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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


companies

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

e
Bond price < Par value - Trading at discount
Bond price > Par value - Trading at premium
re
Coupon payments Coupon is always calculated on Par value
Payments could be annual, semi-annual, quarterly or
monthly
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


nT

and principal repayment in another


Currency option bond - Bondholder has a choice of two
currencies

LOS b Content of bond indenture

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

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
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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 -

e
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
re
Collateral - Those specific assets used in issuing secured
bonds
Covered bonds - Similar to Asset backed securities (ABS)
but the underlying assets remain on the B/S of the issuing
company
Credit enhancement - Internal or external
nT

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
Fi

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
maturity
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
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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
issuance

e
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
re
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
nT

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
Fi

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
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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
securities

LOS b Use of reference rates in floating-rate debt


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

è
è
è
It is a rate at which one bank lends another bank
For short term
Currency is USD
e
Characteristics of US LIBOR
re
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


nT

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
Fi

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
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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
Commercial
paper
e Corporate
bonds
re
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
nT

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

LOS h Short-term funding alternatives available to banks


Fi

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
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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)


Bond
Lender
dealer

Promise to buy back @ 96 after 3 months


Bond
Lender
dealer
3
Repo rate =

e
93
= 3.22%

Repo margin = 97 − 93 = 4
re
nT
Fi
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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

Eg.

e
Spot rates - 1-Yr - 4% 2-Yr - 5% 3-Yr - 6% 4-Yr - 7%
Face value - 1000 Calculate price of the bond
re
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

LOS d
nT

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
Fi

(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
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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
re
EAY = (1 + 10.03)2 − 1 = 21.06%
EAY > YTM

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

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
Fi

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%
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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

e
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
re
LOS g
Yields Spot rates
nT

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

Coupon rates Forward rates

Maturities Maturities
Par curve Forward curve
Constructed from the spot curve Displays yields for same maturities
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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


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

100 201.13 358.31 15 x 5 = 75 65


15%

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

e
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%
re
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


nT

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
Fi

YTM = 15% YTM = 16.48%

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

Market Value = 832 Market Value = 790


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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

Bank

e
Receives cash
Special purpose
entity (SPE)
re
Servicer
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
nT

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)


Fi

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
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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)

e
ª Agency RMBS - Issued by GNMA, FNMA and Freddie Mac. Agency RMBS are
mortgage pass-through securities. Generally high quality.
re
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 -
nT

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
Fi

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)
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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


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

LOS i Collateralized debt obligations (CDOs)


nT

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


Fi

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
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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

LOS b
Macaulay Modified Effective
duration duration duration

Weighted average maturity of


a bond portfolio
e
Approx. measure of %∆ in
bond’s price for a 1% change
in YTM
Appropriate measure of risk
for bonds with embedded
options (callable/putable)
re
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


nT

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


Fi

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
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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 =
2
= 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 ?

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

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
Fi

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


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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
practice
portfolio)

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
re
amount (parallel shift)

LOS g Money Price value of


duration a basis point

Aka dollar duration


Money change in the full price of
nT

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


Fi

= 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
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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

LOS i
e
Calculating % ∆ in the full price of a bond
% ∆ full price of bond = −Duration(∆Y) + 1/2 × Convexity(∆Y)2
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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


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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
Fi

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
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Duration gap = Duration gap =


+ve −ve

−1583 1000

0 3 7 10
Macaulay duration

Duration gap =
Zero

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

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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

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General seniority rankings

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


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

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


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

LOS g Financial ratios used in credit analysis


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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


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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
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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
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Credit risk includes
country’s ability and Analysis is similar to
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bonds willingness to pay analysis of sovereign
debt
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
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