Chapter 2

Fixed Income Securities

What's past is prologue.

—William Shakespeare, The Tempest

A security is a financial asset that yields a measurable payoff, which may be state dependent (for example, it pays $1 if it rains and zero otherwise). The return to the security is the percentage change in the security's value over some well-defined period of time. That return is fixed if payoffs do not vary over the life of the asset. Bonds are securities paying fixed payoffs (coupons). U.S. Treasuries are the least risky bonds because they have the smallest relative likelihood of defaulting on their payoffs. Corporate and municipal bonds are generally riskier because they do not have the power of the federal government (the taxpayer) to guarantee that bondholders will receive the promised payoffs. Bond market participants will therefore pay close attention to bond rating agencies like Standard & Poor's, Moody's, and Fitch when pricing the present value of future coupon streams. Credit risk is covered in more detail in Chapter 11.

In general, a bond is a loan; the holder of the bond is a creditor and the original seller of the bond is the borrower. In the case of government bonds, creditors have a claim on taxpayers (unless the government defaults on its debt). In the case of the corporate bond, the bondholder (creditor) has a claim to the assets of the firm and their claims generally are senior to shareholders (holders of equity, or stock). Thus, there are risks that cash flows like ...

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