FI02 Intro To Fixed Income Trading and Bonds 6523d55268da1

• Cash Equities Fixed Income
Trading
W W W. W A L L S T R E E T P R E P. C O M
v
Fixed Income Trading
Sales & Trading Divisions of an Investment Bank are

split by Asset Class
Markets • Business names for the Sales
Securities & Trading Business
FICC Equities
Cash
Rates Currencies
Equities
Equity
Credit Commodities
Derivatives
Prime
Mortgages Municipals
Brokerage
Footer
Licensed to Kevin Romanteau. Email address: kromanteau.mifft2021@london.edu
Cash versus Derivatives
Cash Derivatives
Cash Derivatives
• Investments
where you need
Stocks Futures • Contracts or
agreements that
to have the cash reference
to buy the another asset
security or
investment Bonds Swaps • Unfunded
investments
• Possible to with embedded
finance and financing (you
reduce the cash don’t need $100
need, but a Loans Options million of cash
separate for $100 million
transaction of exposure)
Deposits Exotics
Footer
Overview of Derivatives Types
Derivatives
Agreement to lock in a price of an asset for delivery in the future. “I

Futures agree to buy 5 barrels of Oil from you in March at $50 per barrel”
Agreement to exchange one set of cashflows for another. “I will pay

Swaps you fixed rates (4% per year), if you pay me floating rates (LIBOR)”
Option buyer pays a premium to enter into a pre-defined derivative if

Options it’s favorable. “I’ll pay $1 to buy a call option on the S&P500 at 3300”
Complex payout, typically used for structured notes. “I will pay you a
Exotics 6% coupon that accrues for every day the S&P500 is above 2800”
Footer
Some Asset Classes are most focused on Cash

(Bonds) while others are more Derivatives focused
Active Cash and Mostly Cash Mostly Derivatives

Derivatives Business Some Derivatives
Rates Mortgages Currencies
Credit Municipals Commodities
Footer
Traders are also split within an asset class between

Short-Term and Long-Term Bonds
Buy Side Investors Sell- Side
Banks, Retail Brokerages, Asset Managers, Mutual Funds, Buy From
Broker-Dealers,
Insurance Companies, Pension Funds, Hedge Funds Investment Banks
Liabilities + Money Market Bonds

Assets
Equity (Short-Term) (Long Term)
T-Bills Treasuries
Central Bank
Pensions
Currency
Bonds Discount Notes Agencies
Infrastructure
VRDO, CP Muni
Cash
Brokerage Mortgages Repo (Financing) MBS
Retirement Auto Loans
Insurance Credit Cards Asset Backed CP ABS
House, Car
Cash CLO, Loans
Loans Commercial Paper
Pension
Inventory
Bonds Corporate Bonds
Factories Equity CD / Bank Deposit
Shares/Equities
Footer
Overview of Money Markets

• Individuals typically leave cash in bank accounts, and benefit from deposit insurance up to the
maximum of $250,000. Interest rates vary, but many checking accounts pay very low interest
rates
• Companies, Governments and Buy-Side Investors all have cash balances in excess of $250,000
and have a desire to earn higher interest rates than a deposit account. They use their cash to
buy securities directly, or hire an asset manager to invest their cash (money market fund)
• Money Markets generally provide lower cost financing compared to issuing longer dated debt,
and many issuers use short term debt as a permanent part of their financing strategy. A
common form of short-term debt is commercial paper, abbreviated CP
• Bond investors can finance their bonds using the repo market, with financing rates for repo
generally closely linked to other short term rates.
• Banks participate on both sides, using the money markets to borrow cash, and using the money
markets to invest excess cash
• Money market rates, including LIBOR and SOFR, form the basis of financing rates used across
all financial products.
Footer
The US Fixed Income Market is Huge - $43 Trillion
Corporate
Bonds
$9,200.7bn
MBS
(Mortgages)
$9,732.3bn
Treasury
Securities
$15,608.0bn
Source: SIFMA. Long-Term Debt Only
Footer
Overview of Mortgage Backed Securities

• Mortgage Backed Securities are a common way to finance mortgages in the US, UK
and Netherlands. The US MBS Market is huge, larger than the corporate bond market
• Mortgage Loans are placed into an SPV, a holding company for the mortgages. The
SPV issues MBS bonds. As the homeowners that took out the underlying loans make
mortgage payments, they go to the MBS bondholders.
• In the US, the market is split into Agency Mortgages and Non-Agency Mortgages.
◽ For Agency Mortgages, a government agency (e.g. Freddie Mac or Fannie Mae)
guarantees the mortgage loan. If the underlying homeowner defaults, the agency
takes the credit risk and repays the loan
◽For Non-Agency Mortgages, there is no guarantee and the bond investors take the
credit risk of the underlying borrowers. This risk is reflected in the interest rate
these borrowers pay, as well as overcollateralization, having a higher value of
loans than MBS bonds issued
Footer
Financing mortgages outside of the US

• In Canada and most of Europe, banks use Covered Bonds to finance
mortgages
• Covered Bonds are issued by a bank and are also secured by a pool of
mortgages
• Covered Bonds are considered less risky than Corporate Bonds as
they are two source of repayment, either from the bank of from the
underlying mortgages.
• As covered bonds are less risky than corporate bonds, they have a lower
return for investors and cost the bank less to borrow with compared to
corporate bonds
Footer
Overview of Asset Backed Securities

• Asset Backed Securities work the same way as Mortgage Backed
Securities
• Although Mortgages are technically an “asset” – we differentiate MBS
and ABS
• ABS is typically used to refer to financing:
◽Credit Card Loans
◽Car Loans / Leases
◽Student Loans
• The ABS market is smaller than the MBS market as most consumers
borrow much less for cars, credit cards and student loans than for
mortgages
Footer
Investment Bank’s Trading Floors are Divided by

Asset Class
Traders: By Desk, Type of Bonds Sales: By Asset Class and By Investor
Treasury Rates Hedge Fund

Treasuries
Trader Sales
Agency Rates Central Bank

Agencies
Trader Sales
Mortgage
Mortgages
Trader
Credit
Credit
Trader
Footer
Hierarchy of a Trading Desk

• Director or Managing Director
Desk Head
• Responsible for the P&L of all
the traders
Bills
2-5 Year 7-10 year 30 Year
Short-Term
• Traders are divided into groups and focus on one part of their part of the market. It can be
divided by how long the bond is, or for industry sectors for corporate bonds
• Each one of these groups generally has a more senior trader responsible for trading that
type of bond, and a more junior trader that helps them booking trades and hedges
• Each senior trader has a back-up trader, who knows the product and trades for the senior
trader when they are away
Footer
US Market Size: Investors and Investments
Investors Investments
Households Mutual Funds US Fixed Income

$42 Trillion $18 Trillion AUM $43 Trillion
Direct and via Mutual Funds Outstanding
Retirement ETFs
$3 Trillion AUM US Equities
$34 Trillion
Pensions, Insurance, $30 Trillion
401k. IRAs Market Cap
Hedge Funds
$3 Trillion AUM
Foreign Investors
Derivatives
$17 Trillion Banks
Securities Investments
$690 Trillion
$4 Trillion Notional Outstanding
excludes Mutual Funds Securities Investments
Source: SIFMA Capital Markets Factbook 2019, Federal Reserve
Footer
Fixed Income and Equity Investors Differ

Significantly
US Bonds Investors US Equity Investors
Insurance, Other, 1%
2%
Other,
Asset
7% Foreign
Manager / US
Funds, Investors,
Banks,
16% 15% Asset
1%
Manager /
Foreign Retirement Funds,
Investors, Accounts, 30%
Federal
27% 9%
Reserve, 0%
Households
& Non-
Profits, Households Retirement
10% & Non- Accounts,
Insurance, Federal Profits, 39% 12%
11% Reserve,
10%
US Banks,
10%
Source: SIFMA and Federal Reserve
Footer
Sales & Trading Career Ladder
Footer
What does your desk look like?
Name
Plate
Bloomberg
“IB Chat”
Multiple
Monitors
Headset
Bloomberg Turret
Keyboard
Regular
Mouse
Footer
How do I use the turret: Classic Turret
Microphone
Page Up/Down
for “Hoot” Different Lines
Lines
Number
Pad
How do I
dial out?
Volume Mute
“Hunt”
New Line
Left/Right Left/Right Release

Hold Handset “Hang Up”
Conference
Footer
How do I use the turret: New Turret
Page
Microphone Different Up/Down
for “Hoot” Lines Lines
Left/Right
Handset
Volume
Number
Pad Mute
Left/Right Release
Conference “Hang Up”
and Hold
Footer
The Bloomberg Keyboard
Key Code Description Key Code Description Key Code Description

F2 Govt Government Bonds F5 M-mkt Money Markets F9 Cmdty Commodity
F3 Corp Corporates F6 Muni Municipals F10 Index Index (S&P500)
F4 Mtge Mortgages (& ABS) F7 Pfd Preferred Stock F11 Crncy Currency (FX)
F8 Equity Common Stock
You can always type in the product Code if you do not have a Bloomberg Keyboard on your terminal
Footer
Bloomberg MSG vs IB Chat

Exchange Traded versus Over-The-Counter

Exchange Traded – Most Stocks
Buy Side Sell Side

Exchange
Investor IB/Broker
Sets Prices
Collects Commissions Connects Buyers to Sellers
Over-The-Counter (OTC) – Most Bonds
Buy Side Sell Side

Investor IB/Broker
Sets Prices
Connects Buyers to Sellers
Trading P&L
Footer
Car Dealership Analogy for OTC Trading

Analogy: Car Dealership What is the trade-in value?
• If I wanted to sell my existing car, I
could take it to a car dealership, and
ask them for a quote on where they
would buy my car
• The car dealer provides a price. I can..
◽ Accept the price and sell my car
◽Compare with another dealer
How much for this car?
◽Decide to do nothing
• The same thing works if I wanted to
buy a car. They have cars to sell and
advertised prices. I can ask for a quote,
I can shop it around, and only trade
when I want to
Footer
Car Dealership Analogy for OTC Trading

Analogy: Car Dealership Car Dealer Takeaways
• If I wanted to sell my existing car, I • Dealers job is to provide prices where
could take it to a car dealership, and they will buy or sell the car
ask them for a quote on where they • Dealers provide prices where they will
would buy my car buy almost every car. Even if they don’t
like the car, it will fetch some price at
• The car dealer provides a price. I can.. auction
◽ Accept the price and sell my car • Customers decide when to buy or sell,
and what to buy or sell. Customers turn
◽Compare with another dealer quotes to actual sales on their own
timeframe
◽Decide to do nothing
• Pricing needs to be somewhat
• The same thing works if I wanted to competitive as customers will price shop
buy a car. They have cars to sell and • Dealers hold inventory
advertised prices. I can ask for a quote,
I can shop it around, and only trade • Dealers send advertisements on cars
when I want to they can sell with prices
Footer
How OTC Trading works?

OTC Trading Car Dealer Takeaways
• Traders provide prices where they will • Dealers job is to provide prices where
buy or sell bonds they will buy or sell the car
• Dealers provide prices where they will
• Buy-Side investors expect Sell-Side buy almost every car. Even if they don’t
Traders to bid on almost every traded like the car, it will fetch some price at
bond auction
• Buy-Side investors decide on the timing • Customers decide when to buy or sell,
to buy of sell and transact on their own and what to buy or sell. Customers turn
quotes to actual sales on their own
time frame. Buy-Side investors will
timeframe
compare prices with different banks
• Pricing needs to be somewhat
• Traders hold bond inventories of bonds competitive as customers will price shop
they have bought to sell to other
• Dealers hold inventory
investors
• Dealers send advertisements on cars
• Trader Runs, are a price list of bonds they can sell with prices
that the trader is willing to buy and sell
Footer
Bid / Offer Directionality
• Most trades are quoted in a two-way, where will I buy or

sell this same bond
• These are quoted in the trader direction

Trader Bid-Offer
◽Bids are where the Trader Buys (Client Sells)
◽Offers or Asks are where the Trader Sells (Client Buys) 90 92

• The Slash “/” Separates out the Bid and the Offer: “90/92” Bid Offer
• “Buy Low, Sell High” applies to quoting trades
◽Bids are always lower in Price than Offers
◽For bonds quoted in a spread (or yield basis), the bid is

the higher yield/spread and the lower price
• The average or middle value between the bid and the offer
is called the Mid. The Mid is used for valuations
Footer
Trader Runs: Menus of Bond Prices
RUNZ <GO> on Bloomberg lets Salespeople and Investors receive

traders set prices RUNS
Salesperson tip: 3 <GO> 1 <GO> to forward
Footer
Bond trades are confirmed via Bloomberg VCONs
Footer
Flow Traders profit from crossing the bid-offer
These two trades will

happen at different
times. The market hedge
offsets market move to
the bond price, but does
have transaction costs
Footer
Liquidity and Market Depth

• There are related concepts covering how much you can buy or sell at
one time, and how much you can buy or sell at one time without moving
prices
• There is a concept of “socialable size” which is a standard unit of trade
depending on market. It could be $5mm units for High Grade
Corporates, $1mm in Emerging Markets, or $50mm for US Treasuries
• Anything larger than the socialable size would need to be discussed.
This is why quotes generally have a size attached to them
• Securities that are more liquid and have more depth generally have
more trading volume and a diverse set of investors, each owning a
relatively small percentage of the overall security
Footer
Swaps can hedge a variety of Fixed Income risks
Risk Cause of Bond Price Decline
Bank deposit rates rise, investors want more yield to

Interest Rate Risk
own bonds. Yields rises, prices decline
Investors worry about bonds being repaid and demand

Credit Default Risk
more yield to own bonds. Yields rises, prices decline
The bond issuer pays coupons and principal in a

Foreign Exchange
different currency. I’m worried if the value of that
Risk
currency falls
Footer
Interest Rate Swaps to Hedge Interest Rate Risk

• If you’re looking to hedge the Interest Rate Risk to a Fixed Rate Bond
you bought, you would Pay Fixed on an Interest Rate Swap.
• You would pay a Fixed Interest Rate to your hedge counterparty, who
pays you a LIBOR floating rate which increases as rates increase
• The swap is valued based on the present value of future cash flows and
can approximate the impact of interest rate moves on bonds
Buy Bond as a Pay Fixed

Fixed Rate Bond Trader P&L
Flow Trader IR Swap
Interest Rates Yield Higher, Yield Higher, Bond Loses,
Higher Price Lower Price Higher Swap Gains
Interest Rates Yield Lower, Yield Lower, Bond Gains,
Lower Price Higher Price Lower Swap Loses
Footer
Credit Default Swaps (CDS) to Hedge Credit Risk

• Spreads are yield differential bond investors demand to hold credit risk. It’s the
additional yield over a “risk free” government bond or bank deposits
• If you’re looking to hedge the Credit Risk to Bond you bought, you would buy
protection on CDS.
• You would pay a periodic insurance premium to your hedge counterparty, who
would cover your losses should the bond default. The value of the insurance can
be present-valued and sold when you sell the bond
Buy Bond as a Buy Protection

Fixed Rate Bond Trader P&L
Flow Trader on CDS
Credit Risk Spreads Higher, Spreads Higher, Bond Loses,
Higher Price Lower Price Higher CDS Gains
Credit Risk Spreads Lower, Spreads Lower, Bond Gains,
Lower Price Higher Price Lower CDS Loses
Footer
Cross Currency Swaps hedge both Issuers and

Investors
• The US Dollar Fixed Income Market is the largest and deepest Fixed Income
Market. The next largest is the Euro Fixed Income market and the third largest
is the Japanese Yen. Together, these three currencies are called the G3
• Not every Bond Issuer needs USD and international companies may need funds
in a different currency
• Not every Bond Investor has a home currency of USD.
• Cross Currency swaps exchange one set of currency cashflows to another:
◽I.e. Canadian Corporate borrowing in USD and hedging the cashflows back
into Canadian Dollars
◽Japanese Investor buying a USD bond and hedging the cashflows back into
Japanese Yen
Footer
Swaps can hedge a variety of Fixed Income risks
Risk Swap Hedge Direction
Interest Rate Swap Buy a Fixed Rate Bond,

Interest Rate Risk
(Swaps, IRS) Pay Fixed on IRS
Credit Default Buy a Bond,

Credit Default Risk
Swap (CDS) Buy Protection on CDS
Foreign Exchange Cross Currency Buy a Bond,

Risk Swap (CCS) Hedge to Home Currency
Footer
• Cash Equities Introduction
to Bonds
W W W. W A L L S T R E E T P R E P. C O M
v
Introduction to Bonds
Chapter Overview
• Bearer Securities
• Bond Coupons
• Bloomberg DES Screen
• Coupons versus Yields
• Expected Returns, Carry & Roll-Down (or Slide)
Footer
Bearer versus Registered Securities

Securities used to be issued on pieces of paper (Bearer)
Bearer Stock Certificate Bearer Bond Certificate
$1,000
Principal
$40
Coupon
• Bearer Securities: Your ownership in the stock and bond is based on who owns the piece
of paper. You exchange the piece of paper for cash when you trade
• Registered Securities: Your ownership of a stock and bond is tracked
by a central depository. Central lists of who has bought and sold
securities. No pieces of paper exchange hands. Each security has an
identifier (CUSIP) in the US and ISIN in Europe
Footer
Overview of the Stock Certificate
Bearer Stock Certificate • Stocks represent a share or fractional

ownership in a company
• Owners of stocks, shareholders, can
receive dividends or a share of the
company’s profit. Dividend payments
are not required or contractual
• Shares of a stock can be sold on an
exchange. Current trading prices are
published
• Share prices are driven by supply and
demand, with the company’s future
expected earnings being a key driver
Footer
Overview of the Bond Certificate

• Bonds reflect a borrowing of cash
between an Issuer and a number Bearer Bond Certificate
of Investors
• The total amount borrowed (e.g. $1,000
$1 billion) is called the notional Principal
• The notional is divided into

denominations or denoms, $40
which reflect the smallest unit you Coupon
could buy.
• $1,000 Denoms remain quite common and still used to this date
• If I bought $1 million of this bond, I would have one thousand of these
bearer bond certifications (1,000 x 1,000 = 1 milllion)
Footer
Maturity Dates and Tenors

• Each bond has a maturity date,
which is the date the investors in Bearer Bond Certificate
aggregate receive the notional
from the Issuer. The repayment of
the amount borrowed is called a $1,000
Principal
Principal Payment
• For Bearer Bonds, you would
$40
exchange the piece of paper, with Coupon
the $1,000 on it, for $1,000. If you
bought $1 million of bonds, you
would do this one thousand times
• The number of years to maturity is referred to as the tenor (e.g. a 2 year
bond)
Footer
Coupon Dates
• Each bond has an Issue Date
which is the date the initial bond Bearer Bond Certificate
investors gave cash to the Issuer
and received the Bond certificate
$1,000
• In between the Issue Date when Principal
you provide the Issuer with cash,
and the Maturity Date where you
$40
receive your cash back, you have a Coupon
series of Coupon Dates
• Coupon Dates are generally in a set frequency (semi-annually in the US)
and annually in Europe. On each coupon date, the coupon on the
certificate is removed and exchanged for the coupon payment ($40)
• These payments are contractual or mandatory, unlike a stock dividend
Footer
Fixed versus Floating Rates

• Historically, all bond payments
were Fixed Rate, meaning you Bearer Bond Certificate
received the same payment ($40)
on each payment date
$1,000
• Now, bonds can also have Floating Principal
Rate payments, meaning the
coupon you receive is calculated
$40
based off of a rate index. You Coupon
receive a higher coupon when the
index rate is higher, and a lower
coupon when the Index Rate is
lower.
Footer
Fixed Rate Coupon Rates
Coupon Rate Semi-Annual Payment Denomination Coupon Payment

(Annual) 2 Payments Per Year
8% 2 $1,000 $40.00
Bearer Bond Certificate
• The Coupon Rate is the annual

interest rate paid on the bond, $1,000
based on the Principal or Principal
Notional Amount of the bond

$40
Coupon
Footer
Typical Coupons
• Government Bonds typically price to an one-eight coupon
• Coupons would step-up in increments of 0.125% (e.g. 4%, 4.125%,
4.25%, 4.375%, 4.5%, 4.625%, 4.75%, 4.875% and 5% were the
permissible coupons between 4% and 5%)
• When describing the bonds verbally you quote these in fractions, “four
and one eighth” not “four point one two five”
• Historically US High Grade Bonds have priced to an one-eighth coupon,
but over the past few years the market has moved to increments of
0.05% (4%, 4.05%, 4.10%, etc…)
• Why not be more specific? Rounding. With a par value of $1,000, market
participants wanted to avoid a scenario of rounding where the coupon
payment needed to be rounded up or down
Footer
LIBOR
• 3 month US Dollar LIBOR is the most common floating rate
◽This represents a 3 month bank deposit rate, and is published daily
◽If I placed extra cash at the bank for 3 months, this is the rate I would earn
today for a 3 month Certificate of Deposit at a bank
• LIBOR is commonly used for bonds that pay a floating rate, called Floating Rate
Notes (or FRNs). Fixed Rate Notes are spelt out FXD.
• Every 3 months, they pay the interest based on the LIBOR rate for that coupon
period, plus a spread.
• Investors would compare that return to a cash return, investing in a 3 month
bank deposit or Certificate of Deposit, and rolling that deposit every 3 months
at the then current interest rate. The spread is the additional yield an investor
would earn versus rolling those bank deposits
Footer
Example of a Floating Rate Note

• Here is an example of a
Floating Rate Note that we’ll
take a look at in a later
course
• This is a 3 year FRN
• This FRN pays 3 month USD

LIBOR plus 66 basis points
• A basis point is 0.01%, which

means an investor would
earn 0.66% more than
rolling 3 month CDs for 3
years by buying this 3 year
FRN bond
Footer
Many Fixed Income Investments are available in

Fixed and Floating Rate Coupons
Buy Side Investors Sell- Side
Banks, Retail Brokerages, Asset Managers, Mutual Funds, Buy From
Broker-Dealers,
Insurance Companies, Pension Funds, Hedge Funds Investment Banks
Liabilities + Money Market Fixed Rate Floating Rate

Equity
Cash Foreign Exchange
T-Bills Treasuries Treasury FRN

Currency Agency Agency FRNs
Bonds Discount Notes
VRDO, CP Muni Auction Rate
Repo (Financing) MBS

Mortgages
Auto Loans ABS
Credit Cards Asset Backed CP
CLO, Loans
Loans Commercial Paper Corporate FXD Corporate FRN
Bonds
Equity CD / Bank Deposit Shares/Equities
Footer
Exercise 1: Decoding the Bloomberg DES Screen
CUSIP:
Issuer:
Notional:
Issue Date:
Maturity Date:
Tenor:
Coupon Rate:
Coupon
Frequency:
Coupon on
$1,000 notional:
Bloomberg Tip: To pull up the following screen, type T 2.375 05/15/29 Govt <GO> and then DES <GO>
Footer
Example of actual bond terms
CUSIP: 9128286T2
Issuer: US Treasury
Notional: 36 Billion
Issue Date: 05/15/2019
Maturity Date: 05/15/2029
Tenor: 10 Years
Coupon Rate: 2.375%
Coupon Semi-Annually
Frequency:
Coupon on $11.875 2 coupons
2.375% $1,000 $11.88
$1,000 notional: per year
Bloomberg Tip: To pull up the following screen, type T 2.375 05/15/29 Govt <GO> and then DES <GO>
Footer
Coupons versus Yields

• Coupon - The coupon represents the rate of annual interest paid based on the
notional of the bond
• Yield - The yield is the annual return on the bond including the coupon
payment adjusted for the premium or discount of the purchase price when held
to maturity
• Coupons are fixed for the life of the bond, and yields move with the markets
In General Discount Par Premium

Price < 100 Price = 100 Price > 100
Price
Yield Greater Yield Equal Yield Less
Yield
Than Coupon to Coupon Than Coupon
Footer
Bond Pricing Example

• Bond Prices, are technically quoted in
percentages, but in dollar prices, with $100 equal
to 100%
• If I wanted to buy $1,000 of the following bond at
$100
◽It’s NOT $1,000 x $100 = $100,000, but…
◽It’s $1,000 x 100% = $1,000
• You also need to trade in round increments of the
bond
◽You can buy $2,000 of the bond (2x1,000)
◽You cannot buy $500 of the bond and split the
certificate in half
Footer
Let’s revisit our paper bond example
Notional: $1,000
Issue Date: Today
Maturity Date: 2 Years from Today
$1,000
Tenor: 2 Years Principal
Coupon Rate: 8%
Coupon Frequency: Semi-Annually
$40
Coupon on $1,000 $40 Coupon
notional:
6m 1y 18m 2y
Price: $100 (100%) $40 $40 $40 $40
Cost to Buy: $1,000
($1000 x 100%)
Footer
Bond Cashflows: Buy Bond at Par (100%)
Today 6 months 1 year 18 months 2 years

(1,000) 40 40 40 1,040
Tear out Tear out Tear out Send in

Pay 100% x $40 Coupon $40 Coupon $40 Coupon principal
$1,000 = Receive $40 Receive $40 Receive $40 and last
$1,000
coupon.
Receive
Receive
Bond
$1000+40
Footer
Exercise 2: Return Calculation Example (1/6)

• For our first step, let’s take each period’s cashflow and divide it by our
$1,000 investment, and express the answer as a percentage

Cashflow (1,000) 40 40 40 1,040
% of Initial -100% 4% 4% 4% 104%
Investment


• For our semi-annual return, let’s remove the -100% at the beginning and
100% from the end. That’s the $1,000 put into the investment and the
$1000 we get back at the end of the investment. All the cashflows in
addition to that is interest, or the return we get on the investment
Cashflow (1,000) 40 40 40 1,040
% of Initial -100% 4% 4% 4% 104%
Investment
Semi-Annual 4% 4% 4% 4%
Return
-100% + 104% -
Same Same Same
100% = 0 100% = 4%


• Let’s add up the Semi-Annual Returns to get an Annual Return for our
First and Second Years
Cashflow (1,000) 40 40 40 1,040
% of Initial -100% 4% 4% 4% 104%
Investment
Semi-Annual
4% 4% 4% 4%
Return
Annual Return 8% 8%
Year 1 Year 2
Annual Annual
Return Return


• Let’s average the Semi-Annual Returns to get an Annual Return for our
First and Second Years
Cashflow (1,000) 40 40 40 1,040
% of Initial -100% 4% 4% 4% 104%
Investment
Semi-Annual
4% 4% 4% 4%
Return
Annual Return
8% 8%
(each year)
Annual Return 2
(Total, until
maturity) 8%

Price Today 6 months 1 year 18 months 2 years

$100 (100%) (1,000) 40 40 40 1,040
Par
$98 (98%) (980) 40 40 40 1,040
Discount
$102 (102%) (1,020) 40 40 40 1,040
Premium
Cashflow today changes Future Cashflows are Fixed

based on price paid Printed on the Coupon / Notional
Footer

• In your excel sheet, let’s run the same calculation for the Discount and
Premium Bonds
$100 (100%) Par (1,000) 40 40 40 1,040
$98 (98%) Discount (980) 40 40 40 1,040
% of Initial Investment
Semi-Annual Return
Annual Return (Each Year)
Annual Return (Until Maturity)
$102 (102%) Premium (1,020) 40 40 40 1,040
% of Initial Investment
Semi-Annual Return
Annual Return (Each Year)
Annual Return (Until Maturity)
Footer

• In your excel sheet, let’s run the same calculation for the Discount and
Premium Bonds
$100 (100%) Par (1,000) 40 40 40 1,040
$98 (98%) Discount (980) 40 40 40 1,040
% of Initial Investment -100% 4.1% 4.1% 4.1% 106.1%
Semi-Annual Return 4.1% 4.1% 4.1% 6.1%
Annual Return (Each Year) 8.2% 10.2%
Annual Return (Until Maturity) 9.2%
$102 (102%) Premium (1,020) 40 40 40 1,040
% of Initial Investment -100% 3.9% 3.9% 3.9% 102.0%
Semi-Annual Return 3.9% 3.9% 3.9% 2.0%
Annual Return (Each Year) 7.8% 5.9%
Annual Return (Until Maturity) 6.9%
Footer
Returns versus Yields

• The Annual Return of the Bond closely approximates the Yield of the
Bond
• We’ll formalize the definition of Yield later on
• The primary simplification is the compound interest, earning Interest
on Interest. For our example, we averaged the interest rates which
works for shorter bonds and for bonds trading close to par (not a large
premium or discount)
Scenario Price Coupon “Return” Yield

Par $100 8.0% 8.0% 8.0%
Discount $98 8.0% 9.2% 9.1%
Premium $102 8.0% 6.9% 6.9%
Footer
Review: Price / Yield Directionality

Scenario Price Coupon “Return” Yield
Par $100 8.0% 8.0% 8.0%
Discount $98 8.0% 9.2% 9.1%
Premium $102 8.0% 6.9% 6.9%
In General Discount Par Premium

Price < 100 Price = 100 Price > 100
Price
Yield Greater Yield Equal Yield Less
Yield
Than Coupon to Coupon Than Coupon
Discount represents Premium is “prepaying”

additional coupon for a high coupon
Footer
Returns on a bond
• If you hold your bond to maturity:
◽Yield: Calculates the price you buy at and all the cashflow you receive on the bond
• If you are planning to sell your bond before maturity:
◽Realized Return:
▸You can only calculate this after you sell your bond and exit your position
Realized Price Change on

Carry
Returns the Bond
◽Expected Return:
▸You can calculate this before you buy your bond. Based on the current market
environment and does not factor in future market movements
Expected Slide or
Carry
Returns Roll Down
Footer
Expected Returns
• Why do we consider Expected Returns?
◽Bond Trading desks and Hedge Funds may only hold bonds for a short period
◽Asset Managers and other “longer-term” investors still need to report quarterly or
periodic statements
• If the Fed raises interest rates and investors earn more for bank deposits. You would
expect investors to demand a higher yield for bonds.
◽If bonds yields rise in the future, bond prices decline (losses for the investor currently
owning the bonds)
◽If bond yields decline in the future, prices rise (gains for the investor currently owning
the bonds)
• Expected Returns are based on the current expectations of interest rates in the future
• Expected returns do not factor in future changes in expectations,
Footer
Carry
• Carry refers to the income generated during the investment, less any
financing costs
• It’s calculated over a period:
◽Overnight if you a trading desk
◽Quarterly or Annually if you are an Investor
• When calculating carry for the expected return, we use the annual yield
of the bond (in percentages), even when looking at an overnight trade
◽Bond yield of 8%
◽Financing rate of 2%
◽Carry of 6%
Footer
Slide: Revisiting our Keybank 3 year FRN

• Let’s take a look at our Keybank 3
year Floating Rate Note
• You received Libor + 0.66% or
Libor + 66 basis points (bps) as
interest
• If you bought a 3 month CD and
rolled it every quarter, you would
get LIBOR without the spread
• Here, you get 66 extra basis points
for holding it for 3 years. How
much would you get for 2 years? 1
year?
Footer
Market spread for the Keybank FRN
70 66 Slide: The gain from the FRN going from a 36

60 57 month bond at 66 bps to a 33 bond a 57 bps
49
50
41
Spread to LIBOR
40
33
30 27
21
20 15
10
10 6
3
0
0
36 33 30 27 24 21 18 15 12 9 6 3
Months to Maturity
Footer
Illustrating the gain on Slide (66->57 bps)

If the Bond was bought at a spread of 3mL+66 bps and sold at
3mL+57 bps, the 9 bps gain on all the remaining coupon
payments go to the original investor (seller at 3mL+57)
70
60 9 9 9 9 9 9 9 9 9 9 9
Spread to LIBOR
50
40
30 66
57 57 57 57 57 57 57 57 57 57 57
20
10
0
33 30 27 24 21 18 15 12 9 6 3 0
Months to Maturity
Market Spread Slide Gain
Footer
Calculating the Expected Return on the Keybank FRN

• Assumptions:
◽Buy the FRN at $100 (100%) at 3-month LIBOR + 66 basis points
(annual rate)
◽Finance rate of the bond at 3-month LIBOR (annual rate)
◽Bond Slides to a spread of 3-month LIBOR + 57 basis points in 3
month
• Calculate the expected return for a 3 month period using the following
formula
Expected Slide or
Carry
Returns Roll Down
Footer
Example: Calculating Expected Return

• Carry
◽Yield on Bond: 3 month LIBOR + 66 basis points
◽Finance Rate on the Bond: 3 month LIBOR
◽Carry: 66 basis points or 0.66% annually
• Slide
◽Current Bond (36 month): 3 month LIBOR + 66 basis points
◽33 months: 3 month LIBOR + 57
◽Gain: 9 basis point, 0.09% for the remaining 33 months
◽0.09% x 33 months / 12 months a year = 0.2475% a year
• Expected Return = Carry + Slide
• Expected Return = 0.66% + 0.2475% = 0.9075%
Footer
Example 3: Calculating Expected Return

• Assumptions:
◽Buy the FRN at $100 (100%) at 3-month LIBOR + 66 basis points
(annual rate)
◽Finance rate of the bond at 3-month LIBOR (annual rate). Pay the
current 3 month LIBOR rate every 3 months (match the bond LIBOR
payments)
◽Bond Slides to a spread of 3-month LIBOR + 33 basis points in 12
months
• Calculate the expected return for a 12 month period in Excel
Footer
Example 3 Solved: Calculating Expected Return

• Carry:
◽Buy the FRN at $100 (100%) at 3-month LIBOR + 66 basis points (annual rate)
◽Finance rate of the bond at 3-month LIBOR (annual rate). Pay the current 3
month LIBOR rate every 3 months (match the bond LIBOR payments)
◽66 basis points or 0.66% Annually
• Slide:
◽Buy the bond at 3mL+66, Sell the Bond at 3mL+33
◽Gain of 33 basis points, or 0.33% for the remaining 24 months
◽0.33% x 24 months / 12 months in a year
◽66 basis points or 0.66% Annually
• Expected Return (carry + slide) = 0.66% + 0.66% = 1.32% Annually
Footer
Investor versus Trading Desk Return Calculation
Today 3 months
Investor Hold FRN for entire period

• Earn Carry + Slide
Trading
Desk Buy / Sell Buy / Sell Buy / Sell Buy / Sell
Trading Desk
• Wait for Seller: Buy at Bid-Side Repeat, Earn
• Earn Carry & Slide while on Balance Sheet More Bid-Ask
spread the more
• Wait for Buyer: Sell at Ask
times you trade
• Make Bid-Ask Spread (e.g. 3 bps running)
Footer
Interest Rate Swaps

• Interest Rate Swaps are a derivative that allows investors to convert
Floating Rate cash flows into Fixed Rate cash flows
• Standard conventions are one side pays LIBOR and for a specified tenor
(e.g. 5 years or 10 years) and you solve for the fixed rate on the other side
• This coverts a stream of LIBOR payments into a known coupon rate based
on the current expectation of interest rates and allows investors to compare
Floating Rate Bonds and Fixed Rate Bonds in like terms
• The Swap market is deep and liquid and investors can use swaps to take
opposite views of bonds.
◽They can lock in today’s view on future LIBOR rates using swaps
◽They can convert fixed rates to LIBOR and receive higher LIBOR
payments if LIBOR increases, and lower LIBOR payments if LIBOR goes
down
Footer
Spread to Swaps
• In our Keybank Bond example, the Floating Rate Note pays a coupon of
66 basis points (0.66%) above LIBOR. Keybank also has a 3 year Fixed
Rate Bond that matures the same day. How do we compare which is the
more attractive bond to buy?
• If the 3 year swap rate is 1.79%
◽The Keybank FRN would have an equivalent Yield of 1.79%+0.66%
or 2.45%
◽The Keybank Fixed Rate Bond yields 2.50%. This would pay 5 bps
more than this Keybank FRN, and would have an equivalent spread of
2.50% Yield minus 1.79% Swap Rate = 3mL+71 bps (0.71%)
◽We would call this 3 year Fixed Rate bond yielding at 2.50% to be
trading at a spread to swaps of 71 basis points (I+71, Z+71, ASW+71)
Footer
Expected Returns of Fixed Rate Bonds

• Using a spread to swaps, we can run a similar analysis for fixed rate bond as
we did for a floating rate bonds
• By using spread to swaps, we can normalize for the expectation for future
financing rates for the bond
• Investors can easily hedge the interest rate exposure using interest rate
swaps, but many investors (such as life insurers) want the interest rate
exposure
Expected Slide or
Carry
Returns Roll Down
Spread to Swaps of the Bond Expected declined in the spread

(Assumes LIBOR financing to swaps adjusted for the
rate) remaining months to maturity
Footer
Recap: Return Metrics on a Bond
• Fixed Cashflows you receive on the Bond

Coupon • Does not change once bond is issued
• Bond Return when held to maturity adjusted for the purchase price
Yield (discount/premium)
• How much you earn for holding the bond, adjusted for a financing
Carry rate or cash interest rate
• Yield minus the Interest Rate Swap Rate to calculate the yield in
Spread to
excess of LIBOR (funding rate) over a period of time. Adjusts for
Swaps forward interest rate expectations
• Expected price gain on the bond due to the spread to the bond’s
Slide or Roll
swaps declining at the end of the observation period. Assumes
Down current projected interest rates hold
Footer

FI02 Intro To Fixed Income Trading and Bonds 6523d55268da1

Uploaded by

Document Information

Original Title

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

FI02 Intro To Fixed Income Trading and Bonds 6523d55268da1

Uploaded by

Copyright:

Available Formats

• Cash Equities Fixed Income

Sales & Trading Divisions of an Investment Bank are

Cash versus Derivatives

Overview of Derivatives Types

Agreement to lock in a price of an asset for delivery in the future. “I

Agreement to exchange one set of cashflows for another. “I will pay

Option buyer pays a premium to enter into a pre-defined derivative if

Some Asset Classes are most focused on Cash

Active Cash and Mostly Cash Mostly Derivatives

Rates Mortgages Currencies

Credit Municipals Commodities

Traders are also split within an asset class between

Liabilities + Money Market Bonds

Overview of Money Markets

The US Fixed Income Market is Huge - $43 Trillion

Source: SIFMA. Long-Term Debt Only

Overview of Mortgage Backed Securities

Financing mortgages outside of the US

Overview of Asset Backed Securities

Investment Bank’s Trading Floors are Divided by

Treasury Rates Hedge Fund

Agency Rates Central Bank

Hierarchy of a Trading Desk

US Market Size: Investors and Investments

Households Mutual Funds US Fixed Income

Fixed Income and Equity Investors Differ

Source: SIFMA and Federal Reserve

Sales & Trading Career Ladder

What does your desk look like?

How do I use the turret: Classic Turret

Left/Right Left/Right Release

How do I use the turret: New Turret

The Bloomberg Keyboard

Key Code Description Key Code Description Key Code Description

Bloomberg MSG vs IB Chat

Licensed to Kevin Romanteau. Email address: kromanteau.mifft2021@london.edu

Exchange Traded versus Over-The-Counter

Buy Side Sell Side

Over-The-Counter (OTC) – Most Bonds

Buy Side Sell Side

Car Dealership Analogy for OTC Trading

Car Dealership Analogy for OTC Trading

How OTC Trading works?

Bid / Offer Directionality

• Most trades are quoted in a two-way, where will I buy or

• These are quoted in the trader direction

◽Offers or Asks are where the Trader Sells (Client Buys) 90 92

◽Bids are always lower in Price than Offers

◽For bonds quoted in a spread (or yield basis), the bid is

Trader Runs: Menus of Bond Prices

RUNZ <GO> on Bloomberg lets Salespeople and Investors receive

Salesperson tip: 3 <GO> 1 <GO> to forward

Bond trades are confirmed via Bloomberg VCONs

Flow Traders profit from crossing the bid-offer

These two trades will

Liquidity and Market Depth

Swaps can hedge a variety of Fixed Income risks

Risk Cause of Bond Price Decline

Bank deposit rates rise, investors want more yield to

Investors worry about bonds being repaid and demand

The bond issuer pays coupons and principal in a

Interest Rate Swaps to Hedge Interest Rate Risk

Buy Bond as a Pay Fixed