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Chapter three: Fixed Income Securities 3.1 Bond characteristics A bond is a security that is issued in connection with a borrowing arrangement. The borrowerissues (i.e., sells) a bond to the lender for some amount of cash; the bond is the “IOU” of theborrower. The arrangement obligates the issuer to make specified payments to the bondholder onspecified dates. A typical coupon bond obligates the issuer to make semiannual payments ofinterest to the bondholder for the life of the bond. These are called coupon payments because inpre computer days, most bonds had coupons that investors would clip off and present to claimthe interest payment. When the bond matures, the issuer repays the debt by paying thebondholder the bond’s par value (equivalently, its face value ). The coupon rateof the bond serves to determine the interest payment: The annual payment is the coupon ratetimes the bond’s par value. The coupon rate, maturity date, and par value of the bond are part ofthe bond indenture, which is the contract between the issuer and the bondholder. To illustrate, a bond with par value of $1,000 and coupon rate of 8% might be sold to a buyerfor $1,000. The bondholder is then entitled to a payment of 8% of $1,000, or $80 per year, for thestated life of the bond, say, 30 years. The $80 payment typically comes in two semiannualinstallments of $40 each. At the end of the 30-year life of the bond, the issuer also pays the$1,000 par value to the bondholder.Bonds usually are issued with coupon rates set just high enough to induce investors to pay parvalue to buy the bond. Sometimes, however, zero-coupon bonds are issued that make no couponpayments. In this case, investors receive par value at the maturity date but receive no interestpayments until then: The bond has a coupon rate of zero. These bonds are issued at pricesconsiderably below par value, and the investor’s return comes solely from the difference betweenissue price and the payment of par value at maturity.3.2.BOND PRICINGBecause a bond’s coupon and principal repayments all occur months or years in the future, theprice an investor would be willing to pay for a claim to those payments depends on the value of
dollars to be received in the future compared to dollars in hand today. This “present value”calculation depends in turn on market interest rates. The nominal risk-free interest rate equals thesum of (1) a real risk-free rate of return and (2) a premium above the real rate to compensate forexpected inflation. In addition, because most bonds are not riskless, the discount rate willembody an additional premium that reflects bond-specific characteristics such as default risk,liquidity, tax attributes, call risk, and so on. We simplify for now by assuming there is one interest rate that is appropriate for discountingcash flows of any maturity, but we can relax this assumption easily. In practice, there may bedifferent discount rates for cash flows accruing in different periods. For the time being, however,we ignore this refinement.