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JuiceNotes TM

- By FinTree

eBook 8

Fixed Income

CFA® Level 1 JuiceNotesTM 2017

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Fixed-income Securities: Defining Elements

LOS a Basic features of a fixed-income security
Issuers of bonds Supranational entities - Issued by organizations that
operate globally. Eg. World Bank, IMF etc.
Sovereign governments (national) - Issued by national
government entities. Eg. US T-bills
Nonsovereign governments (local) - Issued by non
national government entities. Eg. California state bonds
Quasi-government entities - Agencies that are owned
and sponsored by governments. Eg. postal services

Corporations - Financial companies & nonfinancial


Bond maturity Perpetual bonds - No maturity. Make periodic interest

payments but do not promise to repay the principal
Original maturity < 1 Yr - Money market securities
Original maturity > 1 Yr - Capital market securities

Par value Also referred to as the face value/maturity

value/redemption value/principal value

Bond price < Par value - Trading at discount
Bond price > Par value - Trading at premium
Coupon payments Coupon is always calculated on Par value
Payments could be annual, semi-annual, quarterly or
Zero coupon bonds - Make no interest payments.
Bonds are issued at discount and redeemed at par

Currencies Dual-currency bond - Coupon payment in one currency


and principal repayment in another

Currency option bond - Bondholder has a choice of two

LOS b Content of bond indenture

A legal contract between the issuer (borrower) and investor (lenders) is called bond indenture

It defines obligations of and restrictions on the borrower

Covenants - Provisions in the bond indenture

LOS c Affirmative Negative

covenants covenants

Actions that borrower Prohibitions on the

promises to perform borrower

Eg. Make timely interest Eg. Restrictions on

and principal payments additional borrowing © 2017 FinTree Education Pvt. Ltd.
LOS d Considerations that affect the issuance and
trading of fixed-income securities

Domestic bonds - They are issued in issuer’s home country and currency
Foreign bonds - Issued by foreign issuers but denominated in the currency
of the country where they trade
Eurobonds - Issued outside a country and denominated in a currency
other than that of the countries in which they trade
Global bonds - Eurobonds that trade in a country other than the country
that issues the currency the bond is denominated in and
in Eurobond market

Issuing entities - Government, corporations etc.

Securitized bonds - Bonds issued by special purpose
entities (SPEs)
Sources of Repayment - Sovereign bonds - Repaid by the tax receipts of the
issuing country
Nonsovereign government bonds - Repaid by general
taxes, revenues of a specific project or fees dedicated to
bond repayment
Corporate bonds - Repaid from cash generated by the
firm’s operations
Collateral and Credit
Enhancements -

Unsecured bonds (debentures) - Represent a claim to
overall assets and cash flows of the issuer
Secured bonds - Backed by a claim to specific assets.
Reduces default risk. They are senior to unsecured bonds
Collateral - Those specific assets used in issuing secured
Covered bonds - Similar to Asset backed securities (ABS)
but the underlying assets remain on the B/S of the issuing
Credit enhancement - Internal or external

Internal credit enhancement methods -

Overcollateralization, excess spread, dividing bond issue
into tranches and cash reserve fund
External credit enhancements - Surety bonds, bank
guarantees and letters of credit

Taxation - Interest income - Taxed at the same rate as ordinary

income. For municipal bonds is usually tax-exempt

Capital gains - Taxed at capital gains tax rate

LOS e Structure of CFs of fixed income securities

Typical bond Bullet structure - Periodic interest payments and principal value at maturity
structure - Balloon payment - Final interest payment + Principal at
Amortizing structure - Part of principal is paid at each payment date
Fully amortizing structure - Equal payments
Partially amortizing structure - Balloon payment of
remaining principal at maturity © 2017 FinTree Education Pvt. Ltd.
Sinking fund provision - Requires the issuer to retire a portion of a bond issue at
specified times

Floating-rate notes Their interest rate is dependant on market rate (reference rate)
FRN coupon = Reference rate (LIBOR) + margin

Variable-rate note - Margin is not fixed

Interest rate cap - Limit on how high the coupon rate can rise
Benefits the issuer (borrower)
Interest rate floor - Minimum rate that investor receives
Benefits the lender (investor)
Inverse floater(FRN) - Coupon rate Ç when reference rate È

Other coupon structures

Step-up coupon bonds - Coupon rate increases over time according to a
predetermined schedule
Credit-linked coupon bond - If credit quality È Coupon rate Ç (Double Jeopardy Bonds)
Payment-in-kind (PIK) bond - Allows the issuer to make coupon payments by increasing
principal amount of the outstanding bonds
Deferred coupon bond - Coupon payments do not begin until a period of time after

Index-linked bond - Coupon payments and/or a principal repayment is based on
a commodity index, equity index or some other index
Inflation-linked bonds - Most common type
Principal protected bonds - Indexed bonds that do not pay
less than their original par value at maturity

LOS f Contingency provisions affecting the timing and/or

nature of cash flows of fixed-income securities

Ê Contingency provision - An action that may be taken if contingency actually occurs

These provisions in bond indentures are referred to as embedded options

Ê Callable bonds - Issuer can buy back the bond from bondholder (value to the issuer)

Ê Putable bonds - Bondholder can sell the bond back to issuer (value to the bondholder)

Ê Convertible bonds - Option to exchange the bond for shares (value to the bondholder)
Owners of these bonds have downside protection. Often referred to as hybrid security

Even if the share price increases to a level where the conversion value is significantly above
the bond’s par value, bondholders might not convert the bonds to common stock because the
interest yield > dividend yield on common shares received through conversion. For this
reason, many convertible bonds have call provision

Ê Warrants - Holder of a warrant has right to buy the firm’s common shares at a given price
over a given period of time

Ê Contingent convertible bonds (CoCos) - Bonds that convert from debt to common shares
automatically if a specific event occurs © 2017 FinTree Education Pvt. Ltd.

Fixed-income Markets: Issuance, Trading And Funding

LOS a Classifications of global fixed-income markets

Type of Credit Original Coupon Tax

Currency Geography Indexing
issuer quality maturity structure status

BBB and above - Fixed rate or Developed Municipal bonds -

Investment grade floating rate markets - Less Tax exempt, lower
bonds riskier yield

BB and below - Emerging markets

Junk bonds - More riskier

Government, Money USD, Euro etc. Index-linked

corporation market, bonds
etc. capital market

LOS b Use of reference rates in floating-rate debt

Most widely used reference rate is London Interbank Offered Rate (LIBOR)

It is a rate at which one bank lends another bank
For short term
Currency is USD
Characteristics of US LIBOR
è Issued out of US
è It is an add-on rate
è No compounding of interest rate
è Different LIBOR exist for different maturities
è 360 day convention is used

Reference rate must match the frequency of the coupon


Eg. If a bond’s interest rate is reset twice a year, appropriate reference rate is 6-month LIBOR

LOS c Mechanisms available for issuing bonds in primary markets

Public offering - Bonds are sold to the public
Private placement - Bonds are sold only to qualified investors
Underwritten offering - Entire bond issue is purchased by the

investment bank (underwriter)

Best efforts offering - Investment bank does not commit to
purchase the whole issue

LOS d Secondary markets

Markets where previously issued bonds trade
Most bonds are traded in dealer markets (OTC markets)
Liquid issues - Difference between bid-ask price is narrower
Less liquid issues - Difference between bid-ask price is wider © 2017 FinTree Education Pvt. Ltd.
Settlement cycle:

Government bonds - T+1

Corporate bonds - T+2 or T+3

LOS e Securities issued by sovereign governments

Sovereign (national) governments issue bonds that are backed by the taxing power

Sovereign governments may issue the bonds denominated in their own currency or
foreign currency

LOS f Securities issued by

Supranational Non-sovereign Quasi-government

agencies governments entities

Backed by taxing authority Yields are marginally

High credit quality, (local) or revenues from a higher than those of
liquid specific project sovereign bonds

LOS g Types of debt issued by corporations

Bank debt
e Corporate
Term maturity
Bilateral loan - Loan It is a short term structure - All bonds
given by only one unsecured debt issued mature on the same
bank by creditworthy date

Syndicated loan - Loan Serial maturity
given by a group of It is used to fund structure - Bonds
banks working capital mature on different

LOS h Short-term funding alternatives available to banks


Customer deposits - Short-term funding source

Certificates of deposit (CDs) - Another short-term funding source. CDs mature
on specific dates. Negotiable CDs can be sold
Central bank funds market - Banks may buy or sell excess reserves
deposited with their central bank
Interbank funds - Funds loaned by one bank to another © 2017 FinTree Education Pvt. Ltd.
LOS i Repurchase agreements
One party sells a security to a counterparty with a commitment to buy it back at a later
date at a specified (higher) price

Repo rate - Annualized percentage difference between selling and buying price

Repo margin (haircut) - Difference between the market value and the amount loaned

Reverse repo - Bond dealer lends funds instead of borrowing

Repo margin will be lower if, Repo rate will be lower if,

Ÿ Borrower has high credit quality Ÿ Collateral is delivered

Ÿ Higher quality of collateral Ÿ Higher quality of collateral
Ÿ Maturity is shorter Ÿ Maturity is shorter
Ÿ Security is in short supply and high demand Ÿ General interest rates are lower

Eg. Sells a security @ 93 (Market Value = 97)


Promise to buy back @ 96 after 3 months

Repo rate =

= 3.22%

Repo margin = 97 − 93 = 4
Fi © 2017 FinTree Education Pvt. Ltd.

Introduction To Fixed-Income Valuation

LOS a Calculating bond price using YTM
MV of bond is PV of future CFs discounted at current YTM (Yield-to-maturity)

Eg. Calculate the bond price when

Maturity = 4 Yrs Coupon rate = 10% YTM = 12% Face value = 1000

N = 4 PMT = 100 I/Y = 12 FV = 1000 CPT PV = −939.25

LOS b Relationship b/w bond price, coupon rate, maturity and YTM

ª If YTM Ç Price of the bond È

ª If Coupon rate > YTM - Premium bond

ª If Coupon rate < YTM - Discount bond

ª Price-yield relationship is convex

ª Longer maturity - Price is more sensitive to a change in yield

LOS c Calculating bond price using spot rates


Spot rates - 1-Yr - 4% 2-Yr - 5% 3-Yr - 6% 4-Yr - 7%
Face value - 1000 Calculate price of the bond
60 60 60 1060
Price = + + +
(1 + 0.04)1 (1 + 0.05)2 (1 + 0.06)3 (1 + 0.07)4

Price = 57.69 + 54.42 + 50.37 + 808.66

= 971.14


Flat price Accrued Full price

(Clean price) interest (Dirty price)

It is the quoted price of a bond Can be calculated using

Transaction price
actual/actual convention (govt.
Full Price − Accrued interest bonds) or 30/360 convention
Includes accrued interest

(Corp. bonds)

Eg. YTM = 15% Face value = 1000 Coupon rate = 20%

0 5 5.7 6 10

Price of the bond at year 5 - FV = 1000 PMT = 200 N = 5 I/Y = 15 PV = 1167

Full price of the bond (5.7) - 1167 × (1 + 0.15)0.7 = 1287

Flat price of the bond (5.7) - 1287 − (200 × 0.7) = 1147 © 2017 FinTree Education Pvt. Ltd.
LOS e Matrix pricing
Method of estimating YTM of the bonds that are not traded
Rating must be same but coupon rate does not have to be same
Eg. Determine YTM of a non traded BB rated, 5% annual-pay
bond that has 4 years remaining until maturity
YTMs of similar bonds are:
BB rated, 3 year annual-pay, 6% coupon bond - 5.5%
BB rated, 6 year annual-pay, 7% coupon bond - 6.5%

3-year bond - 5.5% Difference in 3 years - 1%

6-year bond - 6.5% Difference in 1 year - 0.33%

YTM of non traded bond = 5.5 + 0.33 = 5.83%

LOS f Yield measures

For annual coupon bond
Effective earning yield = Yield to maturity
For semi-annual coupon bond
Effective earning yield > Yield to maturity

Eg. Annual coupon bond Semi-annual coupon bond

Face value = 1000 Coupon rate = 15%
Maturity = 8 yrs. Market value = 800
FV = 1000 PMT = 150 N = 8 PV = −800
CPT I/Y = 19.73 e Face value = 1000 Coupon rate = 17%
Maturity = 10 yrs. Market value = 870
FV = 1000 PMT = 85 N = 20 PV = −870
CPT I/Y = 10.03 x 2 = 20.06
EAY = (1 + 10.03)2 − 1 = 21.06%

Street convention - Yield calculated using the stated coupon payment dates
True yield - Yield calculated after considering weekends and holidays

Street convention yield > True yield

Annual Coupon Annual coupon + Disc. amort. − Prem. amort.

Current yield - Simple yield -
Bond price Bond price

Semi-annual bond Semi-annual bond

Face value = 1000 Coupon rate = 10% Face value = 1000 Coupon rate = 10%
Maturity = 10 yrs. Market value = 850 Maturity = 10 yrs. Market value = 900

Discount amortized = 100/5 = 20

100 100 + 20
Current yield = Simple yield =
850 900
Current yield = 11.76% Simple yield = 13.33%

Yield to call (YTC) Yield to worst (YTW)

Eg. Face value = 1000 Coupon rate = 10% Market value = 1020 Lowest of YTM and YTCs is called
Callable in four years at 103 YTW
YTC - FV = 1030 PMT = 100 N = 4 PV = −1020 I/Y = 10.01% © 2017 FinTree Education Pvt. Ltd.
Floating-rate note yields
ª FRN yield = LIBOR + Quoted margin

ª Coupon rate for the next period is set using the current reference rate
(LIBOR) for the reset period

ª Values of FRNs are more stable than those of fixed-rate debt of similar
maturity because the coupon interest rates are reset periodically

ª Issuer with more credit risk - Quoted margin is higher

ª Issuer with less credit risk - Quoted margin is lower

ª Required margin (discount margin) - Margin that brings FRN to its par value

ª Credit quality Ç - Quoted margin > Required margin

When this happens we say that FRN is trading at premium

ª Credit quality È - Quoted margin < Required margin

When this happens we say that FRN is trading at discount

Money market instrument yields

ª Yield can be quoted on discount basis or add-on basis

ª These may be 360-day or 365-day

ª US T-bills - Quoted as discount bond and is based on 360-day convention
ª Libor and bank CDs - Quoted as add-on yield

ª Appropriate yield measure for money market instruments - Bond equivalent yield
Yields Spot rates

Maturities Maturities
Yield curve Spot curve
Displays yields for different maturities Yield curve for single payments in the future

Coupon rates Forward rates

Maturities Maturities
Par curve Forward curve
Constructed from the spot curve Displays yields for same maturities © 2017 FinTree Education Pvt. Ltd.
LOS h Calculating forward rates using spot rates

Eg. Spot5 = 15% Spot7 = 20% Calculate 2-yr forward rate, 5 years from now

Formula Logic Magic

100 358.31 20 x 7 = 140
(1 + 20%)7
√ (1 + 15%)5
− 1
0 7 0 7

100 201.13 358.31 15 x 5 = 75 65


0 5 7 0 5 7

33.47% 33.47% 65/2 = 32.5%

LOS i Yield spread

It is the difference between yields of two bonds
Benchmark spread - Yield spread relative to a benchmark bond
G-spread - Yield spread relative to a government bond
Interpolated spread (I-spread) - Yield spread relative to a swap rate

Z - spread eg. Risky bond, Face value = 1000 Coupon rate = 10% Maturity = 4 yrs Market value = 860
Spot rates (treasury) - Year 1 - 10%, Year 2 - 11%, Year 3 - 12%, Year 4 - 15%
100 100 100 1100
860 = + + +
(1 + 10% + z-spread)1 (1 + 11% + z-spread)2 (1 + 12% + z-spread)3 (1 + 15% + z-spread)4

Z-spread is determined by trial and error method


Option adjusted spread

Bond - A Bond - B
(With call option) YTM = 16.48%

Face value = 1000 Face value = 1000

Option adjusted Option risk
Coupon rate = 10% Coupon rate = 10% yield

YTM = 15% YTM = 16.48%

Maturity = 5 Yrs Maturity = 5 Yrs 15% 1.48%

Market Value = 832 Market Value = 790 © 2017 FinTree Education Pvt. Ltd.

Introduction To Asset-backed Securities

LOS a Benefits of securitization

Securitization is a process in which an entity (SPE) purchases financial assets such

as mortgages, loans etc. and sells them in the form of securities to investors

Primary benefits:
ΠReduction in funding costs
 Increase in the liquidity of financial assets

Other benefits:

ª Provides higher risk-adjusted returns for investors

ª Investors’ legal claim to the mortgages is stronger
ª After securitization securities are actively traded
ª Banks are able to lend more because the bank receives proceeds when its
financial assets are securitized
ª Securatization has led to financial innovation
ª Provides diversification and risk reduction compared to purchasing whole loans

LOS b Securitization process

Mortgages, loans are sold


Receives cash
Special purpose
entity (SPE)
Mortgages and loans Known as ‘trust’ and is set
(assets) are removed from up specifically for buying
the B/S these loans and selling ABS
to investors
May use cash proceeds to

make more loans Services the loans

Principal and interest payment

received on loans is used to pay
servicing fees to the servicer
and then to ABS owners

Trust may issue ABS in several classes (tranches)


Waterfall structure - Each tranche of ABS is paid sequentially

SPE is a separate legal entity and buyers of ABS do not have claim on other assets of the bank

LOS c Typical structures of securitizations

è In ‘tranches’ structure - Some tranches bear more risk while other bear less
è Credit tranching (senior/subordinate structure) - Losses are first absorbed by the tranche
with lowest priority
è Time tranching - First tranche receives all principal repayments from underlying assets up to
the principal value of the tranche © 2017 FinTree Education Pvt. Ltd.
LOS d Residential mortgage loans
Collateral of the loan is residential real estate

Loan amount
Loan-to-value ratio (LTV) - x 100
Value of collateral real estate

If Ç LTV, then borrower’s equity È

For lenders,

ª Loans with low LTVs is less riskier (because borrower loses more in case of default)
ª If the property value is high compared to the loan amount, lender is more likely to
recover the amount loaned if borrower defaults

Prime loans - Mortgages with high LTV ratios, made to borrowers of high credit quality
Subprime loans - Mortgages to borrowers of lower credit quality

Characteristics of residential mortgage loans:

ª Maturity - Typically 15-30 yrs

ª Interest rate - Fixed rate, adjustable rate or convertible
ª Amortization - Fully amortizing, partially amortizing or interest-only
ª Prepayment provisions - Some loans have prepayment penalty
ª Foreclosure - Non-recourse and recourse loans

LOS e & f Residential mortgage backed securities (RMBS)

ª Agency RMBS - Issued by GNMA, FNMA and Freddie Mac. Agency RMBS are
mortgage pass-through securities. Generally high quality.
ª Non-agency RMBS - Issued by private companies. Non-agency RMBS typically
include credit enhancement

ª Collateralized mortgage obligations (CMOs) - Collateralized by pools of RMBS.

They are structured with tranches

ª In sequential-pay CMO -

Ÿ First tranche to be paid principal has most contraction risk

Ÿ Last tranche to be paid principal has most extension risk

ª Planned amortization class (PAC) tranches - A PAC tranche is structured to

make predictable payments, regardless of actual prepayments. PAC tranches
have both reduced contraction and extension risk

ª Prepayment risk - Uncertainty about timing of the principal CFs from the ABS

ª Contraction risk - Risk that loan principal will be repaid more rapidly than
expected (when interest rates decrease)

ª Extension risk - Risk that loan principal will be repaid more slowly than
expected (when interest rates increase) © 2017 FinTree Education Pvt. Ltd.
LOS g Commercial mortgage backed securities (CMBS)

ª CMBS are backed by income-producing real estate properties such

as shopping malls, office buildings, apartments etc.

ª RMBS loans are repaid by homeowners whereas CMBS loans are

repaid by real estate investors

ª CMBS are typically structured as non-recourse loans

ª There is a two level call protection (loan level and structural level)

ª Two key ratios to assess credit risk

ΠDebt-to-service-coverage ratio
 Loan-to-value ratio

LOS h Non-mortgage ABS

ABS may backed by financial assets other than mortgages. Eg. Auto loan ABS and
credit card ABS

Auto loan ABS Credit card ABS

ª Backed by credit card

Backed by automobile loans
Typically fully amortizing
Shorter maturities than
RMBS e receivables
ª Non-amortizing (revolving
ª Have a lockout period
during which only interest
is paid

LOS i Collateralized debt obligations (CDOs)


è Collateral is a pool of debt obligations that is managed by a collateral manager

è Collateralized bond obligations (CBOs) - When collateral securities are corporate and
emerging market debt

è Structured finance CDOs - Collateral is ABS, RMBS, other CDOs and CMBS

è Collateralized loan obligations (CLOs) - Backed by leveraged bank loans


è Synthetic CDOs - Collateral is portfolio of credit default swaps (CDS) on structured securities
RFR + Selling CDS

è CDOs have 3 tranches - Senior bonds, mezzanine bonds, and subordinated bonds © 2017 FinTree Education Pvt. Ltd.

Understanding Fixed-Income Risk And Return

LOS a Sources of return from fixed-rate bond

ΠCoupon and principal payments

 Reinvestment of coupons

Ž Capital gain/loss if bond is sold before maturity

An investor always earns at YTM, if he holds the bond till maturity and reinvests at YTM

Interest rate risk (market price risk) - Uncertainty about bond’s price
Reinvestment risk - Uncertainty about income from reinvestment of coupon payments

Shorter investment horizon - Interest rate risk > reinvestment risk

Longer investment horizon - Interest rate risk < reinvestment risk

Increase in YTM decreases the bond price but increases reinvestment income

Macaulay Modified Effective
duration duration duration

Weighted average maturity of

a bond portfolio
Approx. measure of %∆ in
bond’s price for a 1% change
in YTM
Appropriate measure of risk
for bonds with embedded
options (callable/putable)
Weights are based on
discounted CFs Modified duration - Effective duration -

Macaulay duration - V− − V+ V− − V+
∑ Weights x Maturities 2 × V0 × %∆ in yield 2 × V0 × ∆ yield curve

For ZCBs, Macaulay duration = Bond maturity


For Fixed coupon bond, Macaulay duration < Bond maturity

Macaulay duration > Modified duration

Macaulay duration
Modified duration can also be calculated as -
(1 + YTM)

V− = Higher bond price V+ = Lower bond price V0 = Base price


Eg #1 Macaulay duration

Maturity Cash flow Disc. CF Weights Weighted avg.

Face value = 1000
Coupon rate = 15% 1 150 136.36 16.83% 0.17
Maturity = 4 yrs
2 150 113.42 14.04% 0.28
Spot1 = 10% 3 150 86.8 10.74% 0.33
Spot2 = 15%
Spot3 = 20% 4 1150 471.04 58% 2.32
Spot4 = 25% Macaulay
Total 807.63 3.1
duration © 2017 FinTree Education Pvt. Ltd.
Eg #2 Modified duration

Face value = 1000

Coupon rate = 10%
− 1% Maturity = 10 Yrs + 1%
9% YTM = 10% 11%

+ 6.4% − 5.9%
1064 1000 941

6.4 + 5.9
Modified duration =
= 6.15

Interpretation - If yield changes by 1%, bond price will change by 6.15%

LOS c Why effective duration is the most appropriate measure

of interest rate risk for bonds with embedded options ?

Embedded options have uncertain future CFs, because of which PV calculations for
bond value based on YTM cannot be used
LOS d Key rate duration (partial duration)
Parallel shift in yield curve Nonparallel shift in yield curve

Duration Key rate duration

Key rate duration - Measure of sensitivity of price of a bond to a change in spot

rate for a specific maturity. It captures shaping risk.

LOS e Effect of maturity, coupon and yield on duration

Bond price Bond price

Variable Effect

Maturity Ç Duration Ç

Coupon Ç Duration È

YTM Ç Duration È Yield Yield

Callable bond Putable bond
(Lower duration (Lower duration
Callable bond - Lesser duration when yields È at lower yield) at higher yield)
Putable bond - Lesser duration when yields Ç

Optionality of bond will never increase the duration © 2017 FinTree Education Pvt. Ltd.
LOS f Duration of portfolio

Calculating weighted Calculating weighted

average number of average of durations of
periods until the individual bonds in the
portfolio’s cash flows portfolio
will be received

Yield measure - Cash flow

This approach is used in
yield (IRR of the bond

Not useful for a portfolio Useful for a portfolio that

that contains bonds with contains bonds with
embedded options embedded options

Weights are based on full

price of each bond

Limitation - For portfolio

e duration to ‘make sense’

the YTM of every bond
in the portfolio must
change by the same
amount (parallel shift)

LOS g Money Price value of

duration a basis point

Aka dollar duration

Money change in the full price of

a bond when YTM changes by

Money duration -
one basis point (0.01%)
Modified duration × Full price

Money duration × % ∆ in YTM = Change in bond price (absolute amount)

Eg. Market value = $1050 Modified duration = 6 ∆ in yield = 50 bps

Money duration = Modified duration × Full price


= 6 × 1050

= $6300

Change in bond price = Money duration × % ∆ in YTM

= 6300 × 0.5%
= $31.25

PVBP = 0.5% ª $31.25

0.01% ª $0.625 © 2017 FinTree Education Pvt. Ltd.
LOS h Convexity
Face value = 1000
Coupon rate = 10%
− 1% Maturity = 10 Yrs + 1%
9% YTM = 10% 11%

+ 6.4% − 5.9%
1064 1000 941

Convexity refers to the curvature of a bond’s price-yield relationship

Due to convexity(+ve), bond price increases more for a given change in yield as
compared to decrease(%) for same change in yield

Increase in yield causes price to decrease at decreasing rate and

Decrease in yield causes price to increase at increasing rate

Calculating % ∆ in the full price of a bond
% ∆ full price of bond = −Duration(∆Y) + 1/2 × Convexity(∆Y)2
LOS j Term structure of yield volatility and duration

Term structure of yield volatility - Relationship between maturity and yield volatility

Short-term yields may be more volatile than long-term yields


LOS k Relationship between bond’s HPR, duration and investment horizon

FV = 1000 Coupon = 12.55% YTM = 5%

Price risk Reinvestment

dominates risk dominates

−1583 1000

0 3 7 10
Macaulay duration

Realized Realized yield is Realized yield

1 YTM = 9%
yield is lower close to 5% is higher

Realized yield Realized yield is Realized

2 YTM = 2%
is higher close to 5% yield is lower © 2017 FinTree Education Pvt. Ltd.

Duration gap = Duration gap =

+ve −ve

−1583 1000

0 3 7 10
Macaulay duration

Duration gap =

LOS l How changes in credit spread and liquidity affect YTM

Bond’s spread to benchmark curve has two components

Credit risk premium and Liquidity premium

Given change in any of these components will have direct impact on YTM

Fi © 2017 FinTree Education Pvt. Ltd.

Fundamentals Of Credit Analysis

LOS a & b
Credit risk Possibility of failure of a borrower to make timely and full
payments of interest or principal. It has two components
Default risk - Probability that borrower (issuer) fails to pay
interest or repay principal
Loss severity (loss given default) - Value a bond investor will
lose if the issuer defaults. 1 − Recovery rate
Expected loss Default risk × loss severity

Recovery rate % of bond value investor receives, if issuer defaults

Downgrade risk Possibility that spreads will increase because the issuer has
(Credit migration risk) become less creditworthy

Liquidity risk Risk of receiving less than market value

Spread risk Possibility that bond’s spread will widen due to downgrade
risk or liquidity risk or both

LOS c Seniority rankings

Seniority ranking - Bond’s priority of claims to the issuer’s assets

General seniority rankings

First lien
Senior secured debt
Junior secured debt
Senior unsecured debt
Senior subordinated debt
Subordinated debt
Junior subordinated debt

All debt within the same category is said to rank pari passu. They have same
priority of claims

Lower seniority ª Higher credit risk ª Higher YTM

Since bankruptcies are costly and take a long time to settle, strict priority of
claims may not be followed

LOS d Issuer credit ratings Issue credit ratings

Called as Corporate Family
Ratings (CFR) Called as Corporate Credit
Ratings (CCR)
Based on the overall
creditworthiness of the company Based on credit risk of specific
debt issue
Issuers are rated on their senior
unsecured debt © 2017 FinTree Education Pvt. Ltd.
Notching It is the practice by rating agencies of assigning different ratings
to bonds of the same issuer

Structural Bonds of parent company are subordinate to bonds of subsidiary

subordination company

LOS e Risks in relying on ratings from credit rating agencies

Credit ratings Rating agencies Event risk is Credit ratings lag

are dynamic are not perfect difficult to assess market pricing

Credit ratings Rating agencies Specific risks of a Market prices and

change over time cannot always judge company or industry credit spreads
credit risk accurately are difficult to change much faster
predict and than credit ratings
incorporate into
credit ratings

LOS f 4 Cs of traditional credit analysis

Œ Capacity - Borrower’s ability repay its debt obligations. Three levels of assessment -
Industry structure, industry fundamentals and company fundamentals

More important for less creditworthy companies

 Collateral - Assets pledged against a debt, available to creditors in case of default.

Ž Covenants - Provisions in bond indenture. They protect lenders. Affirmative/negative

 Character - Management’s professional reputation and the firm’s history of debt

LOS g Financial ratios used in credit analysis


Profit and Leverage Coverage

Cash Flows Ratios Ratios

EBITDA Debt/capital

Funds from operations (FFO) Debt/EBITDA EBITDA/interest expense.

Free cash flow before dividends FFO/debt EBIT/interest expense


Free cash flow after dividends FCF after dividends/debt

LOS h Evaluating credit quality

Indicators of lower credit risk (higher credit rating) -
È Leverage, Ç Interest coverage, and Ç free cash flow

Analyst should consider underfunded pensions and off-balance-sheet financing

while calculating leverage ratios © 2017 FinTree Education Pvt. Ltd.
LOS i Factors that influence level and volatility of yield spreads

ª Credit cycle - Credit spreads narrow as credit cycle improves. Credit spreads widen
as credit cycle deteriorates

ª Economic conditions - Spreads narrow as economy strengthens and spreads widen

as economy weakens

ª Financial market performance - Spreads narrow in strong-performing markets,

spreads widen in weak-performing markets

ª Broker-dealer capital - Spreads narrow when broker-dealers provide sufficient

capital, Spreads widen when capital becomes scarce

ª Market demand and supply - Spreads narrow when demand > supply, spreads widen
when demand < supply

Yield spreads on lower-quality issues tend to be more volatile than spreads on higher-quality issues

LOS j Special considerations when evaluating different debts

High yield debt Sovereign debt Non-sovereign debt

More likely to default

than investment grade
Credit risk includes
country’s ability and Analysis is similar to
bonds willingness to pay analysis of sovereign
Analysis should focus Credit risk is lower for
on liquidity, projected bonds issued in Focus is on local
financial performance, country’s own currency economy and its effect
debt structure and than for bonds issued on tax revenues
debt covenants in foreign currency