Bond Markets, Analysis, and Strategies

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Library of Congress Cataloging-in-Publication Data

Fabozzi, Frank J.

Bond markets, analysis, and strategies/Frank J. Fabozzi.—Ninth edition.

pages cm

Includes index.

ISBN 978-0-13-379677-3—ISBN 0-13-379677-9 1. Bonds. 2.

Investment analysis. 3. Portfolio management. 4. Bond market. I.
Title.

HG4651.F28 2016

332.63’23—dc23

2014033129

10 9 8 7 6 5 4 3 2 1
ISBN 10: 0-13-379677-9

ISBN 13: 978-0-13-379677-3

To the memory of my parents,
Josephine and Alfonso Fabozzi.
Contents
1. Preface x

1. 1 Introduction 1

1. Learning Objectives 1

2. Sectors of the U.S. Bond Market 2

3. Overview of Bond Features 3

4. Risks Associated with Investing in Bonds 8

5. Overview of the Book 11

6. Questions 12

2. 2 Pricing of Bonds 14

1. Learning Objectives 14

2. Review of Time Value of Money 14

3. Pricing a Bond 20

4. Complications 26

5. Pricing Floating-Rate and Inverse-Floating-Rate Securities 28

6. Price Quotes and Accrued Interest 30

7. Key Points 31

8. Questions 32

3. 3 Measuring Yield 34
 1. Learning Objectives 34

2. Computing the Yield or Internal Rate of Return on any

Investment 35

3. Conventional Yield Measures 38

4. Potential Sources of a Bond’s Dollar Return 46

5. Total Return 49

6. Applications of the Total Return (Horizon Analysis) 54

7. Calculating Yield Changes 54

8. Key Points 55

9. Questions 55

4. 4 Bond Price Volatility 58

1. Learning Objectives 58

2. Review of the Price–Yield Relationship for Option-Free Bonds

59

3. Price-Volatility Characteristics of Option-Free Bonds 60

4. Measures of Bond Price Volatility 62

5. Convexity 73

6. Additional Concerns When Using Duration 82

7. Do Not Think of Duration as a Measure of Time 82

8. Approximating a Bond’s Duration and Convexity Measure 83

 9. Measuring a Bond Portfolio’s Responsiveness to Nonparallel
Changes in Interest Rates 85

10. Key Points 89

11. Questions 90

5. 5 Factors Affecting Bond Yields and the Term Structure of Interest

Rates 92

1. Learning Objectives 92

2. Base Interest Rate 93

3. Benchmark Spread 93

4. Term Structure of Interest Rates 99

5. Swap Rate Yield Curve 119

6. Key Points 120

7. Questions 122

6. 6 Treasury and Federal Agency Securities 125

1. Learning Objectives 125

2. Treasury Securities 125

3. Stripped Treasury Securities 133

4. Federal Agency Securities 134

5. Key Points 137

6. Questions 138

7. 7 Corporate Debt Instruments 140

 1. Learning Objectives 140

2. Seniority of Debt in a Corporation’s Capital Structure 141

3. Bankruptcy and Creditor Rights 142

4. Corporate Debt Ratings 144

5. Corporate Bonds 146

6. Medium-Term Notes 153

7. Commercial Paper 156

8. Bank Loans 158

9. Default Risk for Corporate Debt Instruments 162

10. Corporate Downgrade Risk 167

11. Corporate Credit Spread Risk 167

12. Key Points 168

13. Questions 169

8. 8 Municipal Securities 172

1. Learning Objectives 172

2. Types and Features of Municipal Securities 173

3. Municipal Money Market Products 178

4. Floaters/Inverse Floaters 179

5. Credit Risk 180

6. Risks Associated with Investing in Municipal Securities 182

 7. Yields on Municipal Bonds 183

8. Municipal Bond Market 184

9. The Taxable Municipal Bond Market 186

10. Key Points 186

11. Questions 187

9. 9 International Bonds 189

1. Learning Objectives 189

2. Classification of Global Bond Markets 190

3. Non-U.S. Bond Issuers and Bond Structures 191

4. Foreign Exchange Risk and Bond Returns 193

5. Bonds Issued by Non-U.S. Entities 194

6. Key Points 206

7. Questions 207

10. 10 Residential Mortgage Loans 209

1. Learning Objectives 209

2. Origination of Residential Mortgage Loans 210

3. Types of Residential Mortgage Loans 211

4. Conforming Loans 219

5. Risks Associated with Investing in Mortgage Loans 220

6. Key Points 221

 7. Questions 221

11. 11 Agency Mortgage Pass-Through Securities 223

1. Learning Objectives 223

2. Sectors of the Residential Mortgage-Backed Security Market

224

3. General Description of an Agency Mortgage Pass-Through

Security 225

4. Issuers of Agency Pass-Through Securities 227

5. Prepayment Conventions and Cash Flow 228

6. Factors Affecting Prepayments and Prepayment Modeling 235

7. Cash Flow Yield 240

8. Prepayment Risk and Asset/Liability Management 242

9. Secondary Market Trading 243

10. Key Points 244

11. Questions 245

12. 12 Agency Collateralized Mortgage Obligations and Stripped

Mortgage-Backed Securities 248

1. Learning Objectives 248

2. Agency Collateralized Mortgage Obligations 249

3. Agency Stripped Mortgage-Backed Securities 282

4. Key Points 284

 5. Questions 285

13. 13 Nonagency Residential Mortgage-Backed Securities 288

1. Learning Objectives 288

2. Collateral Types 290

3. Credit Enhancement 290

4. Cash Flow for Nonagency Mortgage-Backed Securities 296

5. Key Points 301

6. Questions 302

14. 14 Commercial Mortgage Loans and Commercial Mortgage–

Backed Securities 304

1. Learning Objectives 304

2. Commercial Mortgage Loans 305

3. Commercial Mortgage-Backed Securities 307

4. Types of Deals 312

5. Key Points 314

6. Questions 315

15. 15 Asset-Backed Securities 317

1. Learning Objectives 317

2. Creation of an Asset-Backed Security 318

3. Collateral Type and Securitization Structure 323

 4. Credit Risks Associated with Investing in Asset-Backed
Securities 324

5. Review of Several Major Types of Asset-Backed Securities 327

6. Dodd-Frank Wall Street Reform and Consumer Protection Act

334

7. Collateralized Debt Obligations 335

8. Key Points 337

9. Questions 338

16. 16 Pooled Investment Vehicles for Fixed-Income Investors 340

1. Learning Objectives 340

2. Investing in Pooled Investment Vehicles 341

3. Investment Company Shares 342

4. Exchange-Traded Funds 346

5. Hedge Funds 352

6. Real Estate Investment Mortgage Trusts 354

7. Key Points 356

8. Questions 357

17. 17 Interest-Rate Models 358

1. Learning Objectives 358

2. Mathematical Description of One-Factor Interest-Rate Models

359
 3. Arbitrage-Free versus Equilibrium Models 362

4. Empirical Evidence on Interest-Rate Changes 364

5. Selecting an Interest-Rate Model 366

6. Estimating Interest-Rate Volatility Using Historical Data 367

7. Key Points 370

8. Questions 371

18. 18 Analysis of Bonds with Embedded Options 372

1. Learning Objectives 372

2. Drawbacks of Traditional Yield Spread Analysis 373

3. Static Spread: An Alternative to Yield Spread 373

4. Callable Bonds and their Investment Characteristics 378

5. Components of a Bond with an Embedded Option 380

6. Valuation Model 382

7. Option-Adjusted Spread 395

8. Effective Duration and Convexity 395

9. Key Points 397

10. Questions 398

19. 19 Analysis of Residential Mortgage–Backed Securities 400

1. Learning Objectives 400

2. Static Cash Flow Yield Methodology 401

 3. Monte Carlo Simulation Methodology 409

4. Total Return Analysis 423

5. Key Points 424

6. Questions 425

20. 20 Analysis of Convertible Bonds 428

1. Learning Objectives 428

2. Convertible Bond Provisions 429

3. Categorization of Convertible Securities 430

4. Basic Analytics and Concepts for Convertible Bond Analysis

432

5. Option Measures 436

6. Profile of a Convertible Bond 438

7. Pros and Cons of Investing in a Convertible Bond 438

8. Convertible Bond Arbitrage 440

9. Options Approach to Valuation 442

10. Key Points 443

11. Questions 444

21. 21 Measuring Credit Spread Exposures of Corporate Bonds 446

1. Learning Objectives 446

2. Measuring Changes in Credit Spreads 447

3. Measuring Credit Spread Sensitivity 447

 4. Empirical Duration for Corporate Bonds 451

5. Key Points 458

6. Questions 459

22. 22 Corporate Bond Credit Analysis 462

1. Learning Objectives 462

2. Overview of Corporate Bond Credit Analysis 463

3. Analysis of Business Risk 464

4. Corporate Governance Risk 466

5. Financial Risk 468

6. The Investment Decision 471

7. Corporate Bond Credit Analysis and Equity Analysis 472

8. Case Study: Credit Analysis of Sirius XM Holdings Inc. 472

9. Case Study: Sino-Forest Corporation 482

10. Key Points 488

11. Questions 488

23. 23 Credit Risk Modeling 490

1. Learning Objectives 490

2. Difficulties in Credit Risk Modeling 491

3. Overview of Credit Risk Modeling 492

4. Credit Ratings versus Credit Risk Models 493

 5. Structural Models 493

6. Estimating Portfolio Credit Risk: Default Correlation and

Copulas 498

7. Reduced-Form Models 499

8. Empirical Evidence: Credit Ratings, Structural Models, and

Reduced-Form Models 502

9. An Application of Credit Risk Modeling 503

10. Incomplete-Information Models 507

11. Key Points 508

12. Questions 509

24. 24 Bond Portfolio Management Strategies 510

1. Learning Objectives 510

2. The Asset Allocation Decision 511

3. Portfolio Management Team 512

4. Spectrum of Bond Portfolio Strategies 513

5. Bond Benchmarks 515

6. The Primary Risk Factors 521

7. Top-Down versus Bottom-Up Portfolio Construction and

Management 522

8. Active Portfolio Strategies 523

9. Smart Beta Bond Strategies 537

 10. The Use of Leverage 539

11. Key Points 545

12. Questions 546

25. 25 Bond Portfolio Construction 550

1. Learning Objectives 550

2. Brief Review of Portfolio Theory and Risk Decomposition 551

3. Application of Portfolio Theory to Bond Portfolio Construction

552

4. Tracking Error 554

5. Cell-Based Approach to Bond Portfolio Construction 558

6. Portfolio Construction with Multi-Factor Models 560

7. Key Points 575

8. Questions 575

26. 26 Considerations in Corporate Bond Portfolio Management 580

1. Learning Objectives 580

2. Risk–Return for Corporate Bonds versus Equities 581

3. Corporate Bond Benchmarks 583

4. Credit Relative Value Strategies 588

5. Constraint-Tolerant Investing 592

6. Using Credit Risk Modeling to Construct Corporate Bond

Portfolios 595
 7. Liquidity Management for Corporate Bond Portfolios 598

8. Key Points 604

9. Questions 605

27. 27 Liability-Driven Investing for Defined Benefit Pension Plans

607

1. Learning Objectives 607

2. Historical Background 608

3. Understanding the Liabilities of DB Pension Plan Liabilities 608

4. LDI Strategies 611

5. De-Risking Solutions to Mitigate Risk 614

6. Strategies for Hedging Interest-Rate Risk 615

7. Key Points 623

8. Questions 624

28. 28 Bond Performance Measurement and Evaluation 626

1. Learning Objectives 626

2. Requirements for a Bond Performance and Attribution Analysis

Process 627

3. Performance Measurement 627

4. Performance Attribution Analysis 633

5. Key Points 638

6. Questions 639
29. 29 Interest-Rate Futures Contracts 641

1. Learning Objectives 641

2. Mechanics of Futures Trading 642

3. Futures versus Forward Contracts 644

4. Risk and Return Characteristics of Futures Contracts 644

5. Interest-Rate Futures Contracts 645

6. Pricing and Arbitrage in the Interest-Rate Futures Market 651

7. Bond Portfolio Management Applications 658

8. Key Points 676

9. Questions 677

30. 30 Interest-Rate Options 679

1. Learning Objectives 679

2. Options Defined 680

3. Differences Between an Option and a Futures Contract 680

4. Types of Interest-Rate Options 680

5. Intrinsic Value and Time Value of an Option 683

6. Profit and Loss Profiles for Simple Naked Option Strategies 684

7. Put–Call Parity Relationship and Equivalent Positions 696

8. Option Price 698

9. Models for Pricing Options 699

 10. Sensitivity of Option Price to Change in Factors 708

11. Hedge Strategies 712

12. Key Points 718

13. Questions 719

31. 31 Interest-Rate Swaps, Caps, and Floors 721

1. Learning Objectives 721

2. Interest-Rate Swaps 722

3. Interest-Rate Caps and Floors 744

4. Key Points 750

5. Questions 751

32. 32 Credit Default Swaps 754

1. Learning Objectives 754

2. Credit Events 755

3. Single-Name CDS 758

4. Index CDS 764

5. Economic Interpretation of a CDS and an Index CDS 766

6. Using CDSs for Controlling Credit Risk 768

7. Key Points 769

8. Questions 770

1. Index 773
Preface
The objective of the first edition of Bond Markets, Analysis, and
Strategies published in 1989 was to provide coverage of the products,
analytical techniques for valuing bonds and quantifying their exposure to
changes in interest rates, and portfolio strategies for achieving a client’s
objectives. In the seven editions subsequently published and in the current
edition, the coverage of each of these areas has been substantially updated.
Throughout this book there are practical applications of principles as
provided by third-party commercial vendors.

Each edition has benefited from the feedback of readers and instructors
using the book at universities and training programs. I benefited from
many discussions with chief investment officers, portfolio managers,
analysts, traders, and regulators, as well as my experiences serving on the
board of directors of two BlackRock fund complexes and consulting
engagements,

I am confident that the ninth edition continues the tradition of providing

up-to-date information about the bond market and the tools for managing
bond portfolios.

Chapters New to the Ninth Edition

Chapter 16: Pooled Investment
Vehicles for Fixed-Income
Investors
The chapters prior to this chapter in the book focus on individual debt
instruments. This new chapter describes investment vehicles that represent
pooled investments and are also referred to as collective investment
vehicles. They include investment company shares, exchange-traded
shares, hedge funds, and real estate investment trusts. We discuss them
from two perspectives: their investment characteristics and their use as
part of a bond portfolio strategy.
Chapter 21: Measuring Credit
Spread Exposures of Corporate
Bonds
Earlier chapters in the book explain how to quantify the interest-rate
sensitivity of a bond and a bond portfolio to a change in the level of
Treasury rates. In this new chapter, the focus is on how to best model
credit spread behavior and how to measure exposure to credit spread risk
when Treasury rates change.
Chapter 26: Considerations in
Corporate Bond Portfolio
Management
Whereas earlier chapters in the book describe bond portfolio strategies and
management in general, this new chapter covers issues associated
specifically with the management of corporate bond portfolios. Coverage
includes the stability of the investment characteristics of bond market
indexes, credit relative value trades, constraint-tolerating investing, and
how to quantify liquidity risk for corporate bonds.
Chapter 27: Liability-Driven
Investing for Defined Benefit
Pension Plans
The eighth edition of the book had a chapter entitled “Liability-Driven
Strategies,” which just described immunization and cash flow matching
strategies. That chapter (Chapter 24) is replaced with this new chapter
that focuses on liability-driven investing for defined benefit pension plans.
The chapter begins with a description of how historically pension plan
sponsors incorrectly formulated investment policy by focusing solely on
the asset side. After covering measures used to describe the health of a
defined benefit pension plan, liability-driven investing strategies are
described that take into account their liability obligations.

Significantly Revised Chapters

Chapter 22: Corporate Bond
Credit Analysis (Chapter 19 in the
previous edition)
Expanded coverage and the addition of two cases—credit analysis and
covenant analysis of Sirius XM Holdings Inc. and credit analysis of Sino-
Forest Corporation (a commercial forestry company in China)—are
provided.
Chapter 24: Bond Portfolio
Management Strategies (Chapter
22 in the previous edition)
New material on selection of bond benchmarks, problems with market-
capitalization-weighted bond indexes, customized indexes, alternative
bond benchmarks, and smart beta strategies are provided.

Other Noteworthy Changes to

Chapters
Another random document with
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it’s a case of work at the oars and make time. Let’s get a move on
ourselves.”
We did, most effectually, and in just two hours’ time were shoving
a crude, whipsawed skiff out into the river, and feeling the current
catch us and sweep us toward the Ramparts below. We had begun
the grim chase to overtake the one man who had paid his toll of
gratitude by robbing the man who had twice saved his life, and it was
certain that, did we overtake him, this time there would be no
escape; for we would bring him back for trial.
The current helped us, and, to our satisfaction, we discovered that
the apparently clumsy skiff handled excellently and responded
bravely to our steady oars. We tore through the Ramparts where the
waters lashed the rocks, and out into the breadths below, and then
set ourselves to our task, as we traveled through that great
uninhabited country. Save for the flying fowl, and a bear that lazily
paused from drinking on a distant shore, we saw no living thing, and
we did not pause for luncheon, but took turns with the oars.
Accustomed as we were to the heaviest work, and in the perfect
physical condition that comes from healthful food and clean lives, we
did not suffer from the prolonged exertion. Indeed, had our mission
been less melancholy and desperate, I, for one, would have enjoyed
that steady, rhythmic motion, the gurgling of the water under our
bow, the ever-changing scenery at our sides, and the beauties of a
perfect day. We did not talk much, but once or twice Shakespeare
George, brooding, quoted as if to himself, in a bitter tone, his own
version of Wordsworth’s “Gratitude.”
What would have been evening in a more southerly latitude came
on, and found us still rowing with that same measured stroke, save
that we took shorter turns at the oars, and found the resting spells
more grateful. The current carried us closer toward a shore, around
a point that seemed blanketed with the evening’s purple haze, and
we stopped rowing abruptly at the sound of a rifle shot. Nestled at
the foot of a bluff was a squalid little Indian village, and the natives
were running excitedly up and down the water’s edge and waving to
us. It was evident that the shot had been fired to attract our attention.
We headed the boat toward them, and they caught our prow and
pulled us up on the shingle before we could protest.
 “Come! Quick come!” urged a withered, kindly faced old native,
presumably the tyune of this little domain. “White man ’most peluck!
Him soon die. Quick come!”
We hastened after him to the big Kazima, a sort of clubhouse
which each village of any size possesses, crawled in after him, and
when our eyes grew accustomed to the dull, smoke-blackened,
raftered interior, lighted only by a huge hole in the upper center over
the fire pit through which the soft daylight streamed, we stood above
the cause of his solicitude. Our chase was ended; for on the skins, at
our feet, lay Laughing Jim.
George knelt beside him, and ran his hand inside the blue shirt
that was torn open across the chest, and then looked up at us.
“Somethin’s happened to him,” he said, “feels to me as if he was
all shot to pieces.”
At the sound of his voice Laughing Jim opened his eyes a little
wildly, then smiled as recognition crept into their clear, but pain-
drawn, depths.
“I’m going,” he croaked, with a queer, gasping effort. “You got here
just in time. I—I⸺ Drink!”
Bill Davis pulled our little emergency flask from his pocket, George
lifted the wounded man up, and gave him a strong sup of the brandy,
and it momentarily strengthened him. All our animosity was forgotten
now, as we stood there rubbing shoulders with death, such is the
queer awe and pity that assails us at sight of the mortally stricken
regardless of their merits.
“Who did it, Jim?” asked George, still supporting the dying man’s
shoulders and head.
“Mahoney. But I got him! He’s over there!”
He rolled his eyes toward the dark corner of the Kazima, and with
exclamations of surprise all of us, save George, hurried to the
corner, struck matches, and looked. There lay Phil Mahoney, beyond
all aid, dead. I threw my handkerchief over his face before we went
back to George and Jim, on tiptoe, as if the sound of our footsteps
on that beaten earth would ever matter to him. We gave Jim another
draft of the brandy, and he feebly waved for silence.
 “Let me talk,” he said. “Not much time left. Been going out all day.
I’ve never been any good. Gambler’s habit of sleeping days, awake
nights. Took walk yesterday morning. Wanted to get close to birds
and hear ’em sing. Mile above camp. Saw Phil Mahoney toting
something toward boat. Acted queer. Didn’t see me. Got in boat and
shoved off. Skirted opposite shore as if afraid being seen. ‘Funny,’
says I. ‘Wonder what that big, ugly devil’s up to?’ Forgot all about it
and went back to my cabin, to clean up. Couldn’t find best shoes.
Cussed some, and wondered what Siwash could have swiped them.
Then, all of sudden, remembered Mahoney walked queer. So I⸺”
He stopped and his lithe, wounded body was twisted with a harsh
cough that threatened to undo him, and again we gave him brandy.
After a time, but in a weaker and more broken voice, he went on: “So
I went back. Never trusted him, anyhow. Sure enough there were
tracks in the mud. He had ’em on. I back-tracked him. Found thicket
of pussy willows, and inside of it empty gold sacks. Special buck.
You fellows’ names on ’em in indelible pencil. Got wild! Ran back
farther along tracks and saw he must have come from gulch trail—
your direction. Saw it all in a minute. Saw you fellows wouldn’t
believe me, because you know I’ve been a bad one—sometimes—
not always. Maybe not so bad as some. Only thing I could do to
show you I wasn’t a dog, and appreciated what you all had done for
me, was to catch thief. Grabbed canoe and chased him. Caught him
here, where he’d stopped to make tea, above village. Saw smoke.
Found boat—nothing in it. Crept up on him. He had gold dust with
him. Tried to get drop on him, but he was too quick. Whirled and
shot.”
He rested silently for a moment as if to gather strength, and there
was a little, exultant gleam in his eyes as he continued:
“I was down. Played fox. ‘That’s all right!’ says he, as he came up
and stood over me, ‘but I’d rather you’d been hanged by them
Competents.’ Then he laughed and turned back. I got to my elbow
and shot. He went down. Then we shot from the ground, and luck
was against me. Could feel every one of his hit. Didn’t know any
more till Indians came running and picked me up. Phil was dead.
Made natives bring me here with your dust. Told ’em better bring
Phil, too, so if I went out, and you came, you’d understand.”
 He coughed again, more violently, and the brandy seemed to
have lost its effect. He motioned with his dying fingers toward his
side, and we had to bend over to catch his whispered words:
“It’s there—by me—all of it—and—and—George, you’re white and
—I’m not so bad—after all—am I? Wanted you boys to know that
⸺”
As if the severing of soul and body had given him an instant’s
strength, he half stiffened, struggled, and then tried to laugh, a
ghastly semblance of that reckless, full-throated laugh that had given
him his sobriquet, twitched, gasped, seemed to abruptly relax, and
rested very still.
“Right? You’re right as rain! You are! God knows you are!”
George shouted the words to him as if speeding them out to
overtake his parting soul, and I like to remember that Laughing Jim’s
eyes seemed to twitch and that he went out with a smile on his face.
Side by side we buried them there, close to where the babble of
the Yukon might croon to them in the long summers, or display to the
cold skies its beaten winter trails, Phil Mahoney, the thief, in his
stolen shoes, and Laughing Jim, the strange admixture of evil and
nobility. And over each, with equal forgiveness, we put a rude
wooden cross, while curious, stolid natives stood quietly by. The sole
distinction we made was that the cross above Jim was carefully
hewn. But George lingered behind as we made our preparations to
camp in the village for the night, and the next morning, still filled with
the tragedy, I slipped back up the hillside for a last look at the
graves. On that of Laughing Jim, who would laugh no more, lay a
handful of dying wild flowers, and I saw scrawled on the cross, in the
handwriting of Shakespeare George, these words:
Under here is Laughing Jim. Paid a little favor with his life,
And died with a laugh on his lips! Bad as he was, better’n
Most of us, and provin’ that sometimes even poets is
wrong, and
That men don’t forget. Lord help us all to do as well.
And so we left him, and my eyes were fixed, as we rowed back up
the river, and the village with its natives was lost to view, on the
rough-hewn cross that seemed to blaze with a peculiar glory all its
own, a shining standard for one honorably dead on the field of
gratitude.

Transcriber’s Note: This story appeared in the December 1, 1913

issue of The Popular Magazine.
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