Chapter 20

A debt security is a financial instrument representing the borrower's obligation to the lender from whom he has received funds. This obligation provides for a schedule of financial flows defining the terms of repayment of the funds and the lender's remuneration in the interval.

The price of a bond does not reflect its actual cost. The yield to maturity (which cancels out the bond's NPV – that is the difference between the issue price and the present value of future flows) is the only criterion allowing investors to evaluate the various investment opportunities (according to risk and length of investment). On the secondary market, the yield to maturity is merely an opportunity cost for the issuer, i.e. the cost of re-funding today.

The basic parameters for bonds are as follows:

The diversity of these parameters explains why the yield to maturity may differ from the coupon rate.

Fixed-rate debt securities are exposed to the risk of interest rate fluctuations: the value of a fixed-rate debt security increases when interest rates fall, and vice versa. This fluctuation is measured by:

Floating-rate securities have a coupon that is not fixed but indexed to an observable market rate (with a fixed margin that is added to the variable rate when the coupon is calculated). Variable-rate bonds are not very volatile securities, even though their value is not always exactly 100% of the nominal.

All debt securities are exposed to default risk which is assessed by rating agencies on the basis of ratings (AAA, AA, A, BBB, etc.) which depend on the volatility of the economic assets and the financial structure of the issuer. The result is a spread which is the difference between the bond's yield to maturity and that of a no-risk loan over an identical period. Obviously, the better the perceived solvency of the issuer, the lower the spread.