Investments, tenth edition

   14

  IN THE PREVIOUS 

chapters on risk and return 

relationships, we treated securities at a high 

level of abstraction. We assumed implicitly 

that a prior, detailed analysis of each security 

already had been performed, and that its risk 

and return features had been assessed. 

 We turn now to specific analyses of partic-

ular security markets. We examine valuation 

principles, determinants of risk and return, 

and portfolio strategies commonly used 

within and across the various markets. 

 We begin by analyzing    debt securities    .  A 

debt security is a claim on a specified periodic 

stream of income. Debt securities are often 

called  

fixed-income securities  because they 

promise either a fixed stream of income or 

one that is determined according to a speci-

fied formula. These securities have the advan-

tage of being relatively easy to understand 

because the payment formulas are specified 

in advance. Uncertainty about their cash flows 

is minimal as long as the issuer of the secu-

rity is sufficiently creditworthy. That makes 

these securities a convenient starting point 

for our analysis of the universe of potential 

 investment vehicles. 

 The bond is the basic debt security, and 

this chapter starts with an overview of the 

universe of bond markets, including Treasury, 

corporate, and international bonds. We turn 

next to bond pricing, showing how bond 

prices are set in accordance with market 

interest rates and why bond prices change 

with those rates. Given this background, we 

can compare the myriad measures of bond 

returns such as yield to maturity, yield to call, 

holding-period return, and realized com-

pound rate of return. We show how bond 

prices evolve over time, discuss certain tax 

rules that apply to debt securities, and show 

how to calculate after-tax returns. Finally, we 

consider the impact of default or credit risk 

on bond pricing and look at the determinants 

of credit risk and the default premium built 

into bond yields. Credit risk is central to both 

collateralized debt obligations and credit 

default swaps, so we examine these instru-

ments as well.