Chapter three: Fixed Income Securities
3.1 Bond characteristics
A bond is a security that is issued in connection with a borrowing arrangement. The borrower
issues (i.e., sells) a bond to the lender for some amount of cash; the bond is the “IOU” of the
borrower. The arrangement obligates the issuer to make specified payments to the bondholder on
specified dates. A typical coupon bond obligates the issuer to make semiannual payments of
interest to the bondholder for the life of the bond. These are called
coupon payments because in
pre computer days, most bonds had coupons that investors would clip off and present to claim
the interest payment. When the bond matures, the issuer repays the debt by paying the
bondholder the bond’s
par value
(equivalently, its
face value
). The
coupon rate
of the bond serves to determine the interest payment: The annual payment is the coupon rate
times the bond’s par value. The coupon rate, maturity date, and par value of the bond are part of
the
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 buyer
for $1,000. The bondholder is then entitled to a payment of 8% of $1,000, or $80 per year, for the
stated life of the bond, say, 30 years. The $80 payment typically comes in two semiannual
installments 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 par
value to buy the bond. Sometimes, however, zero-coupon bonds are issued that make no coupon
payments. In this case, investors receive par value at the maturity date but receive no interest
payments until then: The bond has a coupon rate of zero. These bonds are issued at prices
considerably below par value, and the investor’s return comes solely from the difference between
issue price and the payment of par value at maturity.
3.2.BOND PRICING
Because a bond’s coupon and principal repayments all occur months or years in the future, the
price 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 the
sum of (1) a real risk-free rate of return and (2) a premium above the real rate to compensate for
expected inflation. In addition, because most bonds are not riskless, the discount rate will
embody 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 discounting
cash flows of any maturity, but we can relax this assumption easily. In practice, there may be
different discount rates for cash flows accruing in different periods. For the time being, however,
we ignore this refinement.