Chapter 12 Supplement A

1. Chapter 12Supplement A • Fixed-Income Securities

2. Basic Concepts of Lending Securities (1 of 2) • Fixed-income securities • Specified payment dates and amounts • Lending securities • An investor in bonds lends funds to issuer in exchange for a promise of a stream of periodic interest payments and a repayment of principal at maturity

3. Basic Concepts of Lending Securities (2 of 2) • Coupon payments • Interest payments paid to bondholder on semiannual basis • Based on percentage of par value of bond • Maturity • Period of time through which issuer has control over bond proceeds • Period of time required to pay coupon payments

4. Valuation of Fixed-Income Securities • Value of a bond is equal to the present value of expected future cash flows • Cash flows are discounted at appropriate discount rate (determined in same manner as an annuity)

5. Measures of Return • Current yield (CY) • Indication of income or cash flow an investor will receive on basis of coupon payment and current price • Yield to maturity (YTM) • Compounded rate of return on bond purchased at current market price and held to maturity • Yield to call (YTC) • Expected return on bond from purchase date to first call date

6. Corporate Returns Vs. Municipal Returns • Taxable equivalent yield • Method used to compare yield on municipal bonds with yield on taxable bonds

7. Treasury bills Zero-coupon bonds Commercial paper Certificates of deposit Banker’s acceptances Repurchase agreements Eurodollars Promissory notes Treasury notes and bonds Treasury Inflation-Protected Securities (TIPS) Treasury STRIPS Types of Fixed-Income Securities (1 of 3)

8. Types of Fixed-Income Securities (2 of 3) • US savings bonds • Series EE • Series HH • Series I • Municipal bonds • General obligation • Backed by full faith and credit • Revenue • Finance specific revenue-producing projects

9. Types of Fixed-Income Securities (3 of 3) • Corporate bonds • Call provision • Unsecured or secured • Convertible bonds • Acquire stock by exchanging bonds under specific formula • Asset-backed securities • Mortgage-backed securities (MBSs) • Prepayment risk • Collateralized mortgage obligations (CMOs)

10. Systematic Interest rate risk Reinvestment risk Purchasing power risk Unsystematic Default risk Call risk Risks of Fixed-Income Securities

11. Volatility of Fixed-Income Securities • Two key factors influencing volatility • Coupon rate: Volatility in price for a bond is inversely related to the bond’s coupon payment when interest rates change • Maturity: Bonds with longer terms are subject to more volatility with changing interest rates than bonds with shorter terms

12. Term Structure of Interest Rates • Yield curves • Normal (upward sloping) • Flat • Downward sloping • Yield curve theories • Pure expectations theory • Liquidity preference theory • Preferred habitat theory • Market segmentation theory

13. Duration and Immunization • Duration: Provides a time-weighted measure of a security’s cash flows in terms of payback • Factors impacting duration • Coupon rate • Maturity • Yield to maturity • Immunization: Concept of minimizing the impact of changes in interest rates on the value of investments

14. Uses for Duration • Measuring a bond’s volatility • Estimating the change in the price of a bond based on changes in interest rates • Immunizing a bond or bond portfolio against interest rate risk

15. Traditional Methods of Immunizing Bond Portfolios • Ladder strategy • Portfolio of bonds with staggered maturities • Barbell strategy • One-half of portfolio is invested in short-term bonds, the other-half in long-term bonds • Bullet strategy • Purchasing a series of bonds with similar maturities, focused around a single point in time