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Copyright©2010PearsonEducation,Inc.PublishingasPrenticeHall.1OVERVIEWOFCONTENTSChapter1introducesthetext.Chapters2-5setforththebasicanalyticalframeworknecessarytounderstandthepricingofbondsandtheirinvestmentcharacteristics.Chapter6describesthetreasurymarket.Chapters7-9explaintheinvestmentcharacteristicsandspecialfeaturesofU.S.corporatedebt,municipalsecurities,andnon-U.S.bonds.Chapters10-13focusonresidentialmortgage-backedsecurities.Chapter14coverscommercialmortgageloansandcommercialmortgage-backedsecurities.Chapters15-16lookatasset-backedsecuritiesandcollateralizeddebtobligations.Chapters17-20describemethodologiesforvaluingbonds.Chapters21and22dealswithcorporatebondcreditrisk.Chapters23-26discussportfoliostrategies.Chapters27-30explainthevariousinstrumentsthatcanbeusedtocontrolportfoliorisk.CHAPTER1INTRODUCTIONCHAPTERSUMMARYThisintroductorychapterwillfocusonthefundamentalfeaturesofbond,thetypeofissuers,andriskfacedbyinvestorsinfixed-incomesecurities.Abondisadebtinstrumentrequiringtheissuertorepaytothelendertheamountborrowedplusinterestoveraspecifiedperiodoftime.Atypical(“plainvanilla”)bondissuedintheUnitedStatesspecifies(1)afixeddatewhentheamountborrowed(theprincipal)isdue,and(2)thecontractualamountofinterest,whichtypicallyispaideverysixmonths.Thedateonwhichtheprincipalisrequiredtoberepaidiscalledthematuritydate.Assumingthattheissuerdoesnotdefaultorredeemtheissuepriortothematuritydate,aninvestorholdingthisbonduntilthematuritydateisassuredofaknowncashflowpattern.SECTORSOFTHEU.S.BONDMARKETTheU.S.bondmarketisdividedintosixsectors:U.S.Treasurysector,agencysector,municipalsector,corporatesector,asset-backedsecurities,andmortgagesector.TheTreasurySectorTheTreasurysectorincludessecuritiesissuedbytheU.S.government.ThesesecuritiesincludeTreasurybills,notes,andbonds.Thissectorplaysakeyroleinthevaluationofsecuritiesandthedeterminationofinterestratesthroughouttheworld.TheAgencySectorTheagencysectorincludessecuritiesissuedbyfederallyrelatedinstitutionsandgovernment-sponsoredenterprises.Thesecuritiesissuedarenotbackedbyanycollateralandarereferredtoasagencydebenturesecurities.Copyright©2010PearsonEducation,Inc.PublishingasPrenticeHall.2TheMunicipalSectorThemunicipalsectoriswherestateandlocalgovernmentsandtheirauthoritiesraisefunds.Bondsissuedinthissectortypicallyareexemptfromfederalincometaxes.TheCorporateSectorThecorporatesectorincludes(i)securitiesissuedbyU.S.corporationsand(ii)securitiesissuedintheUnitedStatesbyforeigncorporations.Issuersinthecorporatesectorissuebonds,medium-termnotes,structurednotes,andcommercialpaper.Thecorporatesectorisdividedintotheinvestmentgradeandnoninvestmentgradesectors.TheAsset-BackedSecuritiesSectorIntheasset-backedsecuritiessector,acorporateissuerpoolsloansorreceivablesandusesthepoolofassetsascollateralfortheissuanceofasecurity.TheMortgageSectorThemortgagesectoristhesectorwheresecuritiesarebackedbymortgageloans.Theseareloansobtainedbyborrowersinordertopurchaseresidentialpropertyoranentitytopurchasecommercialproperty(i.e.,income-producingproperty).Themortgagesectoristhendividedintotheresidentialmortgagesectorandthecommercialmortgagesector.OVERVIEWOFBONDFEATURESThebondindentureisthecontractbetweentheissuerandthebondholder,whichsetsforthalltheobligationsoftheissuer.TypeofIssuerTherearethreeissuersofbonds:thefederalgovernmentanditsagencies,municipalgovernments,andcorporations(domesticandforeign).TermtoMaturityThematurityofabondreferstothedatethatthedebtwillceasetoexist,atwhichtimetheissuerwillredeemthebondbypayingtheprincipal.Theremaybeprovisionsintheindenturethatalloweithertheissuerorbondholdertoalterabond’stermtomaturity.Generally,bondswithamaturityofbetweenoneandfiveyearsareconsideredshort-term.Bondswithamaturitybetween5and12yearsareviewedasintermediate-term,andthosewithamaturityofmorethan12yearsarecalledlong-term.Withallotherfactorsconstant,thelongerthematurityofabond,thegreaterthepricevolatilityresultingfromachangeinmarketyields.Copyright©2010PearsonEducation,Inc.PublishingasPrenticeHall.3PrincipalandCouponRateTheprincipalofabondistheamountthattheissueragreestorepaythebondholderatthematuritydate.Thisamountisalsoreferredtoastheredemptionvalue,maturityvalue,parvalue,orfacevalue.Thecouponrate,alsocalledthenominalrate,istheinterestratethattheissueragreestopayeachyear.Theannualamountoftheinterestpaymentmadetoownersduringthetermofthebondiscalledthecoupon.Theholderofazero-couponbondrealizesinterestbybuyingthebondsubstantiallybelowitsprincipalvalue.Interestisthenpaidatthematuritydate,withtheexactamountbeingthedifferencebetweentheprincipalvalueandthepricepaidforthebond.Floating-ratebondsareissueswherethecouponrateresetsperiodically(thecouponresetdate)basedonaformula.Thecouponresetformulahasthefollowinggeneralform:referencerate+quotedmargin.Thereferencerateforfloating-ratesecuritiescanbeaninterestrateoraninterestrateindexorafinancialindexoranonfinancialindex.Thequotedmarginistheadditionalamountthattheissueragreestopayabovethereferencerate.Thecoupononfloating-ratebonds(whichisdependentonaninterestrat