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FIXED INCOME

FEATURES OF DEBT SECURITIES


Cross-Reference to CFA Institute Assigned Reading #53

A fixed-income security is a financial obligation of an entity that promises to pay a


specified sum of money at specified future dates. The issuer of a fixed income security
is the entity that promises to make the payments. There are three types of issuers:

· Federal government and agencies.


· Municipal governments.
· Corporations (domestic and foreign).

Categories of Fixed-Income Securities Vol 5, pg 322

Debt obligations: The borrower issues a fixed-income security and the lender purchases the
security. The issuer makes interest and principal payments.

Preferred stock: An equity instrument that has features similar to bonds. Holders of preferred
stock receive dividends and enjoy priority over common shareholders in the hierarchy of
claims.

The bond’s indenture (also trust indenture) is a legal document issued to lenders
(investors) that describes the key terms of the lending agreement; including the coupon
rate, the trustee, and covenants.

Covenants Vol 5, pg 323

Affirmative covenants are actions that the issuer promises to carry out. Examples of
affirmative covenants include making interest and principal payments in a timely manner.
Affirmative covenants may also require the issuer to maintain certain liquidity ratios
within a specified range.

Negative covenants impose restrictions on the issuer’s activities. Examples of negative


covenants include limitations on the issuer’s ability to issue additional debt (unless certain
prespecified conditions are met) and restrictions on the sale of long-lived assets.

Basic Features of Bonds Vol 5, pg 323

· Maturity.
· Par value.
· Coupon rate.

Coupon Rate Structures Vol 5, pg 326

· Zero-coupon bonds do not make any periodic coupon (interest) payments.


· Step-up notes have coupon rates that increase over time at a specified rate.

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· Deferred coupon bonds are issued at a discount to par and initially do not pay interest
for a specified period (the deferral period).
· Floating-rate securities offer coupon rates that are reset periodically based on a
specified reference rate. A floating-rate security may have maximum and minimum
coupon rate limits. The maximum coupon rate that will be paid is called a cap and
the minimum rate is called a floor.
· Inflation-adjusted securities guarantee a return that exceeds the inflation rate if held
till maturity.
· Inverse-floaters have coupon rates that are inversely related to short-term interest
rates.
· Dual-currency bonds make coupon payments in one currency and the principal
repayment in another currency.

Accrued Interest, Full Price and Dirty Price Vol 5, pg 330

If an investor purchases a bond between coupon payments, she must compensate the
seller for the unpaid coupon interest from the last coupon payment date to the transaction
date. This interest is called accrued (unpaid) interest. The investor will recover the accrued
interest paid to the seller at the time of purchase from the next coupon payment (she will
receive the entire amount of the coupon).
· The full or dirty price of the bond is the agreed upon selling price plus any accrued
interest.
· The clean price of the bond is the price without accrued interest. It is basically the
agreed upon selling price.

Provisions for Redemption and Retirement of Bonds Vol 5, pg 331

· A bullet maturity or bullet bond refers to a bond where the issuer retires the bond
in one lump sum payment at maturity.
· An amortizing security is a bond where the issuer makes both principal and interest
payments over the term of the bond.
· A security with a prepayment option allows the borrower to make principal repayments
in excess of scheduled principal repayments.
· A call provision gives the issuer the right, but not the obligation to retire all, or part
of an issue prior to maturity.
· A refunding occurs when a borrower replaces an old bond issue with a new issue
to save interest costs. The newer issue carries lower interest rates.
· A redemption refers to the calling of bonds through a call provision or through a
sinking fund schedule.
· Non-refundable bonds are bonds whose redemption via a call provision cannot be
financed with the issue of another bond. These bonds are therefore callable, but not
refundable. They can be called for any reason other than simply to save interest
costs.
· A sinking fund provision requires the issuer to retire a certain portion of the loan
every year.

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Regular versus Special Redemptions Vol 5, pg 335

· When bonds are redeemed under the call provisions of the bond indenture, it is
referred to as a regular redemption. Regular redemption prices generally tend to be
above par until the first par call date.
· Sometimes bonds are called with the proceeds of government-enforced sales of
properties of the company, or from the proceeds of sale of assets due to deregulation.
Such redemptions are known as special redemptions. Under special redemptions,
bonds are usually called at par.
· The par call problem occurs when issuers try to manipulate the call so that special
redemption rules apply. Special redemptions allow issuers to call bonds at lower
prices (par) than under regular redemptions (in which call prices usually exceed par).

Security Issuer Options Vol 5, pg 337

When the embedded option is granted to the issuer of the fixed income security, the
security will be priced lower, and will have a higher coupon than an otherwise identical
bond that has no embedded options.

· Call provisions grant the issuer the right to retire the bonds (fully/partially) before
the scheduled maturity date.
· Prepayment options grant the issuer the right to repay a loan prior to maturity.
Principal repayments can exceed scheduled repayments.
· Accelerating sinking fund provisions allow the issuer to repay more than the amount
required under the sinking fund schedule, up to a specified limit.
· A cap on a floating-rate security effectively places a limit on the maximum periodic
coupon rate that the issuer must pay on a floating-rate loan.

Security Owner Options Vol 5, pg 337

When the embedded option is granted to the investor (owner), the security will hold more
value for the investor so it will be priced higher, and will have a lower coupon than an
otherwise identical bond that has no embedded options.

· Conversion options grant the investor the right to convert the bonds into shares of
common stock in the issuing company at a pre-specified ratio.
· Put provisions grant bondholders the right to sell back (or put) the bond to the issuer
at a specified price (usually par) prior to maturity.
· A floor on a floating-rate security effectively places a limit on the minimum interest
rate that an investor must receive on a floating-rate security.

Margin buying involves the purchase of securities with borrowed funds, using the
securities themselves as collateral. Margin buying is usually carried out using a margin
account at a brokerage firm, where the broker gets the money for the arrangement from
a bank. The interest rate charged is called the call money rate (or broker loan rate).

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A repurchase agreement is an arrangement between two parties, in which an institution


sells a security to a purchaser with a commitment to buy the security back at a later date
for a predetermined, higher price. The difference between the selling price and the
repurchase price is the interest cost of the loan. The annualized interest cost of the loan
is called the repo rate. A repurchase agreement for one day is known as an overnight repo,
and one for a longer period is known as a term repo. Repo rates are usually lower than
the rates that a broker or bank would charge on a margin loan.

RISKS ASSOCIATED WITH INVESTING IN BONDS


Cross-Reference to CFA Institute Assigned Reading #54

Interest Rate Risk Vol 5, pg 352

Bond prices and interest rates are inversely related. Because bond prices fluctuate with
changes in interest rates, bond investors face the risk of a price decline as a result of an
upward movement in interest rates. This risk is referred to as interest rate risk and is the
major risk faced by bond investors.

Important Relationships Regarding Bond Prices and Interest Rates Vol 5, pg 353

· A bond will trade at par when the coupon rate equals the yield required by the
market.
· A bond will trade at a premium when the coupon rate is greater than the yield required
by the market.
· A bond will trade at a discount when the coupon rate is lower than the yield required
by the market.
· If interest rates rise, bond prices fall.
· If interest rates fall, bond prices rise.

Effects of Bond Features on the Bond’s Interest Rate Risk Vol 5, pg 354

· All other factors constant, the longer the bond’s remaining term to maturity, the
greater the bond’s sensitivity to changes in interest rates.
· All other factors constant, the lower the coupon rate, the greater the bond’s price
sensitivity to changes in interest rates. The implication of this relationship is that
zero-coupon bonds are more sensitive to changes in interest rates than coupon-
bearing bonds with the same term and yield to maturity.
· The existence of embedded options results in different sensitivities to interest rate
changes for callable and putable bonds as compared to straight bonds.
· All other factors constant, the lower the bond’s yield, the higher the sensitivity of
the bond’s price to changes in interest rates. An implication of this is that for a given
change in interest rates, price sensitivity is lower when market interest rates are high,
and price sensitivity is higher when market interest rates are low.

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Callable Bonds Vol 5, pg 355

Price of a callable bond = Value of option-free bond - Value of embedded call option

An investor in a callable bond is long on the straight bond, but short on the call option.
Therefore, the price of a callable bond does not rise as much as the price of an option-
free bond in response to a decrease in interest rates because:

· The option-free (straight) bond increases in value when interest rates fall.
· The call option also increases in value as interest rates fall because the market value
of the bond rises. The call option allows the issuer to recall the bond at the lower-
than-market call price.

When interest rates rise, the price of a callable bond does not fall as much as the price
of a straight bond because the reduction in value of the straight bond is partially offset
by the decrease in price of the embedded call option (which the callable bond investor
is short on).

Putable Bonds

Price of a putable bond = Value of option-free bond + Value of embedded put option

An investor in a putable bond is long on the straight bond, and long on the put option.
The price of a putable bond does not fall as much as the price of an option-free bond in
response to an increase in interest rates because:

· The option-free (straight) bond decreases in value when interest rates rise.
· The put option increases in value as interest rates rise because the market value of
the bond rises. The put option allows the investor to sell the bond back to the issuer
at the higher-than-market put price.

When interest rates fall, the price of a putable bond does not rise as much as the price
of a straight bond because the increase in value of the straight bond is partially offset by
the decrease in value of the embedded put option (which the putable bond investor is long
on).

Interest Rate Risk of Floating-Rate Securities Vol 5, pg 356

Despite the fact that their coupon rates are reset periodically in line with market interest
rates, floating-rate security prices still deviate from par because of the following three
factors:

· The longer the time left till the next reset date, the greater the potential price
fluctuation. Basically, the longer the period left till the bond’s coupon reflects market
requirements, the higher the bond’s price sensitivity to changes in interest rates.

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· If the quoted margin no longer accurately compensates investors for the risk inherent
in the bond, the floating rate bond’s price can deviate from par.
· Once market interest rates exceed the cap rate on floating-rate instruments, the
floating-rate bond only pays out coupon at the cap rate, and the instrument behaves
like a fixed-rate bond. Since the coupon rate is lower than the market interest rate,
the security’s price will fall. This is referred to as cap risk.

Duration Vol 5, pg 358

Duration is an approximate measure of the percentage change in price of a bond in


response to a 1% (100 basis point) change in interest rates across all maturities (parallel
shift in the yield curve). When solving questions related to duration, remember that bond
prices and interest rates move in opposite directions. It is also important to remember
that:

· The duration of a zero-coupon bond approximately equals its remaining term to


maturity in years.
· The duration of a floating-rate instrument equals the fraction of the year remaining
till the next reset date.
· Duration is a linear measure of the sensitivity of bond prices to changes in
interest rates.

Dollar duration refers to the approximate price change, in dollars, in the value of a bond
for a 100bp change in yields.

Dollar duration = Duration * Bond value

Yield Curve Risk Vol 5, pg 359

Yield curve risk arises from the possibility of changes in the shape of the yield curve that
may affect bond prices adversely The yield curve illustrates the relationship between bond
yields and their terms to maturity.

Duration only measures the change in bond prices in response to an equal change in yields
across all maturities (parallel shift in the yield curve). Portfolios of bonds are composed of
individual securities that may each have different maturities and different exposures to yield
curve changes. This risk exposure is known as yield curve risk.

The implication here is that any measure of interest rate risk that assumes that interest rates
change by the same amount for all maturities (like duration) will provide a poor approximation
for the change in portfolio value when the shift in the yield curve is not parallel.

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Reinvestment Risk Vol 5, pg 364

Reinvestment risk refers to the risk that the interim cash flows received from a bond, (in the
form of coupon payments, scheduled principal repayments, and prepayments) which are
available for investing again might have to be invested at a rate lower than the rate at which
they were invested previously.

Calculations of yield to maturity (YTM) assume that any interim cash flows from the
bond will be reinvested at the bond’s YTM until maturity. If the coupon payments from
a fixed income investment have to be reinvested at a rate lower than the YTM, the investor
is exposed to reinvestment risk. The actual realized yield on the instrument will turn out
to be lower than the calculated yield to maturity.

With amortizing securities, reinvestment risk is even greater. In a declining interest rate
environment, borrowers can accelerate principal prepayments (to refinance their loans
at the new lower rates) and leave holders of amortizing securities with no choice but to
reinvest their funds at the prevailing lower rates.

Zero-coupon bonds have zero reinvestment risk. However, this advantage is offset by
their greater duration and interest rate risk. Zero-coupon bonds have the lowest possible
coupon (zero), and hence the greatest interest rate risk.

A security has more reinvestment risk when:


· It carries a higher coupon rate.
· It has a call or prepayment feature.
· It is an amortizing security.

Call Risk Vol 5, pg 363

Investors in callable and prepayable securities face the following three disadvantages,
which represent various forms of call risk.

· There is uncertainty associated with pattern of cash flows as it is not known when
these securities might be called or the rate at which they will be prepaid.
· Bonds are likely to be called when interest rates fall. This exposes investors to
reinvestment rate risk because the proceeds will have to be reinvested at the
prevailing lower interest rates.
· The potential upside in the price of a callable bond is limited compared to that of
a straight bond. This is known as price compression.

Mortgage and asset-backed securities allow borrowers to repay their debt obligations ahead
of schedule. The risk faced by investors in mortgage and asset-backed securities that they
will be repaid ahead of schedule is known as prepayment risk.

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Credit Risk Vol 5, pg 365

· Default risk is the risk that an issuer will fail to perform on its obligations under the
terms of a bond contract with respect to the timing of payments, and the amount
owed to investors.
· Credit spreads reflect the riskiness of an investment as perceived by the market. If
a bond issue becomes more risky, the spread that the market will demand on top
of the return required from a risk-free borrower (the U.S. Government) will increase.
The increase in the credit spread will translate into an increase in the required yield,
and force the bond’s price lower. This risk, known as credit-spread risk, exists for
individual firms, industries and for all non-Treasury issuers in an economy.
· Downgrade risk is the risk that credit rating agencies will downgrade the credit rating
of a particular issue. A downgrade would result in investors demanding a higher
return to compensate them for the higher risk inherent in the instrument, which in
turn will reduce the market price of the bond.

Liquidity Risk Vol 5, pg 369

Liquidity risk is the risk that an investor will have to sell her investments at a price lower
than its indicated value, which is the price suggested by the most recent market transaction.
The primary measure of liquidity risk is the spread between the bid (the price at which a
dealer is willing to buy the asset) and the ask (the price at which a dealer is willing to sell
the asset). A higher bid-ask spread indicates low market liquidity and a higher level of
liquidity risk. Unreliable price information can affect investors in two ways:

· The price may misstate the true value of the investment and not reflect portfolio
performance accurately.
· Unreliable price information due to lack of liquidity makes it difficult to assess
the quality and adequacy of the collateral used in repurchase agreements

Liquidity risk can also change over the horizon of the investment as specific product
structures gain or lose popularity among market participants in changing economic
scenarios.

Exchange Rate Risk Vol 5, pg 371

Exchange risk refers to the risk of receiving a lower amount, (in domestic currency terms)
at maturity of a foreign currency-denominated bond, than invested (in domestic currency
terms) to acquire the bond.

Inflation Risk Vol 5, pg 371

Inflation risk refers to the risk of a decline in the purchasing power of the security’s cash
flows due to inflation.

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Volatility Risk Vol 5, pg 372

Price of callable bond = Price of option-free bond – Price of embedded call option

Price of putable bond = Price of option-free bond + Price of embedded put option

· An increase in yield volatility will increase the value of the embedded call
option in a callable bond. Since the issuer effectively owns the option, the increase
in volatility works to the issuer’s benefit and reduces the price of the callable bond.

· An increase in yield volatility will increase the value of the embedded put
option in a putable bond. Since the investor effectively owns the option, the increase
in volatility works to the investor’s benefit and increases the price of the putable
bond.

Since we are trying to state risks here from an investor’s perspective, a callable bond
carries the risk that yield volatility will rise, while a putable bond carries the risk that
yield volatility will fall.

Event risk: Vol 5, pg 372

· A natural disaster may impair the issuer’s ability to satisfy debt obligations.
· Changes in regulations may force some entities to divest certain types of investments.
A sudden barrage of such investments on sale in the market may reduce prices.
· Failure of corporate takeovers or restructurings can increase required yields and
reduce security prices.

Sovereign risk Vol 5, pg 373

Is the risk that a foreign government may be unable or unwilling to satisfy its debt obligations.
Inability to pay arises from adverse economic conditions, while unwillingness may arise
from political decisions.

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OVERVIEW OF BOND SECTORS AND INSTRUMENTS


Cross-Reference to CFA Institute Assigned Reading #55

The U.S. Department of the Treasury (Treasury) issues U.S. Treasury securities (Treasuries).
Treasuries are backed by the full faith and credit of the United States’ government and
are therefore considered risk-free securities. However, this only refers to the fact that they
have no credit risk. Treasuries do suffer from other kinds of risks including liquidity and
reinvestment risk.

Fixed Principal Securities Vol 5, pg 395

Treasury bills: T-bills are short-term debt securities with maturity terms of less than one
year. They are zero-coupon instruments.

Treasury notes: These securities have maturities ranging from one to ten years. They make
semiannual coupon payments at a rate that is fixed at issuance.

Treasury bonds: These are coupon-bearing securities whose terms to maturity exceed ten
years.

Inflation-Indexed Treasury Securities Vol 5, pg 395

These are Treasuries (notes and bonds) that provide protection against inflation. They
work in the following manner:

· The semiannual coupon rate is fixed at issuance.


· The par value adjusts semiannually for inflation as measured by the U.S. City
Average All Items All Consumer Price Index for All Urban Consumers (CPI-U).
· The fixed coupon rate is applied to the inflation-adjusted par value to determine the
coupon amount.

TIPS coupon = Inflation-adjusted par value * (stated coupon rate/2)

On-the-Run versus Off-the-Run Issues Vol 5, pg 395

· On-the-run issues are the most recently auctioned issues. These issues are more
actively traded and therefore more liquid.
· Off-the-run issues are older issues that have been replaced by on-the-run issues as
the most recent issues.

The U.S. Treasury does not issue zero-coupon bonds for maturities greater than one year.
Demand for zero-coupon risk-free securities with longer maturities has led to the creation
of Treasury STRIPS (Separate Trading of Registered Interest and Principal Securities).
The Treasury still issues coupon- paying notes and bonds, but allows certain dealers to
buy large amounts of these securities. These dealers strip the coupons from the principal,
repackage the cash flows and sell them separately as zero-coupon bonds at a discount to
par.

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· Coupon strips are created from coupon payments from Treasuries.


· Principal strips are created from the principal payment.

Even though interest is not paid till maturity of the strips (the bullet payment at maturity
includes interest) the accrued interest (movement in price towards par) over the term of the
bond is taxed each year. Effectively, investments in strips result in negative cash flows for
investors in the years prior to maturity.

Agency Bonds Vol 5, pg 399

Agency bonds are issued by agencies of the U.S. Government, but not all of them are
guaranteed by the U.S. Government. Even so, they are high quality securities with very little
risk of default. Federal agencies are classified into:

· Federally related institutions.


· Government sponsored enterprises.

Mortgage Loans Vol 5, pg 401

A mortgage loan is a borrowing that is secured by some form of real estate. In case a borrower
(homeowner) fails to make her mortgage payments, the lender has the right to seize the
property and recover the amount due by selling it. The interest rate on a mortgage loan is
called the mortgage rate or contract rate.

In the basic structure, the monthly mortgage payment is fixed. Over the term of the loan,
the interest component of the monthly payment decreases as the principal amount outstanding
falls, and the principal component rises. Issuers of the mortgage (homeowners who borrow
money from banks) are allowed to repay a portion, or the entire amount of the mortgage
balance at any point during the term of the mortgage. If homeowners choose to repay only
a portion of the total principal outstanding it is known as a curtailment, and if they pay back
the entire loan ahead of time it is known as a prepayment.

U.S. Agency Mortgage-Backed Securities

Mortgage Passthrough Securities Vol 5, pg 404

A mortgage passthrough security is one in which homeowners' payments pass through the
government agency on to investors. An investor in a mortgage passthrough who owns 10%
of the issue will receive 10% of net monthly payments (including monthly payments and
any prepayments and curtailments) received from the mortgage pool. The prepayment risk
faced by each individual investor in the passthrough is spread across all the loans in the pool.

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Collateralized Mortgage Obligations Vol 5, pg 406

A collateralized mortgage obligation (CMO) has different “tranches”, each of which is


exposed to a different level of prepayment risk. Repackaging mortgage loans as CMOs
attracts a variety of investors with different risk appetites and investment horizons, making
them more marketable than mortgage passthrough securities.

Stripped Mortgage-Backed Securities

These are MBS that are divided into principal-only (PO) and interest-only (IO) strips, which
are affected differently by prepayments. PO strips are entitled to all the principal repayments
and prepayments, and perform well as an investment when prepayment rates are high (the
earlier holders receive payments, the better the investment performance). IO strips are only
entitled to interest payments from the mortgage loans. The quicker the principal repayments
are received, the lower the total amount of interest collected from the mortgages and the
poorer the performance of IO strips as an investment.

Municipal Bonds Vol 5, pg 408

· Tax- exempt bonds are exempt from federal income taxes, but not from federal
capital gains taxes. At the state level, interest on bonds issued within the state is
usually tax exempt, but interest on out-of-state bonds is fully taxable. Most municipal
bonds tend to be tax-exempt.
· Taxable bonds: A bond must meet certain standards to qualify as a ‘tax-exempt’
municipal security. If it does not meet these requirements, interest earned on these
bonds is taxed at the federal and state level.

Tax-Backed versus Revenue Bonds Vol 5, pg 409

Tax-back debt is issued by states, special districts, cities, towns and schools. Tax-backed
debt obligations are backed by full faith, credit and taxing power of the issuing authority.
Tax-backed bonds include:
· General obligation bonds.
· Appropriation-backed bonds.
· Debt supported by public enhancement programs.

Revenue bonds are issued to finance specific projects, and are serviced by the revenues
generated from the projects themselves. Only if sufficient revenues are generated from the
projects will the issuer be obligated to make the payments on these bonds. Investors in
revenue bonds are exposed to more credit risk so they require higher yields compared to
general obligation bonds (which must be serviced in a timely manner regardless of the level
of income generated by the issuer).

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Insured bonds are insured, or guaranteed by a third party. The insurer commits to make
interest and principal payments to investors in a timely manner if the issuer fails to do so.
Insurance coverage extends for the entire term of the bonds and cannot be cancelled by the
insurance firm. Insurance benefits issuers in that it improves credit ratings, which reduces
required yields and improves the liquidity of the issue.

Prerefunded bonds are collateralized by U.S. Treasuries that have already been purchased
and placed in an escrow account. The amount of bonds purchased is sufficient to meet
all the remaining payment obligations on the bonds. Prerefunded bonds have little or no
credit risk and usually receive very high credit ratings.

Corporate Bonds Vol 5, pg 414

Secured debt is backed by some form of collateral. Investors in secured bonds hold a lien
on the pledged collateral. If the issuer defaults on payments, investors can sell the collateral
and use the proceeds to recover the amount that they are owed.

Unsecured debt is not backed by the pledge of any specific collateral. Unsecured bonds
are also known as debentures. Investors in debentures have a general claim on issuer
assets that are not pledged as collateral to secure any other debt. In case of liquidation,
if pledged assets generate funds in excess of the amount due to secured bondholders, the
excess funds are used to settle claims of holders of unsecured debt. Subordinated debentures
are bonds whose claims are met after those of holders of senior debt.

Credit enhancements refer to guarantees made by third parties that the obligations of a
loan agreement will be fulfilled. Credit enhancements include:

· Third party guarantees: Parent companies sometimes guarantee debt obligations


of their subsidiaries and affiliates.
· Letters of credit: Banks guarantee that they will provide funds for interest and
principal payments when they are due if the issuer is unable to make these payments.
· Bond insurance: Certain insurance companies provide this facility.

Medium-Term Notes versus Commercial Paper Vol 5, pg 418

Medium-term notes are shelf-registered securities that do not need to be issued all at once.
They are issued by companies because they enable them to obtain cash flows as financing
needs arise.

Structured MTNs are investment instruments that are geared towards satisfying the needs
of institutional investors who are prohibited from using swaps and other derivatives for
hedging or speculating. Further, they allow investors who face restrictions on the kind
of asset classes they can invest in to gain indirect exposure to these asset classes. Structured
MTNs allow issuers to lower their borrowing costs, as the kinds of exposure that they offer
are in high demand.

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Commercial paper is a short term, unsecured debt instrument that is issued by companies
in the open market at rates lower than bank rates. Commercial paper is usually issued
as a zero-coupon instrument with a term to maturity of 270 days or less. Investors usually
hold commercial paper till maturity so there is very little secondary market trading in
these securities.

Commercial paper is usually rolled over. This means that companies obtain the funds to
pay off a maturing issue by issuing more commercial paper. Issuers often maintain access
to unused bank lines of credit in case new commercial paper cannot be issued to replace
maturing paper.

A certificate of deposit (CD) is issued by a bank to its clients when they deposit money.
A CD bears an interest rate and a maturity date, and can be issued in any denomination.
In the U.S., CDs are insured by FDIC (Federal Deposit Insurance Corporation) for amounts
up to $100,000.

A nonnegotiable CD is one in which an early withdrawal penalty is imposed if the depositor


wishes to withdraw funds prior to the maturity date. Negotiable CDs provide depositors
with the option to sell the CD in the market if they wish to liquidate it before maturity.
Negotiable CDs are issued in denominations of $1 million or more. Therefore, an investor
who purchases a negotiable CD worth more than $100,000 faces credit risk because if
the issuing bank is unable to pay her in full, her investment is not insured above $100,000.

Bankers’ acceptances are basically guarantees made by banks that a loan will be repaid.
A banker's acceptance starts when a customer asks her bank to pay a sum of money at a
future date, typically within six months, to an identified party. At this stage, it is like a
postdated check. When the bank endorses the order for payment as "accepted", it assumes
responsibility for ultimate payment to the holder of the acceptance. At this point, the
acceptance can be traded in secondary markets similar to any other claim on the bank.

Bankers’ acceptances expose investors to credit and liquidity risk. Credit risk refers to
the risk that the issuer and the accepting bank may not be able to make the principal
payment at maturity. Liquidity risk stems from the fact that there are only a few major
dealers in bankers’ acceptances today. However, if bankers’ acceptances are held till
maturity, liquidity risk is eliminated.

An asset-backed security (ABS) has a similar structure to a mortgage-backed security.


While the collateral behind a mortgage-backed security is typically real estate, the securities
that back an ABS are pools of loans or receivables including auto loans and leases,
consumer loans, commercial assets, credit cards, home-equity loans and manufactured
housing loans.

The motivation for issuing an asset-backed security is to minimize borrowing costs. When
ABS are issued, the assets are transferred to an SPV, which allows the company to receive
a higher credit rating on the issue than on unsecured debt, and save on borrowing costs.

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ABS issuers may use credit enhancements to improve the issue’s credit rating. Internal credit
enhancements include reserve funds, overcollateralization and senior/subordinate structures.

The quality of a credit enhancement is only as good as the quality of the party providing
the enhancement. A downgrading of the guarantor can result in a downgrade of the ABS.
Collateralized Debt Obligations Vol 5, pg 426

A collateralized debt obligation (CDO) is an investment product that is backed by a diversified


pool of assets which can include investment grade bonds, high-yield corporate bonds,
emerging market bonds, ABS and even other CDOs.

An asset manager issues the CDO and invests the proceeds in a diversified portfolio of assets.
The investors in the CDO are issued shares in tranches and each tranche is assigned ratings
by a rating agency. Further, there are various restrictions as to how the manager can manage
the portfolio, and failure to adhere to these restrictions can result in a downgrade.

· Arbitrage CDOs are formed with the purpose of earning a spread between the return
on the portfolio and payments to noteholders in the CDO.
· Balance sheet CDOs are formed with the purpose of removing debt instruments from
the issuer’s balance sheet.

Primary Markets Vol 5, pg 427

Primary markets deal with securities that are newly issued to investors by central governments,
agencies and corporations. Usually, investment bankers are hired by the issuer to perform
the following functions:
· Offer advice on the terms and timing of the issue.
· Buy the securities from the issuer.
· Distribute the securities to investors.

When the investment bank buys the securities from the issuer and accepts the risk that the
securities may sell for a lower price, it is known as an underwriting.

· A firm commitment is an underwriting arrangement where the investment bank


agrees to purchase the securities from the issuer at a predetermined price.
· When the investment banking firm only agrees to sell the securities (and does not
buy the entire issue), it is known as a best-efforts arrangement.

Bonds are also issued in the primary market through the bought deal and the auction processes:

· Underwriting firms offer potential issuers of debt securities bids to purchase a


specified amount of securities with a certain coupon rate and maturity. The firm
whose bid is accepted by the issuing company is said to have bought the deal. The
investment bank has effectively ‘gone long’ in the securities and then markets
them to institutional clients and other investors. Further, it uses hedging strategies
to protect itself from the risk that the securities will sell at a lower price.

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· In an auction, it is the issuer who announces the terms of the issue and multiple
investment banks submit bids for the entire issue. The syndicate who bids the lowest
yield wins the issue.

Fixed-income securities offered to the public must be registered with SEC. If a new issue
of securities is not offered to public investors, it may be sold to a small number of investors
in a private placement, which enables the issuer to avoid the registration process.

Secondary Markets Vol 5, pg 429

Secondary markets include exchanges and over-the-counter (OTC) markets. Secondary


markets offer bond investors liquidity, provide information about fair values of securities
and reduce costs of search for bond market participants. Over the last few years, electronic
trading in bond markets has become more popular due to the rising costs of funding bond
trading operations for dealers. Electronic trading has also brought liquidity to bond secondary
markets and made them more efficient.

UNDERSTANDING YIELD SPREADS


Cross-Reference to CFA Institute Assigned Reading #56

Risks of Treasury Securities Vol 5, pg 449

· When market participants say that U.S. Treasuries are risk-free instruments, they are
only referring to credit risk.
· Coupon-bearing Treasuries carry reinvestment risk on coupons.
· Treasuries are not callable so there is no reinvestment risk from the bond being
called.
· Treasury bills, like any other zero-coupon bonds, carry no reinvestment risk.
· Like any other fixed-income instrument, Treasuries carry yield curve and interest
rate risk.
· Treasuries are highly liquid, but off-the-run issues are less liquid than on-the-run
issues so they entail a certain degree of liquidity risk.
· There is no exchange rate risk in Treasuries for U.S. investors, but foreign investors
in US Treasuries do face the exchange rate risk of the dollar depreciating against
their local currencies.
· Fixed-rate Treasuries are exposed to inflation risk.
· There is also an element of event risk in Treasuries in the form of changes in monetary
and fiscal policy in the U.S., and the actions of other central banks and governments.

The yield curve illustrates the relationship between the yield to maturity and term to maturity
of on-the-run Treasury securities.

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There are two factors that complicate the relationship between yields and terms to maturity
as portrayed by the yield curve:

· Investments in on-the-run securities can be financed at lower rates than investments


in off-the-run issues. This results in a greater demand for on-the-run securities, which
increases their prices, and artificially lowers their YTMs.
· Bonds with different coupon rates have different exposures to interest rate and
reinvestment risk. For example, a bond with a 5.35% coupon rate has a higher interest
rate risk (duration) and a lower reinvestment risk than a 5.75% coupon bond with
a similar term to maturity.

Theories of the Term Structure of Interest Rates Vol 5, pg 453

The pure (or unbiased) expectations theory asserts that long-term yields are simply the
geometric means of short term yields. Under the pure expectations theory:
· An upward sloping yield curve implies that short-term rates are expected to rise in
the future.
· A flat curve indicates that short-term yields are expected to remain constant.
· A downward sloping yield curve suggests that short-term rates are expected to fall
in the future.
· A humped yield curve can be explained by investors expecting short-term yields
to rise for a number of years before falling eventually.

The liquidity preference or biased expectations theory accounts for the fact that investors
in long-term securities require compensation for higher exposure to interest rate risk. The
longer the term to maturity, the greater the price sensitivity (duration) of a bond to interest
rate changes, and the greater the compensation required by investors. Longer-term
investors are rewarded for investing over a longer horizon with higher yields or a liquidity
premium. Under the liquidity preference theory, yields are determined by two factors:

· Expected future short-term rates (as in the pure expectations theory).


· A yield premium for taking greater interest rate risk. The greater the interest rate risk
of a bond, the lower the liquidity, hence the liquidity preference for short-term
instruments, and the higher liquidity premium on long term investments.

Under this theory, an upward sloping yield curve can be explained by:

· Higher expected future short term rates; or by


· Unchanged or even falling expected future short term rates, but with a yield premium
that increases with maturity to produce an overall upward-sloping yield curve.

Under the liquidity preference theory, if the yield curve is flat or downward sloping, one
can conclude that short-term interest rates are expected to fall.

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The market segmentation theory asserts that the yield for each maturity along the yield
curve is determined independently by the supply and demand of funds over the particular
horizon. The market for bonds is divided into segments and each segment determines its
own equilibrium yield. Therefore, a yield curve of any shape can be explained by the
market segmentation theory. However, because is asserts that the supply and demand of
funds in different segments markets are independent, the theory fails to explain the
observed fact that yields for different maturities tend to move together.

The preferred habitat theory states that in addition to interest rate expectations, investors
have distinct investment horizons and require a meaningful premium to purchase bonds
with maturities outside their ‘preferred’ maturity, or ‘habitat’. This theory can explain any
shape of the yield curve, and also explains the tendency of the yield curve to shift up or
down while retaining its shape (yields on similar maturities moving in the same direction).

Spot Rates Vol 5, pg 456

The yield to maturity on any zero-coupon bond is known as a spot rate and is distinguished
as the yield that has no element of reinvestment risk. For example, the yield on a Treasury
strip that matures in 5 years is known as the five-year spot rate. Because investments in
Treasury strips are free from reinvestment risk, using yields on strips with different maturities
provides a more accurate relationship between yields and terms to maturity relative to using
yields on on-the-run (coupon-bearing) Treasuries.

Yields on Non-Treasury Securities Vol 5, pg 456

A yield spread is the difference between the quoted YTMs (rates of return) on two investments,
usually of different credit quality. In simple terms, the yield spread is an indication of the
risk premium for investing in one investment instrument over another.

The absolute yield spread or nominal spread is simply the difference between the yields on
two bonds:

Nominal spread (Bond Y as the reference bond) = Yield on Bond X


– Yield on Bond Y

The relative yield spread is the ratio of the yield spread to the yield on the reference bond.

Yield on Bond X – Yield on Bond Y


Relative yield spread =
Yield on Bond Y

The yield ratio equals the yield on a particular bond divided by the yield on the reference
bond.

Yield on Bond X
Yield ratio =
Yield on Bond Y

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The absolute yield spread is the most commonly used measure. However, it has a significant
shortcoming in that it remains constant when overall rates change, misrepresenting true
economic return. This shortcoming is countered by the relative yield spread and the yield
ratio.

Credit Spreads Vol 5, pg 459

The yield spread between non-Treasury securities and Treasury securities that have the same
maturity and no embedded options is known as the credit or quality spread. Treasuries
have no credit risk, but corporate bonds do. Specifically:

· The lower the company’s credit rating, the higher the credit spread on its bonds
· The longer the term to maturity of a company’s bonds, the higher the credit spread.

Credit spreads tend to fluctuate with changes in the economy. In a recession, credit spreads
tend to widen, while in an expansion they tend to narrow.

Embedded Options and Yield Spreads Vol 5, pg 461

The presence of embedded options has an effect on the yield spread of the issue relative
to a Treasury, and on the yield spread relative to a similar bond with no embedded options.

If the embedded option favors the issuer, like in a callable bond, the investor has effectively
purchased a straight bond and sold a call option to the issuer. The yield on the callable
bond should be higher than that on a straight bond to compensate the investor for the
option that she has sold to the issuer.

The yield spread for a callable bond also depends on the call deferral period. The longer
the deferral period, the longer the protection for the investor. Therefore, the less valuable
the option is to the issuer, and the lower the yield attributable to the call feature. All other
factors equal, a callable bond with a longer call deferral period will have a lower yield
spread compared to one with a shorter deferral period.

If the embedded option favors the investor, like in a putable bond, the investor has
effectively purchased a straight bond and a put option from the issuer. The yield on the
putable bond should be lower than that on a straight bond to compensate the issuer (in
the form of lower payments) for the option that it has sold to the investor.

Interestingly, in a situation where the option favors the investor, the yield on the instrument
may be lower than the yield on a Treasury with a similar investment horizon. This does
not mean that the putable corporate bond is less risky than the Treasury. The spread on
a bond with embedded options does not only compensate investors for liquidity, credit
and interest rate risk, but also includes the cost of the embedded option.

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Impact of Liquidity and Issue Size on Yield Spreads Vol 5, pg 462

· Bonds that are less liquid have higher yield spreads and lower prices compared to
bonds with identical features that are more liquid (more actively traded in the
secondary market).
· Larger issues are usually more actively traded and have greater liquidity. Empirical
evidence has confirmed that larger issues have lower yield spreads.

After-Tax and Tax Equivalent Yields Vol 5, pg 464

· The yield on a taxable bond after taxes have been paid is known as the after-tax
yield.

After-tax yield = Pretax yield * (1- marginal tax rate)

· The yield that must be offered on a taxable bond to make its after-tax yield the same
as the yield on a tax-exempt issue is known as taxable-equivalent yield.

Tax-exempt yield
Taxable-equivalent yield =
(1 – Marginal tax rate)

Remember that the higher the marginal tax rate, the higher the taxable equivalent yield.

LIBOR Vol 5, pg 468

The London Interbank Offered Rate (LIBOR) is the interest rate at which banks can borrow
funds from other banks in the London interbank market. LIBOR is determined on a daily
basis by the British Bankers' Association as a filtered average of the world's most creditworthy
banks' interbank deposit rates for large loans with maturities between one day and one year.

LIBOR is the most widely used benchmark for short-term interest rates. It is important
because:

· It is the rate at which low-risk borrowers are able to borrow funds.


· It is also used as a benchmark for calculating borrowing rates for more risky borrowers.

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INTRODUCTION TO THE VALUATION OF DEBT SECURITIES


Cross-Reference to CFA Institute Assigned Reading #57

The value of a bond equals the present value of its expected future cash flows. Valuing
a bond involves the following three steps:

1. Forecasting the future cash flows.


2. Determining the appropriate discount rate.
3. Calculating the present value.

Relationship between Discount Rates and Fixed-Income Security Prices Vol 5, pg 492

· The higher the discount rate, the lower the present value of each individual cash
flow, and lower the value of the fixed-income security.
· The lower the discount rate, the higher the present value of each individual cash
flow, and higher the value of the fixed-income security.

Other Important Relationships

· For a given discount rate, the further into the future the cash flow is received, the
lower its present value; and the sooner it is received, the higher its present value.
· When the coupon rate equals the yield required by the market, the bond will be
valued at par.
· When the coupon rate exceeds the yield required by the market, the bond will be
valued at a premium to par
· When the coupon rate is less than the yield required by the market, the bond will
be priced at a discount to par.

Relationships Between the Price of a Bond and its Maturity Vol 5, pg 492

Assuming that the discount rate does not change:

· A premium bond’s value decreases towards par as it nears maturity.


· A discount bond’s value increases towards par as it nears maturity.
· A par bond’s value remains at par as it nears maturity.

Valuing a Bond between Coupon Payments Vol 5, pg 499

When a coupon-bearing bond is sold between coupon payment dates, we need to account
for the earned, yet unpaid, interest due to the seller. The amount that the buyer should
pay is the present value of the future cash flows, but the very next cash flow (the next
coupon payment) includes two components:

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1. Interest earned by the seller, which has been accrued from the last payment date
till the transaction date. This is called accrued interest.
2. Interest earned by the buyer.

When the price of the bond is determined by calculating the present value of future cash
flows, the computed value is known as the full or dirty price. This price includes accrued
interest and is the amount that the buyer pays the seller. From the full price, the accrued
interest must be deducted to determine the clean price of the bond.

Arbitrage-Free Valuation Approach Vol 5, pg 504

Under traditional methods of bond valuation, expected future cash flows are discounted
at an appropriate rate that reflects the risks inherent in the investment. The arbitrage-free
valuation approach does not use the same rate to discount cash flows, but uses the relevant
spot rate to discount each cash flow that occurs at a different point in time.

· If a bond is selling for more than the sum of the present values of the individual cash
flows discounted at the relevant spot rates, arbitrageurs would purchase the individual
zero-coupon bonds in the strip market, ‘reconstitute’ the cash flows and sell the bond.
The obligations arising from selling the bond would be met by the cash flows from
strips as individual securities mature.

· If a bond is selling for less than the sum of the present value of the individual cash
flows discounted at the relevant spot rates, arbitrageurs would sell the individual
components in the Treasury Strip market and purchase the bond. The obligations
that arise as the individual strips mature would be met by the periodic cash flows
received from the bond.

YIELD MEASURES, SPOT RATES AND FORWARD RATES


Cross-Reference to CFA Institute Assigned Reading #58

Sources of Return from a Fixed-Income Security Vol 5, pg 536

· Periodic coupon payments.


· Capital gains if the proceeds from selling the bond exceed the amount initially
invested.
· Income from reinvestment of interim cash flows (interest and principal payments
received prior to maturity).

Traditional Yield Measures for Fixed-Income Instruments Vol 5, pg 537

1. The current yield is the ratio of the annual dollar coupon to the current market price:

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Annual cash coupon


Current yield =
Bond price

· The current yield is greater than the coupon rate when the bond is selling at a
discount.
· The current yield is lower than the coupon rate when the bond is selling at a premium.

A limitation of the current yield is that it only considers coupon income and ignores
other sources of investment return (capital gains and losses and reinvestment income).

2. The yield to maturity is the annualized discount rate that equates the present value
of the bonds cash flows to its current market price plus accrued interest. The YTM
is essentially the internal rate of return (IRR) of the bond’s cash flows if the bond
is held to maturity.
· If you are given the bond equivalent yield, make sure that you divide the rate by two
to obtain the semiannual discount rate when working with semiannual pay bonds.
· For bonds that pay coupon annually, the annual-pay YTM is simply the IRR of the
bond’s cash flow stream.

Bond selling at Relationship


Par Coupon rate = Current yield = Yield to maturity
Discount Coupon rate < Current yield < Yield to maturity
Premium Coupon rate > Current yield > Yield to maturity

Limitations of the YTM

· YTM assumes that interim cash flows will be reinvested at the yield to maturity.
Practically speaking, it can never be guaranteed that the bond’s interim cash flows
will be successfully invested at a rate equal to the YTM.

· An investor will only realize the yield to maturity calculated at the time of purchase
if:
o The interim cash flows are reinvested at the stated yield to maturity. The
investor faces the risk that future interest rates could be lower than the YTM
at the time of purchase. This is known as reinvestment risk.
o The bond is held till maturity. If the investor sells the bonds prior to maturity
she faces the risk of receiving less than the purchase price, which would result
in a lower return on investment than the YTM. This is known as interest rate
risk.

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Reinvestment Income Vol 5, pg 537

Reinvestment income is important because if the reinvestment rate is less than the YTM
calculated at the time of bond purchase, the actual yield realized on the investment will
be lower than the YTM.

Factors that Affect Reinvestment Risk Vol 5, pg 543

· For a given yield to maturity and coupon rate, the longer the term to maturity, the
more the bond’s total dollar return depends on reinvestment income, so greater the
reinvestment risk.
· For a coupon-bearing bond with a given YTM and term to maturity, the higher the
coupon rate, the higher the proceeds from the reinvestment of coupon payments,
and higher the reliance on reinvestment income.
· Given the term and yield to maturity, bonds selling at a premium will be more reliant
on reinvestment income than those selling at a discount. For discount bonds, the
capital gains (from receiving par at maturity and purchasing the bond for less than
par) will contribute to the total yield.
· Zero-coupon bonds do not depend on reinvestment income at all and therefore have
zero reinvestment risk.

Bond Equivalent Yield and Annual Pay Yield Vol 5, pg 545

· BEY of annual-pay bond = 2 [(1+ Yield on annual-pay bond) 0.5 – 1]

o Given the semiannual-pay yield for a bond, the bond equivalent yield will
always be lower than the yield on an annual-pay basis.

· Semiannual YTM = 1 + BEY 2


-1
2
o Given the semiannual-pay yield for a bond, the yield on an annual-pay basis
is always greater than the bond equivalent yield.

Yield to Call Vol 5, pg 546

The yield to call is calculated for callable bonds that are trading at a premium. The yield
to call does consider all three sources of investment income for fixed income instruments,
but it assumes that interim cash flows will be reinvested at the yield to call. Moreover,
the yield to call assumes that:

· The investor will hold the bond till the call date
· The issuer will call the bond on that particular call date.

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These two assumptions are unrealistic. Further, comparisons between yields to call and
yields to maturity are meaningless because coupon payments will not be made once the bond
is called, so the investment horizons that the two measures relate to may be different.

Yield to Put Vol 5, pg 548

The yield to put is the interest rate that equates the present value of cash flows till the first
put date to the price of the bond plus accrued interest. Limitations of the yield to put
calculation include the following assumptions:

· The interim cash flows will be reinvested at the yield to put.


· The bond will be put at the first put date.

Yields to put are calculated for putable bonds that are trading at a discount.

Yield to Worst Vol 5, pg 548

After calculating the yield to every call and put date, and the yield to maturity, the yield to
worst is defined as the lowest of all these calculated yields. It is supposed to indicate the
worst yield that the investor could realize on her investment, but it does not recognize that
each yield calculation has a different exposure to reinvestment risk because it is based on
a different time horizon.

Yield to Refunding

This yield measure is used for bonds that are currently callable, and are trading at a premium
to par, (which makes it is feasible for the issuer to call them) but cannot be called due to the
existence of certain bond covenants that preclude a refunding.

Cash Flow Yield Vol 5, pg 548

Mortgage and asset-backed securities are backed by pools of loans or receivables. There is
no way to accurately predict the rate at which the principal will be repaid on these investments.
If interest rates were to rise, the prepayment rate would be slower than expected, and if
interest rates were to fall, prepayments would occur at a higher than expected rate. Usually,
an assumption is made about the rate at which prepayments will occur over the term of the
security. The yield that equates the present value of the projected cash flows, using a
prepayment rate assumption, to the price plus accrued interest is known as the cash flow
yield of the bond.

BEY = [(1 + monthly CFY)6 – 1] * 2

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Limitations of the Cash Flow Yield Vol 5, pg 549

· The projected cash flows are assumed to be reinvested at the calculated cash flow
yield. This assumption regarding the reinvestment rate has even more significance
for MBS and ABS because, unlike other fixed-income instruments, interim interest
AND principal payments are assumed to be reinvested at the calculated cash flow
yield.
· The security is assumed to be held till maturity.
· The cash flow yield is dependent on realizing the projected cash flows according to
the assumed prepayment rate. If the actual prepayment rate turns out to be different,
the calculated cash flow yield will not be realized.

Spread/Margin Measures for Floating-Rate Securities Vol 5, pg 549

Spread for life is a measure of potential return that accounts for the quoted margin as well
as the accretion of any discount and the amortization of any premium (as the case may be)
over the security’s remaining term.

The limitation of this yield measure for floating-rate securities is that it does not consider
the level of coupon rates or the time value of money.

Discount Margin estimates the yearly margin over the reference rate that the investor can
expect to earn over the term of the security. It determines future cash flows assuming that
reference rates will not change and then uses trial and error to find the margin above the
reference rate that would equate the present value of expected cash flows to the security’s
current price.

· If the bond is selling for par, the quoted margin is the discount margin.
· If the bond is selling at a premium, the discount margin is lower than the quoted
margin.
· If the bond is selling at a discount, the discount margin is higher than the quoted
margin.

The limitations of the discount margin are that it assumes that the reference rate will not
change over time, and it does not account for any floor or cap that may be embedded in the
security.

Yield on T-Bills Vol 5, pg 552

The yield on Treasury bills is determined by two variables:

1. The settlement or transaction price per $1 of face value, (p).


2. The number of days to maturity, (N). This equals the number of days between the
settlement date and the maturity date.

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The yield on a discount basis, denoted by d, is calculated as follows:

360
d = (1-p)
N

Limitations Vol 5, pg 553

· The yield is annualized on a 360-day year; not a 365-day year.


· The measure is based on a maturity value investment; not on the actual amount
invested.

The Treasury Spot Rate Curve Vol 5, pg 554

The Treasury spot rate curve is derived through the ‘bootstrapping’ process. The process
begins by first deriving the Treasury yield curve, which illustrates the relationship between
YTMs on Treasuries and their terms to maturity. The spot rates obtained through the
bootstrapping process illustrate the term structure of default-free spot rates at the point in
time that the bond price quotes are taken from.

· The spot rate curve lies above the par yield curve when the par yield curve is upward
sloping.
· When the par yield curve is downward sloping, the theoretical spot rate curve will
lie below the par yield curve.
· When the yield curve is flat, the spot rate curve is the same as the yield curve.

The Nominal Spread Vol 5, pg 559

The difference in the YTMs between a Treasury and a non Treasury bond is known as the
nominal spread. The nominal spread accounts for the higher credit risk, liquidity risk and
option risk (if the bond has embedded options) in the non-Treasury bond compared to the
Treasury bond. The nominal spread is a spread on top of the Treasury yield curve.

Limitations of the Nominal Spread as a Yield Spread Measure Vol 5, pg 560

· The yield to maturity ignores the shape of the spot rate curve. It is appropriate to use
spread measures based on the YTM only if the yield curve is flat (essentially because
the yield curve would then be identical to the spot rate curve).
· The nominal spread does not consider any embedded options that may alter the cash
flows from a non-Treasury bond, and materially affect the value of the security.

The Zero-Volatility Spread Vol 5, pg 560

The zero-volatility spread or Z-spread is the static or constant spread that makes the
present value of the cash flows from a non-Treasury bond, when discounted at Treasury
spot rates plus the spread, equal to the non-Treasury bond’s price. In other words, the Z-

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spread is the spread an investor would earn above the entire Treasury spot rate curve by
investing in a non-Treasury bond as opposed to a Treasury bond, and holding the instrument
till maturity.

The difference between the nominal spread and the Z-spread is that the nominal spread
is a spread on any one point on the Treasury yield curve, while the Z-spread is a constant
spread over the entire Treasury spot rate curve.

The Z-spread measures the additional compensation for the liquidity risk, credit risk and
any option risk in a non-Treasury security when the benchmark is the Treasury spot rate
curve. If the non-Treasury issuer’s own spot rate curve is used as the benchmark, the Z-
spread measures only liquidity and option risk. Therefore, when a Z-spread is given, the
benchmark spot rate curve must be stated.

Divergence between the Z-spread and the Nominal Spread Vol 5, pg 563

· When the Treasury spot rate curve is flat, the Z-spread and the nominal spread are
equal because the same benchmark rates are being used to discount the bond’s cash
flows. (When the Treasury spot rate curve is flat, it is identical to the Treasury yield
curve).
· As the Treasury spot rate curve steepens, the difference between the nominal spread
and Z-spread widens.
· The difference between the Z-spread and the nominal spread is greater for securities
that repay principal over time as opposed to in a single bullet payment at maturity.
For example, the difference between the two spread measures will be greater for
mortgage and asset-backed securities than for straight bonds.

The Z-spread successfully counters the first limitation of the nominal spread as it is based
on the Treasury spot rate curve; not the Treasury yield curve. However, it does not account
for any options embedded in the bond’s structure.

The Option-Adjusted Spread Vol 5, pg 564

The option-adjusted spread (OAS) counters both the limitations of the nominal spread. It
is a spread on top of a spot rate curve, and it accounts for embedded options as well. To
determine the OAS, first the dollar value of the embedded option is calculated and then the
bond’s dollar price is adjusted for the cost of the option. The resulting ‘option-free’ price
is then converted into a yield measure that is ‘option-adjusted’.

The OAS adjusts the Z-spread for the option risk in the bond. The OAS of a bond with
embedded options is comparable to the Z-spread of an option-free bond.

Z-spread = OAS + Option cost; and OAS = Z-spread - Option cost

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· If option cost is positive in terms of yield, it means that the issuer is making payments
at a greater spread that the than the spread on an option-free bond (the Z-spread).
This implies that the issuer has purchased the option to alter the bond’s payments
when circumstances change in its favor, as is the case with a callable bond.

· If option cost is negative in terms of yield, it means that the issuer is paying a lower
spread than it would on an option-free bond. This occurs when the issuer’s interest
payments have been subsidized by selling an option to bondholders to alter the bonds
cash flows when circumstances suit them, as is the case with putable bonds.

Risks Captured by the Various Spread Measures

Spread Measure Benchmark Reflects compensation for


Nominal Treasury yield curve Credit risk, option risk, liquidity risk
Zero-volatility Treasury spot rate curve Credit risk, option risk, liquidity risk
Option-adjusted Treasury spot rate curve Credit risk, liquidity risk

Spot Rates and Forward Rates Vol 5, pg 483

Forward rates can be described as the market’s current estimate of future spot rates.

To calculate the y-period forward rate x periods from today, yfx, simply remember the
following formula:
(1 + xs0)x (1 + yfx)y
(1+ xs0)x (1 + yfx)y = (1 + x+ys0)x+y
(1 + x+ys0)x+y

Example

Calculate the 1-year forward rate 6 years from today if the 6-year spot rate is 6.25% and
the 7-year spot rate is 6%.

Solution
(1 + 6s0)6 1 + 1f6
6 7
(1+ 6s0) (1 + 1f6) = (1 + 7s0)
(1 + 7s0)7
(1 + 1f6) = (1.06)7 => 1f6 = 4.51%
(1.0625)6

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INTRODUCTION TO THE MEASUREMENT OF INTEREST RATE RISK


Cross-Reference to CFA Institute Assigned Reading #59

The full valuation or scenario analysis approach actually calculates the change in the
value of a fixed-income security or portfolio in response to a change in interest rates

· Bonds with higher coupon rates have lower interest rate risk (duration). Bonds with
lower coupon rates have higher interest rate risk.
· Longer maturity bonds have higher interest rate risk.
· Higher existing levels of market yields imply lower interest rate risk for bonds.

The duration/convexity approach is a simpler, two-step approach to evaluate interest


rate sensitivity of a fixed-income security or portfolio.

Effect of Yield Changes on Bond Prices Vol 5, pg 612

· For small changes in yields, the percentage price change for a given bond is roughly
the same regardless of whether yields move up or down.
· For large changes in yields the percentage price increase resulting from a decrease
in yields is greater than the percentage price decrease from an increase in yields.

The implication of this is that an investor in an option-free bond has more to gain from a
decrease in yields, than she has to lose from an identical increase in yields. Due to the convex
shape of the price-yield relationship, bond price fall at a decreasing rate as yields increase,
and increase at an increasing rate as yields decrease.

Price Volatility of Bonds with Embedded Options Vol 5, pg 616

For callable bonds, the price-yield relationship exhibits positive convexity only at higher
yields. At lower yields, callable bonds exhibit negative convexity- for a given change in
yields, the price appreciation is less than the price decline. At a certain yield level, there is
very little appreciation in the price of callable bonds as yields decline (because it becomes
increasingly likely that the issue will be called), and the bond exhibits ‘price compression’.

The effect of a prepayment option is similar to that of the call option in a callable bond- it
results in negative convexity at low yields and reduces the price volatility of the security.
Although callable and prepayable securities exhibit lower interest rate risk at lower yields,
they suffer from greater reinvestment risk. At lower yields, the probability that the issuer
will call a callable bond, or that a mortgage borrower will prepay her obligations, increases.
This magnifies the risk that an investor in these securities might have to reinvest principal
repayments at the newer, lower interest rates.

At low yield levels, the price of the putable bond moves very similarly to the price of a
straight bond in response to yield changes. At higher yield levels, as rates rise, the embedded
put option increases in value, and cushions the price reduction.

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Duration Vol 5, pg 620

Duration is a linear, approximate measure of the change in price of a bond in response to


changes in yields. More specifically, it is the approximate change in the price of a bond
when yields change by 100 basis points.

V- - V+
Effective duration =
2 V0 (ry)

No matter what magnitude of change in yields is used to calculate bond prices in the
numerator, the duration figure calculated from the formula above will always give us the
percentage change in the price of a bond in response to a 100 basis point change in yields.
Calculation of the change in the price of a bond when interest rates change by 50 basis points
would require halving the calculated value of duration.

· Duration is an accurate measure of changes in bond prices only in response to small


changes in yield.
· When yields change more significantly, using duration to estimate bond prices will
underestimate the price increase, and overestimate the price decrease. In both cases,
price estimates based on duration fall short of actual prices.

Modified, Effective, and Macaulay Duration Vol 5, pg 628

Modified duration is an estimate of the percentage change in the price of a bond in response
to a 100bp change in yields assuming that the bond’s cash flows do not change when yields
change. This assumption holds true only for option-free bonds.

Effective duration is an estimate of the percentage change in a bond’s price in response to


a 100bp change in yields after accounting for any changes in the bond’s expected cash flows
due to yield changes. Therefore, it is the more appropriate measure of interest rate risk for
bonds with embedded options. For bonds with no embedded options, modified duration and
effective duration can both be used.

Macaulay Duration is the weighted average maturity of a bond where the individual weights
are based on the relative discounted cash flows to be received in each period. Macaulay
duration does not consider possible changes in a bond’s cash flows, so it is a flawed measure
of the price sensitivity of bonds with embedded options to changes in interest rates.

Interpretations of Duration Vol 5, pg 630

· Duration is the ‘first derivative’ of the price-yield function. Mathematically speaking,


the first derivative of a curve at any point is the slope or gradient of the curve at the
given point. Therefore, given the convex shape of the price-yield curve, duration
at any given yield is simply the slope of the price-yield relationship at that particular
yield level.

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· Duration is the weighted average time it takes for all the bond’s cash flows
to be realized. Each cash flow is weighted by the proportion of the bond’s total cash
flows that it comprises. Therefore, duration can also be expressed in years.
· Duration is simply the approximate change in the value of a bond in response to a
100 basis points change in interest rates (a 1% change in yields).

Portfolio Duration Vol 5, pg 632

A portfolio’s duration equals the weighted average of the durations of the individual bonds
in the portfolio. Each bond’s weight is the proportion of the total portfolio’s market value
that it comprises.

Duration assumes that yields for all maturities change by the same amount (there is a parallel
shift in the yield curve). Portfolios of bonds are composed of a variety of bonds, each with
different maturities, credit risks, and embedded options, and realistically speaking, there is
no reason to expect yields for all maturities to change by the same amount.

Duration and Convexity Vol 5, pg 633

Duration suggests that bond prices approximately change by the same amount whether
interest rates increase or decrease by a given amount. Duration is a good approximation
for changes in bond prices only for small changes in yields. However, for large changes
in yields, duration underestimates the price increase caused by a reduction in yields, and
overestimates the decrease in price when yields rise. Therefore, price estimates of option-
free bonds based on duration need to be revised upwards to bring them closer to their
actual values. This revision is performed via the convexity adjustment.

Percentage change in bond price = duration effect + convexity adjustment


= {[-duration * (ry)] + [convexity * (ry)2]} * 100

Convexity and Bonds with Embedded Options Vol 5, pg 634

Option-free bonds have a convex price-yield relationship so the convexity adjustment is


always positive for them However, bonds with embedded options may exhibit negative
convexity. For example, callable bonds exhibit negative convexity at low yields. The
percentage price increase from a decrease in yields is actually lower than the percentage
price decrease from an increase in yields for callable bonds at low yield levels. In such
circumstances, the duration effect and the convexity adjustment are both negative.

Modified and Effective Convexity Vol 5, pg 636

· Modified convexity assumes that cash flows from the bond do not change when
interest rates change. Therefore, it is not appropriate to use modified convexity for
bonds with embedded options. The calculated value for modified convexity is always
positive- whether the bond is option-free or if it has embedded options.

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· Effective convexity does not assume that cash flows from the bond will not change
when there is a change in yields. The effective convexity adjustment is negative for
bonds with embedded options.

Price Value of a Basis Point Vol 5, pg 636

The price value of a basis point equals the dollar change in the price of a bond when yields
change by 1 basis point or 0.01%. While we can calculate the actual change in the price of
the bond by changing the YTM by 1 basis point, it is practically easier to use duration to
estimate the price value of a basis point through this formula:

Price value of a basis point = Duration * 0.0001 * bond value

Yield Volatility

The greater the expected yield volatility, the greater the interest rate risk for a given duration
and current value of a bond. To measure the exposure of a bond portfolio to changes in
interest rates, it is therefore necessary to measure yield volatility as well. Value-at-risk is a
measure that ties together the duration of a bond and yield volatility.

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