7. Fixed-income Securities: Pricing And Trading

Fixed-Income Securities:

Pricing and Trading

Chapter Overview

In this chapter, you will learn how to calculate the price and yield of fixed-income securities. You will also understand the intricacies of interest rates on bonds, including the critical distinction between the nominal and the real rate of return. The chapter will cover the concept of how interest rates are depicted on a yield curve and determined by three theoretical principles. You will then examine how and why bond prices fluctuate based on specific fixed-income pricing properties. The chapter also delves deep into bond trading—discussing delivery rules, transaction settlement—and concludes by describing how bond indexes serve portfolio managers in performance measurement and fund construction.

Learning Objectives

• Perform calculations relating to bond pricing and yield.
• Describe the factors that determine the term structure of interest rates and the shape of the yield curve.
• Explain the bond price reactions to changes in interest rates, maturity, coupon, and yield.
• Describe how bond trading is conducted and enforced through rules and regulations.
• Define bond indexes and their use in the securities industry.

Key Terms

Accrued Interest: The interest accumulated on a bond since its last payment date up to, but not including, the settlement date.

Bearer Bonds: A bond that is not registered in the investor’s name and can be transferred by delivery.

Buy Side: Institutional investors and money managers who writ large part of the market purchases or investments.

Current Yield: Annual coupon payment divided by the bond’s current market price. Simplifies the view of returns.

Discount Rate: Interest rate used in discounted cash flow (DCF) analysis to determine the present value of future cash flows.

Duration: A measure of the sensitivity of the price of a bond to a change in interest rates, expressing the weighted average time until the bond’s cash flows are received.

Expectations Theory: The theory that the yields on long-term securities can help to predict future short-term interest rates.

Inter-Dealer Broker: A broker who facilitates transactions and negotiates trades between dealers and traders.

Liquidity Preference Theory: Suggests investors demand a premium for securities that cannot be easily liquidated.

Market Segmentation Theory: Suggests different maturities are good investment needs for different parties; thus, competing interest doesn’t need to lead to price shifts across the board.

Nominal Rate: The interest rate before adjustments for inflation.

Present Value: The current value of a future amount of money or stream of cash flows given a specified rate of return.

Real Rate of Return: The rate of return on an investment after adjusting for inflation.

Registered Bonds: Bonds whose ownership is recorded by the issuer or issuer’s agent. Transfers of ownership require specific documentation.

Reinvestment Risk: The risk associated with reinvesting any predictable cash flows (like coupon payments) to hit the identical yield.

Sell Side: Service providers, such as investment banks, securities brokerage firms, and those who manage loan or secondary note sales.

Trade Ticket: A document that describes all of the terms, conditions, and instructions about an upcoming or executed trade.

Yield Curve: A graph that displays the relationship between yield and maturity. Generally serves to describe interest rates on bonds offering fixed-interest payments across all durations. Student’s learning task

Mathematical Formulas

• Bond’s Price:
  $$ P = \frac{C}{{(1 + r)^1}} + \frac{C}{{(1 + r)^2}} + ... + \frac{C + F}{{(1 + r)^t}} $$

Where:

• P: Price of the bond

• C: Coupon payment

• r: Market interest rate per period

• F: Face value of the bond

• t: Total number of periods

• Yield:

  $$ Y = \frac{C+ \frac{F - P}{t}}{\frac{F+P}{2}} $$

Diagrams

    graph TD
	a[Bond Price/Yield Calculating Factors] --> b[Face Value]
	a --> c[Coupon Rate]
	a --> d[Market Interest Rate]
	a --> e[Time to Maturity]
	a --> f[Frequency of Payments]

Key Takeaways

1. Understanding Bond Mechanics: Importance of knowing how to price bonds and calculate yields.
2. Interest Rates Insight: Differentiating nominal and real rates, and interpreting the yield curve.
3. Pricing Properties: Factors influencing bond prices such as interest rates, maturity, and yield.
4. Trade Regulations: Detailed insight into the rules governing bond transactions, delivery and settlement.
5. Index Usage: Bond indexes’ role in performance measurement and constructing bond funds.

Investing in fixed-income securities involves a depth of understanding in multiple financial dimensions. This chapter aims at providing a sturdy bridge for professionals preparing for the Canadian Securities Course Exam to confidently handle aspects intertwined with fixed income trading, pricing, and management.

In this section

• 7.1 Introduction
  Learn about the intricacies of fixed-income securities, including risks, rewards, bond yields, pricing, and their relationship with interest rates. Understand the secondary market and factors affecting bond prices.
• 7.2 Calculating Price And Yield Of Bond
  Understand how to calculate the price and yield of a bond by using the present value method, with examples and detailed steps.
  • 7.2.1 Discount Rate
    In-depth information on the discount rate in bond valuation, its relevance, calculation, and distinction from other rates such as the yield and coupon rate.
  • 7.2.2 Calculating Fair Price Of Bond
    Learn how to calculate the fair price of a bond through present value calculations. This guide offers step-by-step instructions and formulas to determine the value of a bond's principal and coupon payments.
  • 7.2.3 Calculating Yield On Treasury Bill
    Learn how to calculate the yield on a Treasury Bill (T-bill) which trades at a discount and matures at par. This guide provides the formula, detailed explanations, and an example calculation.
  • 7.2.4 Calculating Current Yield On Bond
    Learn how to calculate the current yield on a bond using a simple formula, as well as understand its practical applications.
  • 7.2.5 Calculating Yield To Maturity On Bond
    Learn how to calculate yield to maturity on bonds, understand its significance, and explore detailed procedures with examples and formulas.
• 7.3 Term Structure Of Interest Rates
  Understand the factors influencing the term structure of interest rates and the shape of the yield curve through market forces, theories, and key economic concepts.
  • 7.3.1 Real Rate Of Return
    Understand the components and determinants of the real rate of return, how it interacts with the nominal rate, and its implications for investors and businesses in the context of Canadian Securities Course certification.
  • 7.3.2 Yield Curve
    Understand the significance of the yield curve in bond markets, including the key theories explaining its shape: expectations theory, liquidity preference theory, and market segmentation theory.
• 7.4 Fundamental Bond Pricing Properties
  Explore the fundamental properties of bond pricing and understand how factors like interest rates, maturity, coupon rates, and yield affect bond prices. Learn essential calculations and the use of financial calculators for accurate pricing.
  • 7.4.1 Relationship Between Bond Prices And Interest Rates
    Understand the intricate relationship between bond prices and interest rates, including how bond yields are impacted and examples with calculations. Learn to master bond investment strategies in varying interest rate environments.
  • 7.4.2 Impact Of Maturity
    Explore the impact of bond maturity on price volatility, illustrating why longer-term bonds are more volatile than shorter-term bonds. Learn with examples and detailed tables.
  • 7.4.3 Impact Of Coupon
    Explore the nuances of how coupon rates affect bond price volatility with detailed explanations, FAQs, formulas, charts, and a comprehensive glossary of terms.
  • 7.4.4 Impact Of Yield Changes
    Understand the relative impact of yield changes on bond pricing. This section details how percentage changes in yield affect bond prices more significantly when rates are lower and explains the asymmetrical effects of yield increases and decreases.
  • 7.4.5 Duration As Measure Of Bond Price Volatility
    Understand duration as a measure of bond price volatility, and how it can help investors make informed decisions. Delve into bond value changes, interest rate impacts, coupon rates, and time to maturity factors. Includes examples, table analyses, and further reading references.
• 7.5 Bond Market Trading
  Comprehensive guide on how bond trading is conducted, detailing operations in the sell side and the buy side.
  • 7.5.1 Sell Side
    Understand the sell side of fixed-income trading, including the roles of investment bankers, traders, and sales representatives. Learn about their responsibilities and how they contribute to the financial markets.
  • 7.5.2 Buy Side
    Understanding the buy side of fixed-income trading, focusing on portfolio managers, traders, and the institutional clients they serve.
  • 7.5.3 Buying Bonds Through Investment Dealer
    Explore the intricate process of buying bonds through an investment dealer, covering both large institutional and smaller firms, role of inter-dealer brokers, and essential techniques for efficient bond trading.
  • 7.5.4 Mechanics Of Trade
    Learn the comprehensive mechanics of non-electronic securities trade, including trade tickets, clearing and settlement, calculating accrued interest, and understanding bond indexes as described in the Canadian Securities Course.