fixed-income securities

fixed-income securities - Fixed-Income Securities Timothy...

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Fixed-Income Securities Timothy R. Mayes, Ph.D. Metropolitan State University Denver
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What is a Bond? A bond is a tradable instrument that represents a debt owed to the owner by the issuer. Most commonly, bonds pay interest periodically (usually semiannually) and then return the principal at maturity.
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A Bond Certificate
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Advantages of Bonds over Stocks Bonds, while a more conservative investment than stocks, can offer certain investors some very attractive features: Safety Reliable income Potential for capital gains Diversification (especially for an otherwise all-equity portfolio) Tax advantages
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Safety of Bonds The safety of bonds derives mainly from two things: Bondholders are in line ahead of both preferred and common stockholders for payment. Thus, if a firm falls on hard times, it must first pay its bondholders while stockholders may see dividends cut. In the event that a company skips a payment or violates covenants of the indenture, the creditors may force it into bankruptcy to protect the value of their investment. Stockholders have no such right.
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Reliability of Income Most bonds are “fixed-income” securities. As such, they promise a fixed set of interest payments and the return of the principal at maturity. Investors can count on receiving their interest payments in full and on time, except in the event of severe financial distress. Common stockholders can never be sure of the exact amount (and sometimes the exact timing) of dividends. Bonds that are callable (most corporates and some Treasuries issued before 1985) do not offer as much reliability, though it is still far better than stocks. As interest rates decline, the probability of a call increases.
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Potential for Capital Gains Investors who do not hold a bond to maturity may enjoy capital gains or suffer capital losses: When interest rates fall, bond prices rise. Thus an investor who buys when rates are high, and sells after rates fall will earn a capital gain. The rate decrease may be due to general market conditions or improvement in the company’s creditworthiness. When interest rates rise, bond prices fall. Thus an investor who buys when rates are low, and sells after rates rise will suffer a capital loss. The rate increase may be due to general market conditions or a decrease in the company’s creditworthiness. All other things being equal, as the bond moves through time to maturity, the price must move towards its face value. Thus, bonds purchased at a discount will rise in price, and those purchased at a premium will decline in price.
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Diversification Bonds, when added to an equity portfolio, can lower risk while lowering returns slightly (depending on the percentage of the portfolio allocated to bonds). While bond
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This note was uploaded on 10/27/2010 for the course MATH 3113 taught by Professor Xu during the Spring '10 term at Peking Uni..

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fixed-income securities - Fixed-Income Securities Timothy...

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