JuiceNotes” ae - By Fintreex- eBook 8 ee Peirce nes CFA® Level | JuiceNotes™ 2017 © 2017 FinTree Education Pye. Ltd.,All rights r FinTree Eduisgsion Pvt. Ltd. Contact Information Yashwant Ghadge Nagar Road, Mobile - +91- 8888077722 Yashwant Smruti, i fintreeindia.com Building 5, 2” Floor, Pune, India - 41 1007 Disehimer: CFA Institute d a sracy or quality of the product by Fin Tree Education Priv id CFA a sed by CFA Inscicuce Website - https://www-finthitps:www.fintreeindia.com/ ©2017 FinTree Faucation Pvt. Vid Fixed-income Securities: Defining Elements LOSa Issuers of bonds Bond maturity Par value Coupon payments Rebel ud firced Congo MHEG called plods aa boat Currencies LO: ie h Basic features of a fixed-income security Supranational entities - Issued by organizations that operate globally. Eg. World Bank, TMF etc. Sovereign governments (national)= Issued by national government entities: Eg, US T-bills Nonsovereign governments (local) - Tssued by non national government entities. Eg, California state bonds Quasi-government entities - Agencies that are owned and sponsored by governments. Eg. postal services Corporations - Financiat companies & nonfinancial companies Perpetual bonds - No maturity. Make petiodic interest payments but do not promise:to repay the principal Original maturity < 1 Yr - Money market securities Original maturity > 1 Yr ~ Capital market seetfifies Also referred to as the face value/maturity value/redemption value /principal value Bond price < Par value - Frading ai «iis Bond price > Par value - iraciing at premiuir Coupon 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 Dual-currency bond - Coupon payment in one curr and prinelpal repayment in anothe: Currency option bond ~ Hondholder has a choice of t Content of bond indenture 4 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 iS EE dninistubic. Achers Do rot tetsats eperoliey “ cleuisions: @ ipsisvonfintreeindia.com! (© 2017 FinTree Education Pvt Ltd. Losd Considerations that affect the issuance and trading of fixed-income securities Domestic bonds - They are issued in issuer’s home country and currency eign bends _ Yesued by foreign ieeuers but denominated in the currency. neepiele| ofthe country where they trade. Bow) af Todi treve to UF 455 feel, 4 5 Ewrobonds ester Issued outside a country and denominated in.a currency other tian that of the count Sa aan which they trade Washed renee v — Global bonds - Eurobonds that trade in a country other than the country that igstes the currency the bond is denominated in and in Eurobond market > China Issuing entities - Government, corporations ¢! ized bonds - Bonds issued by special purpose Sources of Repayment - Sovereign bonds - Repaid by th iscuing country Nonsovereign government bonds - Repaid by general taves, revenues of specific project oF fees dedicated to bond repayment’ CegntphuGron Conrrc?, Corporate bonds - Repaid from cash generated by the firm's operations ——_—— Collateral and Credit Enhancements - Unsecured bonds (debentures) - averal and cash fic Tre aint afbond redeemed oa-fo Fitetng ead Prorision Coote aking Sch yrod-op inciase 9 Sod Yeoh Oi) -Stoeckecaeceg fllion indere bond |] Nolen. emely bond x Periadte Peymats Weelly egjusr do ieflotien eb ebyloten Sade Jeo Gagan, ‘iginak ot enod 1 TTS ested fossinfle Meo - rls perce). ¢~ Cournn raft. 6 edjstd Jor iflolin while sindgle. Jeone}os dtrangac)- Taxation = ‘Secured bonds - Backed by a claitn to specific assets. Reduces default risk. They are senior to unsecured bonds Collateral - Those specific assets used! in issuing Secured bonds Covered bonds - Similar to Asset backed securities (ABS) but the underlying assets remain om the. igsuing company ° Credit enhancement - Internal or exte: Cobras ped) imernibsteiipanhancementmethods- Cg ccs spiens) aividing SAB Esae OOF spreai into tranches and cash reserve fun External credit enhancements - Surety bonds, bank guarantees and letters of credit Interest income - Ta shel deopalies Aipon income, Fer raunicipal bonds is usualiy tax-exempt Capital gains - Taxed at capital gains tex rate -prrterois Sora prncpe ise Me LOS e ‘Ih Fahl Stencture of CFs of fixed income securiti ‘Typical bond Bullet structure - Periodic interest payn 3d priticipa! value at maturity structure - Balloon payment - Finat interest payment + Principal at maturity _ - _ Amortizing structure - Part of principal is pai at each payment date Fully amortizing structure ~ Esjia! poyment Partially amortizing structure - dailoon vayment of vemining principal t saturityby Aavesfet | ese cy mol heart 2) debe redemetion Cnt (— then Jab tote folte- ‘ utpswwvetintrecinda. com © 2017 Fintree Education Pv, Lit Sinking fund provision - Requires th 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 # when reference rate # Other coupon structures Step-up coupon bonds - Coupon rate increases over time according to a predetermined schedule inked coupon bond - If credit quality # Coupon rate # (Double Jéopardy Bonds) 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 ce Split Gorey bond €g. Gero lerper bore! Indesx-linked bord « ‘ouzon payments and/or a principal repayment is oased on ily Index, equity index oF same other index Refer = Ge 5) —ranatieielinked bends)- Most common type tiolcey-c cipal protected Bonds - Indexed bonds that do not pay less than their oriatnal par value at maturity Losf Contingency provisions affecting the timing and/or nature of cash flows of fixed-income securities “+ Contingency provision = Ai action that may be taken if contingency actually occurs Re eee eee + Callable bonds - Issuer ean buy back the bond from bondholder (value to the issuer) Putable bonds - Bondholder can sell the bond back to issuer (value to the bondholder) pee cae oa Ree Ree Cede) PMc nt one Ce nee ree meee Cac Se eh ihe attisy Even if the share price increases to a level wiiere the conversion value is significantly above the bond's par value, bondholders might not convert the bonds ta common stock because the eee uC. hue etett kite Leiner aay CSE satu saci eu ate f tee rsat MOSS Coca ME We orange Ce eee ets eeu cat Rage ‘+ Contingent convertible bonds (CoCos) - Bonds that convert from debt to common shares Erica aueR courte Equipeat fust Ceifioles | Cac: baked) by Caiprant secs doilrerc) cts. ofl Isthoyeh. Collehyel thstebands;- hacked) Wy dronial oxtal> Sick as SHd/ bends Pam \ hele + Giintnimtey ABC bet Lade Hudng e8e Semetg 09 Be -O ‘yetpse/fwww.fintreeindia.com! (© 2017 FinTree Education Pvt. Ltd, Fixed-income Markets: Issuance, Trading And Funding LOSa Classifications of global fixed-income markets f T tT T T T T 1 Typeof Credit Original-~—Coupon api lindo Tax uer quality, matur structure Currency Geography Indexing status t + + 4 BBB and above - Fixed rate or Developed Municipal bonds - Investment grade floating rate markets - Less Tax exempt Tower et bonds riskier yield veld BB and below ~ Emerging markets Junk bonds = More riskier Government, Money USD, Euro ete. Index-linked corporation market, bonds ete, capital market i" securities LOS b Use of reference rates in floating-rate debt resem kcreancld ike Perth hse kaa) © Characteristics ne eer GRU ee Seo uu ic Mecsas te nURT) pears ats pOerieteeutcis (ferrari cies Pepe eclectic MCA gen neat cs VEVEDY Beer nage su euce me sate Crate re te aie Neem eee wee ee Cun LOSe Mechanisms available for issuing bonds in primary markets suey nicbsy tals hay | Puble offering ~ onde one sold eth vi fact & i Pries te offetio My hig Private placement Underwritten offering - Entire bond issue is purchased by the oe wel 2: Hie investment bank (under vstiter) reais Best efforts offering - Investment bank does not commit to purchase the whole iste Bonds are sold only to qualified investors Losd Secondary markets Most bonds ave tated in dalgrmeriada OTC mthets) Lass liquid fsues- Difference between bid-ask price Widerhups:/www.fintreeindia.com! © 2017 FinTree Edueation Pvt. Ltd, Settlement cycle: oa Government bonds Ti.“ . Corporate bonds “T+20rT#3 Same lag fox Meany hl (asionale LOS c 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 Biacurtcne Noo Quasi-government Prana Poncantent! Grr sued by corporations ! ; dS + Commercial core Term maturity Types of debt is Bilateral loan - Loan Itis a short tern structure ~ Ail bonds given by only one unsecured debt issued mature on the same bank by creditworthy date an Serial maturity Syndicated loan - given by a group of < is used to fund structure - is banks working capital : LOS h Short-term funding alternatives available to hanks Customer deposits - Short-term funding sores Certificates of deposit (CDs) - Another short-term fun mature on specific dates, Negoti old > gshalesele et Central bank funds market - Banks may buy or sell excess reserves 1SSea) by herlrorly, deposited with their centro! b Interbank funds - Funds loaned by one bank to another ollorey. Rice© heips:/fwww-fintreeindia.com! © 2017 FinTree Edueation Pvt, Ltd. Repurchase agreements Csliobed (ox ye one party sels n security to» counterparty with » comment to Gav Bock ote ate ata specified (higher) price Repo margin (haircut) - Difference between the market value and the amount loaned Reverse repo - Bond dealer lends funds inspead of org woeef cass in will be lower if, Chis Repo rate will be lower if, Repo margin will be lower if, Chis) po rate will be lo Chokes) + Borrower has high credit quality \,.., figher quality of collateral (ow Collateral is detivered Higher quality of coltateral bee 5 + Maturity is shorter on Be Maturity is shorter + Security's in short supply and high demand C General interest'rates are re, ea 2 Nees detokun Crnase: Th See ty byes d sme BS Es. pond __ Sells security @ 93 (Market Value = 97) Lender dealer Bond _,_ Promise to buy back @ 96 after 3 months gear Lender Repo rate = Repo margii Sickeing Jun) Qa vesher don't Frover fo edv whi bord ot be tecleenee) Sedial bend “ae “7 Dnvesfas Kaow ta ady whidh beads will be pedeomesd~ a ()Cenessen Rete = Ben) Fes Yor-e Comersion Pryce = o ef Shaves oft lootetse5 6 = Bend Pree = Corvssig Vek Q conais tiie = Pore par sh af bhely ford con he. Conve thea)or) WEEE g, Raye fore et es la ye es nae Pe Introduction To Fixed-Income Valuation [nttps://wwwAintreeindia.com/ Calculating bond price using YTM MV of bond is PV of future CFs discounted at current YTM (Yielg-to-maturity) = Shes 4 Ipot- ale Eg. Calculate the bond price when. SeHes 4 Joreord 22 Maturity = 4 Yrs Coupon rate = 10% YTM = 12% Face Value = 1000 Seljoe YTM- Premium bond oprord stap ter 209 a perro ena eer mite pond Shepkeg en Be ing 0 Wl Coree a yt dec hy He Soe Roe eed tae Regt Longer maturity - Price Is more sensitive to a change in yield bnger Oe etary Eg. a ¥ ace v Calculate price of the bond = so, 60 5 60 __ , __1060 Woo * Troosy * Trove * T+0.07" Price = 57.69 + «S442 + «50.37 + 808.66. = 974.14 LOS da ge dnd, derlees oerpecomm SO nestjen Sbleaastss pas (Clean pr Wirty price) yele > Can be calculated using Tori pres y Ttisthe quoted price ofa bond Oe ete USS, Transaction price Full Price - Accrued interest Ponds) or 30/360 convention Includes accrued interest 7 (Corp. bonds) % ie Eg. YIM = 159% Face value = 1000 Coupon rate = 20% ° 5 57 6 10 Price of the bond at year 5 - FV= 1000 PMT=200 N=5 i/¥= 45 PV= 1167 Full price of the bond (5.7) - 1467 x (2+ Flat price of the bond (5.7) - 1287 ~ (200 x 0.7)ipso Sintresindia.com/ (© 2017 FinTree Education Pvt Ltd. LOSe 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 annusl-pay, 7% coupon bond - 6.5% 3-year bond - 5.5% Difference in 3 years - 1% 6-yearbond - 6.5% Difference in 1 year - 0.33% YTM of non traded bond = 5.5 + 0.33 = 83% Losf Yield measures For annual coupon bond Effective earning yield = Yield to maturity For semi-annual coupon bond Effective earning yield > Yield to maturity Eg. Aannutat coupon bor Semi-enmuat coupon boxe Face value = 1000 Coupon rate = 15% Face value = 1000 Coupon ra Maturity = 8 yrs. Market value = 800 Maturity = 10 yrs. Market valuc = 870 FV = 1000 PMT = 150 N= 8 PV = ~800 FV = 1000 PMT = 85 N = 20 PV = ~870 CPTA/Y = 49.73 CPT I/Y = 10.03 x2 = 20.05 EAY = (1+ 10.03)° ~ 1 = 21.06% EAY > YTM —_ 5 i 5 bynes Street convention - Yield calculated using the stated coupon payment dates ag —_ ideringweckanicanibolays OH Stds True yield - Viel calculated after considering w jays holiday Strect convention yield > True yield Current yield | ps viet - -ABnual coupon + Disc, smort, — Prem. amart Bond price Pa & Semi-annual bond 00 Sem) tne Fare jue = 1000 Coupon rate = 1 2 fat Macaviny = 26 yea. Mavkat value = 850 Maturity = 10 yrs. Market vaiue = 800 | Discount amortized = 100/5 = 20 7 | | 7 eig = 2004.20 Current yield = 420 simple yield = 490 Current yield = 11.76% } Simple yield = 13.33% Yield to call (YTC) Yield to worst (YTW) Tg. Face veiue = 1009 Coupon rats = 19% Market wate = 1020 | Lowest of YIM and YFCs is cate "liable in four years at 1021 rrW ve 1930 PHT = 100 N= 4 PV= 1028 T/Y = 10.01% 19 9 > colitokd by adding doves + coment ONS Colleble Galdg YIM ollodle coil Opt fotte mds’ Corse wars timde as fib golt© 2017 FinTree Education Pvt. Ltd Floating-rate note yields + FRN yield = LIBOR + Quoted margin + Coupon rate for the next period is set using the current reference rate (L1BOR) for the reset period + Values of FRNs are more stable than those of fixed-rate debt of similar maturity because the coupon interest rates are reset periodically +. Issuer with more credit risk - Quoted margin is higher + Issuer with less credit risk - Quoted margin is lower Required margin (discount margin) - Margin that brings FRN to its par value + Credit quality # - Quoted margin > Required margin When this happens we Say that FRN is trading at premium + Credit quality # - Quoted margin < Required margin When this happens we say that FRN is trading at discount Money market instrument yields + Yield can be quoted on discount basis or add-on basis + These may be 360-day or 365-day SL Pobilla = Dupted ag discount bend and is based on 360~iay convention atk EPs > Quoted as add-on viet jor and bank ODs - Quotad a: add-on yield © + Anpropriate yield measure for money market instruments - Bond equivalent yield ( Seo,, aye Yields Spot rates Maturities Maturities 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ittpssliwwwfintreeindia.com! © 2017 FinTree Education Pvt. Ltd. LOSh Calculating forward rates using spot rates Eg. Spot, = 15% Spot, = 20% Calculate 2-yr forward rate, 5 years from now Formula Logic Magic (Approx) 300 358.31 (FRY _, 2 (+ 15%) ° ? 100 59, 20413 358.31 rea 33.47% 33.47% Yield spread the difference between yields of two bonds ‘Benchmark spread - Yield spread rélative to a benchmark bon: G-spread - Yield spread relative to a government bond Interpolated spread (I-spread) - Yield spread relative to a swap rate ASOD Coupen rate = 10% Maturity = 44s Market mae Z-spreadeg. *ishy spot rates (treasury) - Year 1- 10%, Year2~-11%, Year3- 12%, Year| = 45% 100 . 100 * 100 + 1100 WHO + espready * TFT + xapready * (LF 12% +zspready * G+ 15% + zspread) Z-sprendi determined by wa and error method >, 860 = Option adjusted spread Bond - A Bond - ewteeall 0 YTM = 16.48% Face value= 1000 ‘Face value Option adjusted Option risk Coupon rate = 10% Coupon rate = 10% yield : | YIM = 15% | { 15% 1.48% Maturity = 5 Yrs Market Value = 832 Market Value = 790Ihttps:/!www.intreeindia.com/ (© 2017 FinTree Education Pvt. Veh, Introduction To Asset-backed Securities as ee ee Benefits of securitization Securitization is a process in which an entity (SPE) purchases financial assets such PO oR uc eo eee eee i ore Bo Tear ery ee Aue Cima ineir ee} Cina eee ee Lea cone caer cies peed een tutes aed ia ee en eee eC aie ee) (USAC Mus ee Reece et eet eT Ch CIDR eee terete) Bee ee Ou ee Reine eer GOO AN ee Ae dest atts Rer i ea ica ene Rt ete LOS b Securitization process Mortgages. loans are sold - ———+ (Special purpose Bank —————— a entity (SPE) | ee Mortgages and loans —- Known as trust’ and is set (assets) are removed from up specifically for buying the 8/5 these loans and selling ABS to investors May use cash proceeds to ine rae ane Services the loans = Credit cord Hreirebles, Principal and interest payment Ceol srchies) received on loans is used to pay servicing fees tothe servicer - PHOS Heesing Joon and then to ABS owners 05 5 otek thon betty kon ‘Trust may issue ABS in several classes (traniches) Waterfall structure - Each tranche ABS is paid sequentially SPE is a separate legal entity and buyers of ABS de viol have claim on other assets of the bank LOS ¢ ‘Typical structures of securitizations In ‘tranches’ structure - Some tranches bear more risk while other bear less Credit tranching (senior/subordinate structure) - Losses are first absorbed by the tranche with lowest priority ‘> Time tranching - First tranche receives all principal repayments from underlying assets up to the principal value of the tranche- @ epsi/ivwwedintreeindia.com/ © 2017 Fin Tree Education Pvt. Ltd. Losd Residential mortgage loans Collateral of the loan is residential real estate : Loan amount Loan-to-value ratio (LTV) - [zige of collateral real estate * *°° If # LTV, then borrower's equity $ For lenders, + Loans with low LTVs is less riskier (because borrower loses more in case of default) + If the property value is high compared to the foan amount, lender is more likely to recover the amount foaned if borrower defaults. Prime loans - Mortgages with high LT¥ ratios, made to borrowers of high credit quality 42s 2€1) ‘Subprime loans - Mortgages to borrowers of lower credit qual Maturity - Typically 15-30 yrs Interest rate - Fixed rate, adjustable rate or convertible Amortization - Fully aniortizing, partially amortizing or interest-only ‘ome loans have prepayment penalty COUPSE IANS Clow) on Pebsene! Pg Prepayment provi Foreclosure - Non-recourse and Re: Saat ential mortgage backed securities (RMBS) ‘Agency RMBS - Iscued by GNMA, FNMA and Freddie Mac. Agency RMBS are sarc ge paes-through secures, Generally high quality. ee) by eof Senseed Ekp- ye. + Non-agency RMBS - Issued by private companies. Non-agency RMS typically inelude credit enhancement pea ‘exprming bens ~ ‘ Eurehe + Collateralized mortgage obligations (CMOs) - Collateralized by po: MBS. They are structured with tranches + In sequential-pay CMO - * Histtranche to be pid principal has most contracton rs + Last trafiche to be paid ipal has most extension risk Planned amortization class (PAC) tranches - A PAC tranche is structured to make predictable payments, regardless of actual prepayments. PAC tranches See ta ppeeae ion and extensinn risk — — fang Bei eerie ££ —————— + Prepayment risk - Uncertainty about timing of the principal CFs from the ABS + + Contraction risk - Risk that foan principal will be repaid more rapidly than expected (when interest rates decrease) + Extension risk - Risk that loan principal will be repaid more slowly than expected (when interest rates increase) shffing Tak mack =) meted dor eddessing Adee > He tuo y Cr phen frovided by, denier frordes os pePegreds cy pelle Ceteg- Senin] Sebe dion he StrdereIttps:/lwwwsintreeindia.com/ ©2017 FinTree Education Pvt Lid LOS g Commercial mortgage backed securities (CMBS) Ci pete cde eg hobo Rao TC Roaieurase i ketosis cd Pee usu omc Cnr caer Cart se RO ha Aenea ee Rae aca Ree Oat ruta Suite ar +. There is a two level call protection (Ioan level and structural level) Peo teeter CME sor eesti cic) Ceecieenatcte uty ee Be belty- beady LOSh Non-mortgage ABS ‘ABS may backed by financial assets other than mortgages. Eg. Auto loan ABS and credit card ABS PCR G ety ROC geteeevny 7 imernel Or. 20 teal’ Sh Ulelael cy fpvadecs fy recs siouctune Backed byredit card Cobesenct wbhd T's wacked by automobile toans ff, fecevables 13 Desay beg f+ Typically fully amortizing debt) b + Shorter maturities than se Se. aMeS, Have a lockout period ~ yepioraeg 5 grvrell 8 during which only interest is paid beby Wuts [ow Ge Collateralized debt obligations (CDOs) Collateral is a pool of debt obligations that is managed by a collateral manager Collateralized bond obligations (CBOs) - When collateral securities are corporate and emerging market debt nerging market debt Structured finance CDOs - Collaterat is ABS, RMBS, other CDOs and CMBS Collateralized loan obligations (CLOs) - Backed by leveraged bank Igans ‘Synthetic CDOs - Collateral is portfolio of credit default swaps (CDS) on structured securities RFR + Selling CDS > CDOs have 3 tranches - Senior bonds, mezzanin= bonds, and subordinated bonds = The lesen opbidnrye Coo 0S vse) der CPO Strchre. to an deans fron fre Splex) bod fending cost Y par fflia sehen, mt weshe > Gye - &. Horde Seaicy Imeyarne > OF oreks > Mbt ab-© https:#hwoww.fintreeindia.com/ © 2017 Fin Tree Education Pvt. Ltd. Understanding Fixed-Income Risk And Return LOS a Sources of return from fixed-rate bond © Coupon and principal payments @ Reinvestment of coupons © Capital gain/loss if bonds sold before mat PO een eT eke Ru sauce kA) Pesaran Rel ped Cl ocd Yu 4 Fa ete ener aera eos ket eu uci Peirce ree es hare ee cee oc eeu ret yeh Longer investment horizon - Interest rate risk < reinvestment risk ehh Piece eR Abas RL anc lcd 1 Wak ee ANAL Modified Fitri GuheGig L “: Yoeopneshierele Weighted average maturity of Appropriate measure of risk: a bond portfolio for bonds with embedded. options (callabie/putable) Weights are based on ue me ao discounted CFs Effective duration = Macaulay duration - are z Vea. z = Weights x Maturities TRV. x Bin yi . FeV x dyed curve Arcaulay|s = Modified (1410). 208s, Macaulay duration © Bend mats reed coupar: bo \y duration < Bond maturity “losified duration Macaulay duration Cup 7 7 1+ YT™, ~ V. = Higher he V. = Lower bond price VW, = Base fpr senional Eg #1 tay dora Maturity | Cash flow | Dise. CF Face value = 3000 ~ Coupon rate = 15% 4 5 36.3) 047 Maturity = 4 yrs > baa aoe = 10% Ts0.74% 33 7 3 sso [360 [rovave [038 20% i 56 2% - Total 807.63 31 <————_ Macaulay durationItps:/wwwtintreeindta.com’ ©2017 FinTree Education Pvt. Led, Eg #2 Modified duration Pees ory) ee Presa 9% Pieri 11% + 6.4% = 5.9% 1064 <—. 1000 ———————__-» 94; Modified duration = S445.9 6.15 Interpretation - If yield changes by 1%, bond price will change by 6.15% Why effective durat of interest rate ri n is the most appropriate measure isk 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 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 2 bond to a change in anc fate for 2 specific maturity. Ie captures shaping csi, LOS e Effect of maturity, coupon and yield on duration , sieet Bond price Bond price Dyed Maturity # Duration VE rete Noh -VE Converaite, by Coupon # Duration + poben be ta] ——— He 4c] Duration + Yield Yield Caltable bond Putable bond (Lower duration (Lower duration Callable bond - Lesser duration when yields + at lower yield) ‘at higher yiele> Putable bond - Lesser duration when yields ¢ wery — Optionality of bond will never increase the durationIngtps:/iwww.fintreeindia.com/ © 2017 FinTree Edueation Pvt. Ltd. LOSf Duration of portfolio Calculating weighted Calculating weighted average number of average of di of periods until the individual bonasT the portfolio’s cash flows portfolio, will be received | Yield measure - Cash flow , teusdd Vield (RR of the bond ls aypronch le deed In portfolio) — Not useful for a portfolio Useful for a portfolio that that contains bonds with contains bonds with ‘embedded options Tembedded option Weights are based on full price of each bond Limitation - For portfotto durat i “ the YFM of every bon in the portfolic must change by the same amount (parallel shivt) Los ¢ ans reac Comcast a basis point Aercolaaaueea Money change in the full price of ‘a bond when YTM changes by Money duration - i Modified duration x Full price org ea peor (Ley Money duration x % A in YTM = Change in bond price (absolute amount) Eg. Market value = 519 sified duration = 6 yield = Money duration = Change in bond price = PvEP = Modified duration * Full price 6 x 1050 $6300 Money duration x °% Ain YTM 6300 x 0.5% $31.25 0.5% ~ $34.25 0.01% — $0.625,bttps:/vww:Sintreeindl LOSh Convexity © 2017 FinTree Education Pvt. Ltd; Coupon rate Crome thas 9% Ried 11% + 6.4% = 5.9% 1064 ¢————————._ 1000 ———~_» 941 Girone t a mci nein Due to convexity(+ve), bond price increases more for a given change in yleld as. Coed eaten CO ncaa nanan Me UNC eh ba eee tne oe oy Pee Nike ln eee sn ic culating % A in the full price of a bond % 4 full price of bond = —Duratian(AY) + 1/2 % Convexity(AY)” ‘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-ter yields Relationship between bond’s HPR, duration and investment horizon FV = 1000 Coupon = 12.55% YTM = 5% ; Ste Taney Linn dominates isk dominates Strolees =1583 1900 o | 3 7 10 2 Macaulay duration : iy | ¥ — on, Realized —_—Realized yield is @ vena 9% vctgisiower “dosetese” “ngnee = aop Realized yield Realized yield is _Realized @ maa higher —closeto'5% yield is ower@ © 2017 FinTree Education Pvt. Ltd. Igtpsswwsintrecindia.com/ pce bls buraion soe = omston= cat hale. Bsc — +. 1583 1000 o 3 7 10 Macaulay duration Derolen G.bP= Mecoolog ss Dosotion | co) Welding Postal Ditton asp = LOS] ‘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 - Ge 2” adler effect on fe beed ff Mie chooge, Gjten & Chee ih yti Coe be. bast assbe) os Conveneheps:/iwwwAintreeindia.com/ © 2017 Fin Tree Fdneation Pvt, Lta Fundamentals Of Credit Analysis LOSa&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 of- Loss severity (loss given default) - Value,a bond investor will lose if the issuer defaults, 1 ~ Recovery fate fers Expected loss (Default risk x loss severity SS ————— Recovery rate Got bond value investor receives, issuer defaiits—) jefaitts-) ft Downgrade risk _ Possibility that spreads will Increase because the issuer has (Credit migration risk) _ become less creditworthy Liquidity risk Risk of receiving less than marker value ty that bond's spread will widen due to downgrade risk or liquidity risk or both Spread risk Seniority rankings Seniority ranking - Bond’s priority of claims to the issuer's assets : Benes Iam ‘Senior secured debt Tilia ccs Te as Sees k cs Scene Bree ure cs Ait debt within the same category is said to rank pari passu. priority of claims ey have same Lower seniority ~ Higher credit risk — Higher Yist Since bankruptcies are costly and take a long time to settle, strict priovit iis may not be followed LOS d eee ert peeracretare Called as Corporate Family Ratings (CFR) Called as Corporate Credit Ratings (CCR) Based on the overall = creditworthiness of the company Jf] Based on credit risk of specific debt issue Issuers are rated on their senior@ upsulwwwsintrecingia.com! © 2017 Fin Tree Education Pvt. Ltd. Notching Itis the practice by rating agencies of assigning different r to bonds of the same issuer Structural Bonds of parent’company are subi subordination company Risks in relying on ratings from credit rating agencies Credit ratings | [ Ratingagencies | | Event risk is {Credit rati are dynamic: fare not perfect | {difficult to assess| | market pricing . t + t 4 Credit ratings Rating agencies Spacific risks of a Market prices and change over time cannot always judge company or indus credit spreads credit risk accurately are difficult to change much faster predict a than credit ratings Losf 4Cs of traditional credit analysis ‘© Capacity - Borrower's ability repay its debt obligations. Three levels of assessment - Sndustry structure, industry fundamentals and company fundamentals © Collateral - Assets pledged against a debt, available to creditors in case of default. More important for less creditworthy companies © Covenants Provisions in bond indenture. they protect tenders. affirmative/ negative © Character - Management's professior Tepayment ation and the firm’s history of debt piel LOS g Financial ratios used in credit analysis cemimma (gc: garner PIT SEE) 2) rots 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 LOSh Evaluating credit quality e 198 Indicators of lower credit risk (higher credit rating) - er Be 4 voscrage, # Interest coverage, 2nd free cash fiohttps:/www.fintreeindia.com/ 8 © 2017 FinTree Education Pvt, bide Losi Factors that influence level and volatility of yield spreads =) 4 Seelam e eee =. orto tote hati or Gi SL. BO Coc] Times Matted ee cet eee eee reer l= \ovlor’s ERR ey rere ctr . : tonons ; Gacy, Cocca: PuMREMEE I ier reser reeegee te ore res ke ees RE ECON en rere cea renee Oh Pefend bey pee ere eect eee rey Peerage A ke Be CONT cane te are cern see a Pen akties Bae eke uC asc Leta eat Pear eer terete ree apdol become bean apical Yield spreads on lower-quality LOSj Special considerations when evaluating different debts High yield debt Sovereign debt t t { Mor Ukely to detsate Cresit risk inéludes _ | than investment grade country’s ability and’ | bonds aaa | don Analysis should focus | on tiquidity, projected | financial performance, | debt structure and debt covenants | creat rik te ets for | bonds issued in [country’s own currency | than for bonds issued inforeign currency | is on local economy and its effect 4] On tax revermes (Rew pron flefeck. ~Grprele bend eld Gnplomises He (RER + E, weet % : Pheri % I Photon, @ © Gad airs co sree mit robits Ba hers “yield Spec te Os berchmerk nodes sds | ce + Steed Y tg + Plemicon, Sted SP feds to norew whea Gde & Mkt Y chueler dimond Jor ne fob: Te Cale loping Ceonormy is ng sdiooedte | sheng - % Pttote tet'o molt D) nde Peaster obligations D609 epaaty bere. yee 3) ry hte _tonm ined 2 Pele Bivens given =i \ heabelity