Here your focus should be on learning the basic characteristics of debt securities and
as much of the bond terminology as you can remember. Key items are the coupon
structure of bonds and options embedded in bonds: call options, put options, and
conversion (to common stock) options.
BOND PRICES, YIELDS, AND RATINGS
There are two important points about fixed-income securities that we will develop
further along in the Fixed Income study sessions but may be helpful as you read this
topic review.
The most common type of fixed-income security is a bond that promises to
make a series of interest payments in fixed amounts and to repay the principal
amount at maturity. When market interest rates (i.e., yields on bonds) increase,
the value of such bonds decreases because the present value of a bond’s
promised cash flows decreases when a higher discount rate is used.
Bonds are rated based on their relative probability of default (failure to make
promised payments). Because investors prefer bonds with lower probability of
default, bonds with lower credit quality must offer investors higher yields to
compensate for the greater probability of default. Other things equal, a
decrease in a bond’s rating (an increased probability of default) will decrease
the price of the bond, thus increasing its yield.
LOS 50.a: Describe basic features of a fixed-income security.
CFA
The issuer of the bond.
The maturity date of the bond.
The par value (principal value to be repaid).
Coupon rate and frequency.
Currency in which payments will be made.
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Study Session 15
Program Curriculum, Volume 5, page 299
Issuers of Bonds
There are several types of entities that issue bonds when they borrow money,
including:
Corporations. Often corporate bonds are divided into those issued by financial
companies and those issued by nonfinancial companies.
Sovereign national governments. A prime example is U.S. Treasury bonds, but
many countries issue sovereign bonds.
Nonsovereign governments. Issued by government entities that are not
national governments, such as the state of California or the city of Toronto.
Quasi-government entities. Not a direct obligation of a country’s government or
central bank. An example is the Federal National Mortgage Association (Fannie
Mae).
Supranational entities. Issued by organizations that operate globally such as the
World Bank, the European Investment Bank, and the International Monetary
Fund (IMF).
Bond Maturity
The maturity date of a bond is the date on which the principal is to be repaid. Once a
bond has been issued, the time remaining until maturity is referred to as the term to
maturity or tenor of a bond.
When bonds are issued, their terms to maturity range from one day to 30 years or
more. Both Disney and Coca-Cola have issued bonds with original maturities of 100
years. Bonds that have no maturity date are called perpetual bonds. They make
periodic interest payments but do not promise to repay the principal amount.
Bonds with original maturities of one year or less are referred to as money market
securities. Bonds with original maturities of more than one year are referred to as
capital market securities.
Par Value
The par value of a bond is the principal amount that will be repaid at maturity. The par
value is also referred to as the face value, maturity value, redemption value, or
principal value of a bond. Bonds can have a par value of any amount, and their prices
are quoted as a percentage of par. A bond with a par value of $1,000 quoted at 98 is
selling for $980.
A bond that is selling for more than its par value is said to be trading at a premium to
par; a bond that is selling at less than its par value is said to be trading at a discount to
par; and a bond that is selling for exactly its par value is said to be trading at par.
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