs. Required Return:
Expected HPR: What the investor thinks they will earn.
Required return: The return needed based on the stock’s risk.
If expected HPR > required return → stock may be undervalued.
If expected HPR < required return → stock may be overvalued.

Required Return

CAPM gives the required return, k:

•If the stock is priced correctly, k should equal expected return.

•E(rm) – rf =market premium/ risk premium

Constant Growth DDM

Estimating Dividend Growth Rates

Pitfalls in P/E Analysis!!

A retenir :

Use of Accounting Earnings:

P/E relies on reported earnings, which are based on accounting rules — not always on actual cash flow or business strength.

Earnings Management:

Companies can “adjust” earnings (legally or not) to make profits look better or smoother than they really are.

Choices on GAAP:

Different accounting methods (allowed under GAAP) can affect earnings — so comparing companies is tricky if they use different rules.

Inflation:

Inflation can distort earnings and make them look higher (just because prices rose, not because the company improved).

Cyclicality:

Earnings move up and down with the business cycle.
So P/E can be high when earnings are low (recession) or low when earnings are high (boom) — making it misleading sometimes.

Relative Measure:

P/E compares stocks to each other, but if all stocks are overvalued or undervalued, it does not show the true value clearly.

2007

Other Comparative Value Approaches

Price-to-Book Ratio (P/B):

Compares stock price to book value (assets minus liabilities).
Useful for valuing companies with lots of tangible assets (like banks).

Price-to-Cash-Flow Ratio (P/CF):

Compares stock price to cash flow (money generated by operations).
Less affected by accounting tricks than earnings.

Price-to-Sales Ratio (P/S):

Compares stock price to revenue (sales).
Useful for companies with no profits yet (like start-ups).

Ke = required return

g = dividend growth rate

If (Ke – g) is big → stock value falls

If (Ke – g) is small → stock value rises

Small changes in Ke or g → big impact on stock value

Important assumptions of DDM:

Stock pays dividends
Dividends grow at a constant rate forever
Ke > g (required return must be higher than growth rate)

U.S. Treasury Bonds vs Notes

Notes: Maturity = 1 to 10 years

Bonds: Maturity = 10 to 30 years

Both:

Can be bought directly from the U.S. Treasury
Minimum purchase = $100 (but $1,000 is common)
Bid price 100:08 → means 100 + 8/32 = $1002.50

Main difference = Maturity length

Notes = shorter-term
Bonds = longer-term

U.S. Treasury – Bills, Notes, Bonds

T-Bills (Treasury Bills)

Maturity < 1 year (4 weeks, 3 months, 6 months)
No coupon → sold at discount (you get full value at maturity)

T-Notes (Treasury Notes)

Maturity = 2, 5, 10 years
Non-callable
Pays explicit coupon (regular interest)

T-Bonds (Treasury Bonds)

Maturity > 10 years
Pays coupon

Main difference = Maturity + how interest is paid

Corporate Bonds!!

A retenir :

Callable Bonds

Company can repurchase (call back) the bond before maturity, usually at a set call price.
Often done if interest rates fall (company can refinance cheaper).
Riskier for investor → higher yield to compensate.

Convertible Bonds

Bondholder can convert bond into shares of the company’s stock at a set conversion ratio.
Benefit: upside if stock price rises.
Usually offers lower coupon (because of conversion option).

Puttable Bonds

Bondholder can sell back (put) the bond to the issuer before maturity or extend it.
Benefit: protection if interest rates rise or credit risk increases.
Typically offers lower yield (because of investor protection).

Floating Rate Bonds (Floaters)

Coupon rate adjusts based on a benchmark rate (e.g., LIBOR, SOFR) + a spread.
Benefit: protects investor from rising interest rates (payments increase).
Coupon resets at regular intervals (e.g., every 6 months).

Preferred Stock vs Common Stock

Both = ownership (equity)

Preferred Stock
Pays fixed dividend (like a regular payment)
Dividend lasts forever
Paid before common stock
Company does not go bankrupt if it skips dividend
No tax advantage for company
Common Stock
No fixed dividend (can change or be zero)
Paid after preferred
Voting rights in the company

Innovation in the Bond Market!!

A retenir :

Asset-Backed Bonds

Payments come from pools of assets (e.g. mortgages, car loans, credit card debt)
Investors get cash flows from the underlying loans
Diversifies risk (spread across many loans)

Catastrophe Bonds (Cat Bonds)

Issued by insurers
Payments delayed or cancelled if a disaster happens (e.g. earthquake, hurricane)
Investors get high returns for taking on this risk
Helps insurance companies transfer risk

TIPS (Treasury Inflation-Protected Securities)

US government bonds linked to inflation (CPI)
Principal and interest increase with inflation
Offers a “real” return (protects against inflation)
Low correlation with other investments → good for portfolio diversification
Government guarantees investors get at least the face value at maturity (even if deflation)
Tax advantages for US investors
Not corolated to other assets à good for portfolio

Indexed Bonds

Payments linked to a price index (like inflation)

Inverse Floaters

Coupon falls when interest rates rise (opposite of normal)
Riskier → bigger changes in payments

Principal and Interest Payments for a Treasury Inflation Protected Security

Bond Pricing

Yield to Maturity

Premium and Discounts

YTM vs Current Yield

YTM (Yield to Maturity)

The total return if bond is held to maturity
Makes present value of payments = bond price
Assumes coupons are reinvested at the YTM rate

Current Yield

Annual coupon ÷ bond price
Shows income now (does not include future gains/losses)

Relationships

Premium bond (price > face value):
Coupon rate > Current yield > YTM
Discount bond (price < face value):
YTM > Current yield > Coupon rate

Yield to Call (YTC)!!

A retenir :

Callable bond = can be bought back early by issuer

If interest rates fall

Straight bond price rises a lot
Callable bond price flattens (issuer likely to call it → limits price rise)

If interest rates are high

Low risk of call
Callable bond ≈ Straight bond (prices are similar)

A retenir :

When interest rates go down, the price of a straight bond goes up a lot.
The price of a callable bond goes up much less and flattens out, because the company can buy it back early.
When interest rates are high, both bonds have similar prices, because the company is not likely to call (buy back) the bond.

Default Risk and Bond Pricing

Rating Companies

Moody’s Investor Service
Standard & Poor’s (S&P)
Fitch

Rating Categories

Highest Rating

AAA (S&P, Fitch) or Aaa (Moody’s)

Investment Grade Bonds

BBB or Baa and above (safe bonds)

Speculative Grade/Junk Bonds

Below BBB or Baa (riskier bonds)

Factors Used by Rating Companies!!

A retenir :

Coverage Ratios

What it is: These ratios show how well a company can cover its debt obligations, particularly interest payments.
Why it matters: A higher coverage ratio means the company is more capable of paying off interest and is seen as less risky.
Example: Interest Coverage Ratio = EBIT (Earnings Before Interest and Taxes) ÷ Interest Expense.

Leverage Ratios

What it is: These ratios measure how much debt a company is using compared to its equity.
Why it matters: A company with high debt relative to its equity is riskier since it may have trouble meeting its debt obligations, especially in tough economic times.
Example: Debt-to-Equity Ratio = Total Debt ÷ Total Equity.

Liquidity Ratios

What it is: These ratios show a company's ability to meet its short-term obligations using its most liquid assets.
Why it matters: High liquidity suggests the company can easily pay off short-term debt, which lowers the risk for bondholders.
Example: Current Ratio = Current Assets ÷ Current Liabilities.

Profitability Ratios

What it is: These ratios indicate how effectively a company is generating profit from its resources.
Why it matters: A profitable company is more likely to pay its debts and perform well in the long run.
Example: Return on Equity (ROE) = Net Income ÷ Shareholder Equity.

Cash Flow to Debt

What it is: This ratio measures how well a company’s operating cash flow covers its total debt.
Why it matters: Strong cash flow relative to debt shows a company can comfortably meet its debt payments, reducing default risk.
Example: Cash Flow to Debt Ratio = Operating Cash Flow ÷ Total Debt.

Protection Against Default!!

A retenir :

Sinking Funds

What it is: A sinking fund is a fund set up by the company to buy back or pay off bonds before maturity.
Why it matters: It reduces the risk of the company defaulting by ensuring it has enough money to pay bondholders early or over time.

Subordination of Future Debt

What it is: This means any new debt issued after the bond is sold is ranked lower in priority for repayment in case of bankruptcy.
Why it matters: It helps protect existing bondholders by ensuring they get paid first if the company faces financial trouble.

Dividend Restrictions

What it is: The company is restricted from paying dividends to shareholders if it does not meet certain financial obligations or if it needs to retain earnings.
Why it matters: This ensures that the company keeps enough funds to meet its bond payments and reduces the risk of default.

Collateral

What it is: Collateral refers to specific assets pledged by the company to bondholders as security in case of default.
Why it matters: If the company defaults, the bondholders can seize the collateral (e.g., property or equipment) to recover their investment.

Credit Default Swaps!!

Définition

Credit Default Swaps

A retenir :

How it works

If the borrower defaults on a bond or loan, the CDS issuer pays the buyer the difference between the bond’s par value (original value) and the market value (current value).
For example, if the bond is worth $1,000 but drops to $700 because of default, the CDS seller would pay the buyer $300.

Who uses CDS

Institutional bondholders, like banks, use CDS to enhance the creditworthiness of their loan portfolios.
They may use CDS to create AAA-rated debt from riskier loans by buying CDS protection.

Speculation

CDS can also be used for speculation: buyers may purchase CDS contracts if they believe bond prices will fall or if they think a company will default.
Essentially, they’re betting on the creditworthiness of the borrower.

Potential Risks

Since CDS contracts can exist for more bonds than are actually issued (because of speculation), it can lead to more CDS outstanding than there are bonds to insure, creating a systemic risk if defaults happen on a large scale.