(𝟏+𝒓)𝒏 − 𝟏 (𝟏+𝒓)𝒏 − 𝟏 𝑯𝑷𝑹 𝒏

Sources of bond’s dollar return: 𝑪𝑰 = 𝑪 ( ) ; 𝑹𝑰 = 𝑪 ( ) - nC ; 𝑷𝟎 (𝟏 + ) = 𝑪𝑰𝒕 + 𝑷𝒕 ,

𝒓 𝒓 𝒎
𝑛 𝑖𝑠 # 𝑜𝑓 𝑡𝑖𝑚𝑒𝑠 𝑐𝑜𝑚𝑝𝑜𝑢𝑛𝑑𝑒𝑑, m = annual compounding frequency
𝒎
𝒓 𝒓
Effective annual yield: 𝒓𝒆𝒇𝒇𝒆𝒄𝒕𝒊𝒗𝒆 = (𝟏 + 𝒔 )𝒎 – 𝟏; Adjusted formula: 𝒓𝒑𝒆𝒓 𝒑𝒆𝒓𝒊𝒐𝒅 = (𝟏 + 𝒔 ) 𝒇 – 𝟏, f = payment frequency per year
𝒎 𝒎
BEY underestimates actual rate of return earned; ignores interest on interest; calculation for restating bond yields into an annual yield
∆𝑷
DV01 measures the dollar change in the bond price for a 1 basis point (or 0.01%) change in interest rates; 𝑫𝑽𝟎𝟏 = − = − ∆𝑷
𝟏𝟎,𝟎𝟎𝟎 𝒙 ∆𝒀
𝑫𝑽𝟎𝟏𝑩𝒐𝒏𝒅𝟏 = 𝑷𝑽𝟎𝟏𝑩𝒐𝒏𝒅𝟏 ∗ 𝑭𝒂𝒄𝒆𝑽𝒂𝒍𝒖𝒆𝑩𝒐𝒏𝒅𝟏 ; risk weighted: 𝑷𝑽𝟎𝟏𝑩𝒐𝒏𝒅𝟏 = 𝑷𝑽𝟎𝟏𝑩𝒐𝒏𝒅𝟐 ; PV01 measures the price change for a 1 basis
point change in yield and the change in interest rates is identical for all the bonds in the portfolio
Yield curve steepener – buy short term bonds, sell long term bonds to implement; flattener – buy long, sell short to implement
𝒄𝒊 ×𝒕𝒊 𝒏 𝒑𝒓𝒊𝒏𝒄𝒊𝒑𝒂𝒍
∑𝒏
𝒊=𝟏 𝒕 + (𝟏+𝒚)𝒏
(𝟏+𝒚)
Macaualay duration = ( ), interpreted as either time to receipt or interest rate sensitivity
𝑴𝒂𝒓𝒌𝒆𝒕 𝒑𝒓𝒊𝒄𝒆 𝒐𝒇 𝒕𝒉𝒆 𝒃𝒐𝒏𝒅
𝑴𝒂𝒄𝒂𝒖𝒍𝒂𝒚 𝒅𝒖𝒓𝒂𝒕𝒊𝒐𝒏
Modified duration = – measures percentage change in price given percentage change in yield
(𝟏+𝒚)
𝒅𝟐 𝑷 𝒕(𝒕+𝟏)𝑪 𝒏(𝒏+𝟏)𝑴 𝒅𝟐 𝑷 𝟏 𝑪𝒐𝒏𝒗𝒆𝒙𝒊𝒕𝒚 𝒎𝒆𝒂𝒔𝒖𝒓𝒆 𝒊𝒏 𝒎 𝒑𝒆𝒓𝒊𝒐𝒅𝒔 𝒑𝒆𝒓 𝒚𝒆𝒂𝒓
= ∑𝒏𝒕=𝟏 (𝟏+𝒚)𝒕+𝟐 + (𝟏+𝒚)𝒏+𝟐 , Convexity measure = × , Convexity measure in years =
𝒅𝒚𝟐 𝒅𝒚𝟐 𝑷𝒓𝒊𝒄𝒆 𝒎𝟐
∆𝑩 𝟏 𝑷𝟏 −𝑷𝟐 𝑷𝟏 +𝑷𝟐 −𝟐𝑷𝟎
= −(𝒎𝒐𝒅𝒊𝒇𝒊𝒆𝒅 𝒅𝒖𝒓𝒂𝒕𝒊𝒐𝒏)∆𝒚 + (𝒄𝒐𝒏𝒗𝒆𝒙𝒊𝒕𝒚 𝒎𝒆𝒂𝒔𝒖𝒓𝒆)(∆𝒚) ; Approximations: Modified duration
𝟐
- , convexity measure =
𝑩 𝟐 𝟐(𝑷𝟎 )(𝛁𝒀) 𝟐𝑷𝟎 (∆𝒀)𝟐
Term structure of interest rates - relationship between interest rates or bond yields and different terms or maturities
T
(r-f)( )
360
Cash settlement for an FRA: settlement = (principal) × T , for CAD, will be actual/365; f = FRA rate
1+((r) )
360
Corporate bond structures: bullet bond offering, sinking fund, amortizing bond; Importance of credit ratings: cost of borrowing, covenant
pattern, investor universe (who invests), issue size; Rating agencies do not provide a real-time evaluation of borrowers; score “the
probability of continued & uninterrupted streams of interest & principal payments to investors”; EBITDA = Revenue – Operating Expenses +
Depreciation; FFO = EBITDA – Cash Interest Paid – Cash taxes paid; CFO = Net income + Noncash expenses + Changes in working capital;
FOCF = CFO – CAPEX; DCF = FOCF – cash dividends paid – stock buybacks; Bank loans are typically secured for high yield bank loans and
unsecured for investment grade companies; Recovery waterfall: debt, outstanding, Recovery (% recovered) (with the range of expected
recoveries, ie. 3x, 4x, 5x); aggregate at bottom; Positive covenants – makes issuer do certain things, i.e. obtain insurance; negative
covenants – exist to protect bondholders, prevent certain actions, Not adhering to a covenant may constitute an “Event of Default”
Basic covenants for investment grade: negative pledge or limitations on liens, cross default, cross acceleration; exceptions sometimes exist
Other major restrictive covenants: limitation on indebtedness, limitation on restricted payments, limitation on asset sales, change of
control; Maintenance test: maintain compliance every reporting period; incurrence test: only checked for compliance when relevant action
occurs; Offering methods: public market via prospectus – continuous disclosure requirements; IG bond issuers use Medium Term Note
(MTN) Shelf Prospectus (valid for 25 months, one page pricing supplement containing terms of offering for each transaction)
Distribution alternatives: marketed underwritten, agented transactions; Securitization is the process of pooling assets into packages of
securities; Securitization process - 1. transfer of assets from the Seller to a special purpose vehicle(SPV) 2. SPV’s issuance of debt to fund
the purchase of the assets; Asset backed securities (ABS) – bonds backed by income producing assets; assets generally illiquid on a
standalone basis; Parties to an ABS transaction: SPV or trust, Originator of loans, Servicer of loans, Swap counterparty; Securitization credit
enhancement: overcollateralization - issuing a lesser dollar amount of securities than the value of the assets, excess spread - difference in
the yield generated by the Assets and the funding cost, holding of cash and securities in reserve funds – reserve accounts from excess
interest not paid out, subordinated notes – issuing more than one security class; Subordination calculations: default loss rate = cumulative
default rate ( 1 – recovery rate); senior tranches can be supported by (100% - default loss rate x expected loss multiplier) of cash flows from
assets; Collateralization Debt Obligations (CDO) – security backed by Investment grade bonds, high yield corporate bonds, leveraged bank
loans ( CLO ), distressed debt, emerging market bonds etc.; Debt obligations (bonds) are collateral assets; issuance of debt obligations –
tranches; credit ratings are obtained for all tranches except the equity piece; In a typical CDO structure, one of the tranches has a floating
rate; CDO cash flows: coupon interest from collateral assets, maturing collateral assets, sale of collateral assets; Covered bonds: guarantor -
bankruptcy remote vehicle that purchases the mortgages and grants a ‘security’ interest in those assets to secure the covered bonds; swap
providers – hedge currency and interest rate risk; covered bond swaps - ensure that the currency of the underlying pool is transformed to
match the currency of the Covered Bonds issued; “full faith and credit”; monetary policy – short end of yield curve; normal fraction for
bonds = 1/32; Open market operations – buy/sell gov securities; yield curve importance – benchmark; Coupon – benchmark government
bond + credit spread; credit spread – risk compensation premium; competitive bid – quantity + price; non-competitive bid – quantity;
Government bond auctions: Single/uniform price (dutch) auction, multiple/discriminatory price auction; bid-cover ratio(auction coverage):
total demand(all prices)/total quantity; auction tail - # basis points between highest yield accepted and average yield; small tail –
transparent pricing; stop-out yield: yield where demand exhausts supply; reopening – new bonds, same features; mitigates liquidity risk,
but increases refinancing risk; Liquidity importance: enables investors to be price takers not setters, Government: GoC used as benchmark,
liquid market provides the correct basis on which to price riskier debt; required for use in derivatives; improved liquidity lowers yields
increasing economic efficiency; bond price table: time, period (w) [w – time to next coupon], coupon, PV of $1, PV of cash flow; Callable
bonds – reinvestment risk, limited price appreciation; call provision - call provision grants the issuer the right to retire the debt; make
whole provisions (IG bonds) - allow the issuer to redeem the bond ahead of the scheduled maturity date; call schedule – non-IG bonds
specify a call price for each call date (yield to first call, yield to next call, yield to first par call); change of control + rating event = put option