2022 LI FixedIncome

Last Revised: 05/06/2021
MarkMeldrum.com
Level I - Fixed Income

Readings Page
Fixed-Income Securities: Defining Elements 2
Fixed-Income Markets: Issuance, Trading, and Funding 15
Introduction to Fixed-Income Valuation 26
Introduction to Asset-Based Securities 42
Understanding Fixed-Income Risk and Return 64
Fundamentals of Credit Analysis 80
Reviews 91
This document should be used in conjunction with the corresponding readings in the 2022 Level I CFA® Program curriculum.
Some of the graphs, charts, tables, examples, and figures are copyright 2022, CFA Institute. Reproduced and republished with
permission from CFA Institute. All rights reserved.
Required disclaimer: CFA Institute does not endorse, promote, or warrant accuracy or quality of the products or services
offered by MarkMeldrum.com. CFA Institute, CFA®, and Chartered Financial Analyst® are trademarks owned by CFA
Institute.
© markmeldrum.com. All rights reserved.

Fixed-Income Securities: Defining Elements
a. describe basic features of a fixed-income security;
b. describe content of a bond indenture;
c. compare affirmative and negative covenants and identify examples of each;
d. describe how legal, regulatory, and tax considerations affect the issuance
and trading of fixed-income securities;
e. describe how cash flows of fixed-income securities are structured;
f. describe contingency provisions affecting the timing and/or nature of cash

flows of fixed-income securities and identify whether such provisions
benefit the borrower or the lender.
Fixed-Income Securities: Defining Elements

Page 1
any borrowing of money is debt (fixed income security)
LOS a
- promised payments are contractual obligations - describe
- payment of interest and principal are a prior claim on
the company’s earnings and assets versus equity
Bond a contractual agreement between the issuer & bondholders
Basic Features/
1/ Issuer
Supranational organizations (World Bank)
gov’t. Governments sovereign (national)
sector non-sovereign (state, provincial, municipal)
quasi-government (government owned or
corporate sponsored agencies)
sector Companies (corporate, either financial or non-financial)
Structured special purpose entities (securitization ABS, MBS)

finance
sector
Page 2
Basic Features/
LOS a
2/ Maturity - maturity date principal due - describe
- tenor time remaining to maturity date
- range from overnight to 30 years (or longer)
money market securities - maturities, at issuance, < 1 yr.

(e.g. commercial paper, CDs, T-Bills)
capital market securities - maturities, at issuance, > 1 yr.
perpetual bonds - no maturity (consols)
3/ Par Value a.k.a. principal amount, principal value, future value,

maturity value, face value, nominal value,
redemption value
- bonds can have any par value 100 - par bond

- bonds are typically quoted as a percentage of par 98 - discount bond
104 - premium bond
Page 3
Basic Features/
LOS a
4/ Coupon Rate & Frequency - describe
coupon annual amount of interest payments made
(coupon rate × par value)
e.g./ 6%, $1000 bond $60 annually typically gov’t., corporate
$30 semi-annually
QUIBS - quarterly interest
$15 quarterly
QUIDS bonds
$5 monthly quarterly interest
MBS
debt securities
plain vanilla or conventional bond – fixed coupon
floating rate notes (FRNs, floaters) - a reference rate + a spread
London pays pays pays fluctuates constant
Interbank 4.75% 4.65% 4.50% (e.g. Libor) (in bps)
offered Dec June Dec June
e.g. Libor + 150 bps
rate (Libor)
3.25 3.15 3.00 2.95
Page 4
Basic Features/ LOS a
4/ Coupon Rate & Frequency - describe
no coupon payments - sold at a discount
zero-coupon bond
all income = interest
most money market securities = zero coupon
5/ Currency Denomination - can be issued in any currency
EM countries typically opt to issue either USD or EUR
- makes it easier to place the bond denominated bonds
- dual-currency bonds coupon payments in one currency

principal payments in another
- currency-option bonds single currency bond bondholders choose
+ the currency of each
foreign currency option interest payment
& principal
Page 5
Yield Measures/ current or running yield LOS a
- describe
yield-to-maturity (yield-to-redemption, redemption yield)

- the IRR of the bond’s expected cash flows
an estimate of the bond’s expected return
inverse relationship between price and YTM

higher price, lower YTM
lower price, higher YTM
par bond coupon rate = YTM

premium bond coupon rate > YTM
discount bond coupon rate < YTM
Page 6
Bond Indenture LOS b
- trust deed legal contract form of the bond - describe
obligations of the issuer
guided by
rights of the bondholder
issuer appoints trustee typically a financial institution with

trust powers
acts as a
monitors fiduciary for
for compliance bondholders
trust deed includes/
1/ Legal identity of the bond issuer and its legal form
Holding Co. Securitization
credit transfers
Co. A Co. B Co. C quality & assets to
recourse bankruptcy
Subs. of remoteness
to assets Co. A SPE
Co. A from Co. A
bondholders
Page 7
2/ Sources of repayment proceeds - describe
Supranational repayment of previous loans
paid-in capital from its members
tax revenues
Government Sovereign full ‘faith and credit’
print money
Non-sovereign taxes
project cash flows
special taxes/fees specific to the
Corporate CFO funding
Securitized periodic payments of principle + interest
from securities held
3/ Asset or Collateral Backing
A/ Senior Ranking secured bond backed by assets (less risky)
unsecured bond general pledge
senior
junior
Debenture - can be secured or unsecured
Page 8
Bond Indenture
LOS b
3/ Asset or Collateral Backing - describe
B/ Types of Collateral Backing
Collateral Trust Bond - backed by other financial assets (held by a
Equipment Trust Certificate - backed by specific equipment trustee)
- typically used to engineer a lease
pays issues
Airline Trustee Certificate
leases $
buys
assets
MBS - backed by a pool of mortgages
Covered bonds - backed by a segregated pool of assets
that are not transferred to a SPE
- if the assets become non-performing, must be
replaced by other assets
Page 9
4/ Credit Enhancements - reduce the credit risk of a bond - describe
a) Internal subordination or credit tranching junior – last
overcollateralization paid
senior 2
- posting more collateral senior 1
than is needed ‘waterfall structure’
reserve accounts or reserve funds
• cash reserve fund➁ - a deposit of cash that can
be used to absorb losses
• excess spread account e.g. 8% in, 6.5% out
b) External Bank guarantee and surety bonds up to some %’age
(Bank) (Insurance Co.)
called the
Letter of credit - a credit line to ‘penal sum’
reimburse any cash flow shortfalls from
the assets backing the issue
Page 10
LOS b, c
Bond Indenture - describe
4/ Credit Enhancements - compare
b) External cash collateral account - does not rely on 3rd party
creditworthiness
5/ Covenants - legally enforceable rules
Affirmative - typically administrative in nature
- what issuers are required to do
➁
e.g./ What the issuer will do with the proceeds, promise to comply
with all laws and regulations, maintain its current line of
business, insure/maintain its assets, pay taxes
Negative - what an issuer will not do

- purpose is to protect bondholders
Restrictions on debt max debt ratios, min. Interest Coverage Ratios

Negative pledges no debt senior to this issue
Page 11
Bond Indenture LOS b, c
5/ Covenants · Negative - describe
· Restrictions on prior claims (for unsecured bonds) - cannot use - compare
unsecured assets for future collateral

· Restrictions on distributions to shareholders - dividends and
Share buybacks out of earnings above some threshold profit only
· Restrictions on asset disposal - set a limit on asset disposal
➁
during bond’s life (%’age of gross assets)
· Restrictions on investment - blocks speculative investment
(i.e. stay in its current line of business)
· Restrictions on M&A - unless bond/collateral survive
- common element ensure issuer will not take any actions

that would reduce its ability to make interest
payments and repay the principal
Page 12
Legal/Regulatory Considerations/ LOS d
- describe
· Domestic bonds - issued in issuer’s home country in the currency
of that country (e.g. Can. Co. issues in Canada in CAD)
· Foreign bonds - issuing entity not of the target country
(e.g. U.S. Co. issues in Canada in CAD)
- regulated by the market the bonds are issued in

➁
· Euro bonds - originally created to bypass legal/regulatory/tax constraints
imposed on issuers
- named after the currency in which they are denominated
e.g. Eurodollar, Euroyen
- less regulated since they are issued outside the jurisdiction of
any single country
- usually unsecured - can be issued in any currency
Page 13
Legal/Regulatory Considerations/ LOS d
- global bonds bonds issued simultaneously in the Eurobond - describe
market and in at least one domestic market
- ensures sufficient demand for large bond issues
- domestic, foreign, Eurobond & global bonds are subject to different
legal, regulatory & tax requirements
- the market rate that affects a bond’s price is the currency
in which the bond is denominated ➁
Tax Considerations/
· Interest - typically taxed as ordinary income (unless tax-exempt)
· Capital gains/losses - long-term vs. short-term
favourable ordinary income

· Discount bonds - discount is amortized over life of bond and
treated as implied interest (opposite effect for
premium bond) - but not always
Page 14
Bullet, Fully-amortizing, Partially amortizing bonds
LOS e
- describe
- most common
- almost all gov’t.
& corporate bonds
➁
(N = 5, PV = -1000, FV = 0, I/Y = 6) CPT PMT 237.3964
- MBS each payment

is fixed ‘interest +
principal’ until paid
in full
- reduces credit risk

over time
Page 15
Bullet, Fully-amortizing, Partially amortizing bonds LOS e
- describe
N = 5, I/Y = 6, PV = -1000,
FV = 200
CPT PMT = 201.917
balloon payment required = $200

Sinking Fund arrangements/ - issuer sets aside funds over time to
retire the bond
- specifies the portion (e.g. 5%) of the bond’s principal outstanding
that must be repaid each year throughout the bond’s life
(or after a specified date)
Page 16
Sinking fund arrangement/ LOS e
issuer trustee redeems bonds in open - describe
$
market or serial #
- also may involve redeeming some lottery
increasing %’age each year
- lowers default (i.e. credit) risk, but raises re-investment risk or
call risk (called at par but trading at a premium)
Coupon payment structure/ ➁ annual

· Fixed coupon (conventional bond) semi-annual certain
- price volatility quarterly cash-flows
monthly
· Floating rate notes - little price volatility since coupons are
reset at market rates on each coupon date
coupon = reference rate + spread (margin) uncertain cash

flows
typically quarterly
Page 17
Coupon payment structure/ LOS e
- describe
cap - maximum rate
· Floating rate notes - may have if both, called
floor - minimum rate
a collared FRN
· inverse or reverse FRN (inverse floater) - if the
reference rate ↓, coupon ↑ instead
· Step-up coupons - may be fixed or floating
- coupon increases by specified margins at specified dates
- offer bondholders some➁ protection against rising rates
· Credit-linked coupon bonds - coupon changes when bond’s credit
rating changes (↓/↑ by some margin with every ↑/↓
in credit rating)
· PIK (payment-in-kind) bonds - interest paid with more amounts
of the bond (or with common shares)
PIK toggle issuer has the option to pay coupon
in cash or in kind (or some mix)
· usually tied to a cash flow trigger
Page 18
LOS e
Coupon payment structure/ - describe
· Deferred coupon bonds (split coupon bonds) - no coupon payments
for the first few years followed by higher coupon
than otherwise
- common in project financing (delay payments until the project
is complete)
· Index-Linked bonds - coupons are linked to some index
(e.g. inflation-linked
➁ bonds tied to CPI)
with
without Inf.
Inf.
Inf.
real real real
real rate nominal nominal rate
decreases rate increases
· inflation adjustment can be made to either coupon

payments or principal
Page 19
Coupon payment structure/ LOS e
· Index-Linked bonds - describe
· zero-coupon indexed bond inflation adjustment via principal only
e.g./ $1000 face value principal payment = $1,050
5% inflation
· interest-indexed bonds fixed nominal principal + index-linked coupon
$1000 face value, 4% semi-annual coupon, 5% inflation
principal = $1,000 coupon =

➁
· capital-indexed bonds fixed coupon + index-linked principal
PMT ↑ as principal ↑
$1000 face value, 4% semi-annual coupon, 5% inflation
principal = $1000(1.05) = $1,050 = × % =$
· Indexed-annuity bonds fully amortizing
interest + principal payments ↑ as CPI ↑
$1000 face value, 4% semi-annual coupon, 20 yr. bond, 5% inflation
(N = 40, I/Y = 2, FV = 0, PV = -1000) PMT = 36.56 new PMT = 36.56(1.05) = 38.38
Page 20
Bonds with contingency provisions/ LOS f
- describe
some future event or circumstance that is possible
but not certain
- contingency provision gives issuer or bondholder a right to some
action
1/ Callable Bonds - issuer has the right to embedded
redeem all or part of the bond before maturity ‘option’
- issuer is protected from a decline
➁ in interest rates
- can re-issue at lower rates
- call option has value to the issuer higher coupon or lower price
- detailed in the bond indenture: compensates for higher
· call price · call dates reinvestment risk
· call premium (shrinks as time passes)
· call protection period (lockout period) cannot be called until
some future date
Page 21
1/ Callable bonds - describe
- results in a
- make whole call PV of
call price > current
market price
- calls can be: American - continuously callable
European - only on call date (1 date)
Bermuda - only on call
➁ dates after the lockout period
- usually on coupon dates
2/ Putable bonds - bondholder can put bond back to issuer on
certain dates @ specific prices (value for bondholder)
- lower yield or higher prices
- protects against a rise in rates
one-time put bonds - European
multiple put bonds - Bermuda
Page 22
Bonds with contingency provisions/
LOS f
3/ Convertible bonds - hybrid security, 5-10 yr. maturities - describe
- bondholder has the right to exchange the bond for a
specified number of shares
- if share price ↓, get bond principal (downside protection)
- if share price ↑, get share price (upside participation)
- lower yield or higher price (yield higher than dividend yield however)
- issuer pays lower interest, plus may➁avoid principal repayment
· Key Terms e.g.
· Conversion Price - price/share $20
· Conversion Ratio # of shares/bond 50
· Conversion Value P0 conv. ratio P0 = 19 , CV = 950
· Conversion Premium $Bond - Con. Value $1000 - 950 = 50
· Conversion Parity $Bond = Con. Value below par
Page 23
3/ Convertible bonds - describe
- typically also have call provisions to force conversations
- avoids ‘overhanging convertibles’ when above parity
- bonds with warrants attached warrants

not really ➁
a contingency provision, more of a
yield enhancement
- contingent-convertible bonds contingent write-down provisions
e.g./ if core Tier 1 capital falls below some

minimum level (min. Basel 3 requirement), bond
converts to equity raises Tier 1 capital amount
- conversion happens automatically (not discretionary)
Fixed-Income Securities: Issuance, Trading, and Funding
a. describe classifications of global fixed-income markets;
b. describe the use of interbank offered rates as reference rates in floating-rate

debt;
c. describe mechanisms available for issuing bonds in primary markets;
d. describe secondary markets for bonds;
e. describe securities issued by sovereign governments;
f. describe securities issued by non-sovereign governments, quasi-government

entities, and supranational agencies;
g. describe types of debt issued by corporations;
h. describe structured financial instruments;
i. describe short-term funding alternatives available to banks;
j. describe repurchase agreements (repos) and the risks associated with them.
Issuance, Trading, Funding

Page 1
Classification of Fixed-Income Markets/ LOS a
1/ by issuer · gov’t. & gov’t. related – supranational orgs. - describe
fin. - sovereign & non-sovereign
· corporate
non-fin. - quasi-gov’t.
· structured finance – securitization (MBS, ABS)

2/ by credit quality · Investment grade (Baa3 or BBB – and up)
· Non-Investment grade (high yield, speculative,
junk)
- certain types of investors may be restricted from
holding non-investment grade debt
3/ by maturity · money market < 1 yr. original maturity at
· capital market > 1 yr. issuance
4/ by currency – currency of a bond’s cash flows determines what
country’s interest rate affects price
5/ by coupon – fixed
- floating reference rate + spread
Page 2
Classification of Fixed-Income Markets/
LOS a, b
5/ by coupon – floating rate = reference rate + spread - describe
· resets · typically constant
periodically · set at issuance
Libor – reflects the rate at
· typically Libor · f(credit risk)
which unsecured loans can
be obtained between banks in the
Interbank Money Market is actually a collection of rates
ranging from overnight up to one year
Process/ 8-16 banks submit daily rates they believe they could
borrow at for 5 currencies and 7 time periods (35 rates)
USD, EUR, JPY, GBP, CHF 1 day, 1 wk., 1-2-3-6-12 months
- highest/lowest 25% discarded

LIBOR = mean of mid 50% of bids
- alternatives: Euribor, Tibor, Sibor, Hibor, Mibor
-
EUR JPY SGD HKD INR

Page 3
Classification of Fixed-Income Markets/ LOS a
6/ by Geography · Domestic legal, regulatory and tax - describe
· Foreign issues of ‘issued-in’ country

· Eurobond - issued internationally
also by · developed market
local currency
· emerging market
foreign currency
LOS c
Primary bond markets/ - issuers initially sell bonds
- describe
to investors
· Public Offerings
a) underwritten offerings (firm commitment offering)
Phases: 1. Issuer determines funding need
buys from
spread 2. Select underwriter – typically an investment bank
= revenue (or syndicate)
sells to lead
syndicated
dealers/investors
offering
Page 4
Primary bond markets/ LOS c
· Public Offerings a) underwritten offerings - describe
3. Investment bank structures the offering
· bond terms · regulatory filings · circulars/prospectus
· selects trustee
4. Announcement date to end of subscription period
- underwriter gauges demand + price
- marketing efforts
- anchors (large inst. investors)
- grey market (forward mkt.)
· pricing date
- last day to commit
- final terms solidified
· next day = offering
5. Issuing phase money changes hands
6. Closing date about 14 days from issue date
Page 5
Primary bond markets/ LOS c
· Public Offerings a) underwritten offerings - describe
· shelf registration certain issuers can offer additional bonds
to the public without having to prepare a new
and separate offering
- may be used to cover multiple bond issues
b) best-efforts offering – investment bank/syndicate serve
only as a broker for a commission
c) auction – single price auction all the winning bidders pay
the same price and receive the same coupon
rate (U.S. Treasuries)
- competitive + non-competitive bids
primary dealers accepts the rate determined

- final price = yield at which the issue clears
· multiple price auction each bidder pays their price

(Canada, Germany)
Page 6
Primary bond markets/ LOS c, d
· Public Offerings - describe
d) Private Placements · non-underwritten
· unregistered
· one/few investors (pension fund, insurance)
- typically no active secondary markets · low need for liquidity
· higher yield
Secondary bond markets/
investor investor Central Banks & large
investor dealer investor institutional investors
· exchange-listed very limited - very small retail
· OTC (over-the-counter) vast majority of bonds presence
- dealers act as market makers
· post bid - offer
< 5 bps – very liquid
spread lower = more liquid 10-12 – reasonable
> 50 - illiquid
- no bid/offer = completely illiquid
Page 7
Secondary bond markets/ LOS c, d
· Settlement – bonds passed to buyer and payment made - describe
· gov’t./quasi-gov’t. cash or T + 1
· corporate T + 2 or T + 3, maybe even T + 7
(some jurisdictions)
Sovereign bonds/ LOS e

- usually called Treasuries (even though they - describe
have different names by country)
- name may also denote original maturity
e.g. U.S. Treasury - bill (T-Bill) < 1 yr. (zero coupon)
coupon – - Note (T-Note) 1 yr. ≤ T-Note < 10 yrs.
bearing - Bond (T-Bond) > 10 yrs.
- most recently issued ‘on the run’ or benchmark issue
- most active in secondary market
- as sovereigns age, they trade less frequency
Page 8
Sovereign bonds/ LOS e
· Credit Quality typically unsecured obligations - describe
paid out of budget surplus
deficits require ‘rolling over’ the principal + interest
- risk-free (theoretically) AAA or Aaa (only a few)
· local currency higher credit rating than foreign currency
- strong domestic savings base solid domestic demand
- liquid and freely traded currency strong international demand
· Types/ 1/ Fixed-rate bonds – by far the most common

2/ Floating-rate bonds – lower interest rate risk (i.e. price risk)
than fixed rate bonds
(Germany, Spain, US) (Japan, UK – never)
3/ Inflation-linked bonds – US TIPS (Treasury Inflation
- tied to CPI Protected Securities)
not a perfect proxy for inflation
Page 9
Non-Sovereign/Quasi-government/Supranational/ LOS f
· Non-Sovereign: state, province, municipality - describe
- not guaranteed by the national government
schools
- typically issued to finance public projects roads
hospitals
- ranging tax treatment depending on type & jurisdiction
- credit ratings differ widely, but generally high
- higher yield/lower price than comparable sovereigns
· Quasi-government: agency bonds

- rarely guaranteed by the sovereign (implied however)
- repaid from the cash flows of the entity
- typically high credit rating
· Supranational: supranational bonds highly rated

- some may be used as a benchmark for non-liquid
sovereign bonds
Page 10
Corporate Debt/ LOS g
- companies have a choice: Debt or Equity - describe
public private
· Private debt: 1/ Bi-lateral loans – single lender to single borrower
floating-rate usually bank typically
2/ Syndicated loans – a group of lenders to a single
borrower
can be packaged not all will be banks
and securitized
- private debt can be customized to the borrowers need, can be

interest only or fully amortizing, usually more expensive than public
debt
· Public debt: 1/ Commercial paper – short-term, unsecured
- working capital, seasonal needs, bridge financing
- largest issues are financial institutions
- maturity can range from overnight 1 yr. (3 mos. is typical)

Page 11
Corporate Debt/ LOS g
· Public debt: 1/ Commercial paper Credit quality - describe
prime paper IG
- maturing CP is usually met by ‘rolling over the paper’
introduces ‘rollover risk’

credit rating agencies usually require issuers to secure
‘backup lines of credit’ – referred to as a ‘liquidity
- investors typically hold CP to maturity very low enhancement’
secondary market
- yield on CP > yield on same maturity trading
credit risk sovereign debt
illiquidity
Corporate Debt/ Page 12

LOS g
· Public debt: 1/ Commercial paper U.S. vs. Eurocommercial
- describe
Paper
issued
internationally
also: smaller issue
sizes and less
liquidity
e.g.: issue $50M @ 5% for 180 days
- interest = $1.25M - interest = $1.25M
- proceeds = $48.75M - proceeds = $50M
repay $50M repay $51.25M
2/ Corporate Notes and Bonds (range from 1 to 30 years, typically)

short < 5 yrs.
notes fixed or floating
5 yr. ≤ medium < 12 yrs.
long > 12 yrs. – bonds primarily fixed
Page 13
Corporate Debt/
LOS g
· Public debt: 2/ Corporate Notes and Bonds - describe
quarterly
· Coupon payment structures fixed or inflation
semi-annual
floating market
annual
credit
- also zero coupon, deferred coupon, PIK bonds quality
· Principal repayment structures
- serial maturity – maturity dates are spread out over the bond’s life
- a stated # of bonds mature each year
- term maturity – principal all paid on one date (more credit risk)
· Asset or collateral backing – seniority ranking, secured vs.
unsecured
· Contingency provisions – calls, puts, conversions
· Issuance, Trading, Settlement
underwritten T + 2 or T + 3, longer for new issues
OTC
best efforts
Page 14
Structured Financial Instruments/ LOS h
1/ Capital protected Instruments - describe
buy a zero coupon bond + call options
equity
discount security on an index
commodity
pays principal + option payoff
2/ Yield enhancement instruments e.g./ credit-linked note

- a bond that pays regular coupons but whose principal value
depends on specific credit events - ratings downgrade
default of an underlying
· no credit event pays par
asset
· credit event pays a recovery rate
Note: protects the issuer

- pays higher coupon in return, plus issued at a discount
Page 15
Structured Financial Instruments/ LOS h
3/ Participation instruments – participate in the return of - describe
an underlying asset
- offer exposure to a particular index or asset price
4/ Leveraged instruments e.g./ inverse floater

coupon rate = C – (L R) - if reference rate (R) = 0
leverage factor C is maxed out
e.g./ C = 9.5%
L = 3 9.5% - (3 2.5%) = 2% R ↓ 1.5%
Libor 2.5% 1% 9.5% - (3 1.0%) = 6.5% C ↑ 4.5%
- if L < 1, called a ‘deleveraged inverse floater’
L > 1 ‘leveraged inverse floater’
- often have floors (C is the cap)
Page 16
Short-term funding alternatives for banks
LOS i
1/ Retail Deposits – individual and commercial depositors - describe
· demand deposits pay no interest
· savings accounts pay interest but lack service levels of
demand deposits
· money market accounts money market rates of return
2/ Short-term wholesale funds

a) Reserve funds central bank funds
- banks place minimum level of funds with the central bank
- called reserves
- help ensure sufficient liquidity should depositors withdraw funds
- some banks have surplus reserves, other deficits
can lend extra reserves to other banks for

maturities of one day up to one year
overnight funds term funds
· interest is
called the central bank
funds rate
Page 17
Short-term funding alternatives for banks LOS i
2/ Short-term wholesale funds - describe
b) Interbank funds loans/deposits between banks (unsecured)
term: overnight to one year
rate interbank offered rate bank will typically quote 2 rates
fixed rate rate at which it will lend
rate at which it will accept a
deposit
c) Large denomination negotiable CDs
allows depositor to sell CD in open market
before maturity
· usually issued in denominations of $1M or more (U.S.)
· typically traded among institutional investors
· have maturities < 1 yr., pay interest at maturity
· yields are driven primarily by the credit risk of the issuing bank
Page 18
Short-term funding alternatives for banks
LOS j
3/ Repurchase and reverse repurchase agreements - describe
· repo the sale of a security with
funds
an agreement to buy it back at an Bank Bank
agreed on price at some future date A security B
repurchase price repurchase date
- basically a collateralized
- term = one day called an overnight repo loan
= longer term repo
· Interest rate repo date affected by

1/ risk associated with the collateral – higher quality = lower
2/ term of the repo – longer = higher rate
3/ physical delivery lower rate
4/ supply/demand of collateral the more scarce, the lower the
5/ other market rates rate (on special)
Page 19
Short-term funding alternatives for banks LOS j
3/ Repurchase and reverse repurchase agreements - describe
· interest is paid at the end of the repo term
· if the collateral pays interest, belongs to the borrower
- from the lender’s perspective called a reverse repo

often used to purchase
securities to cover a
· each side in a repo is exposed short position
to counterparty credit risk
- however the repo is structured in favour of the lender
of cash
- the amount lent is lower than the collateral’s
market value
- difference is called the ‘repo margin’ or ‘haircut’
Introduction to Fixed-Income Valuation
a. calculate a bond’s price given a market discount rate;
b. identify the relationships among a bond’s price, coupon rate, maturity, and
market discount rate (yield-to-maturity);
c. define spot rates and calculate the price of a bond using spot rates;
d. describe and calculate the flat price, accrued interest, and the full price of a
bond;
e. describe matrix pricing;
f. calculate annual yield on a bond for varying compounding periods in a year;
g. calculate and interpret yield measures for fixed-rate bonds and floating-rate
notes;
h. calculate and interpret yield measures for money market instruments;
i. define and compare the spot curve, yield curve on coupon bonds, par curve,
and forward curve;
j. define forward rates and calculate spot rates from forward rates, forward
rates from spot rates, and the price of a bond using forward rates;
k. compare, calculate, and interpret yield spread measures.

Introduction to Fixed Income Valuation

Page 1
Bond Prices/
LOS a, b
a) using a single ‘market discount factor’ - a.k.a. - calculate
- required yield
- price of bond = PV(future cash flows) - identify
- required rate of
return
e.g./ 5 yr., 4% annual bond, r = 6% r = market discount rate
coupon + principal
+ + + +
. ( . ) ( . ) ( . ) ( . ) Note: bonds are
quoted as a %’age
= . + . + . + . + . = . of par (i.e. 100 = par)
calculator: N = 5, FV = 100, PMT = 4, I/Y = 6, CPT PV

· if coupon rate = market rate - par bond
coupon rate < market rate - discount bond
coupon rate > market rate - premium bond
e.g./ 5 yr., 8% annual bond, r = 6% (N = 5, I/Y = 6, PMT = 8, FV = 100) CPT PV
= 108.425
Inverse relationship between bond prices and interest rates
(discount rates)
Page 2
Bond Prices/ LOS a, b
a) using a single ‘market discount factor’ - calculate
- semi-annual: 5 yr., 4% semi-annual bond, r = 6% - identify
(N = 10, I/Y = 3, PMT = 2, FV = 100) CPT PV = 91.46979
(vs. 91.575 for annual)
5 yr., 8% semi-annual bond, r = 6%
(N = 10, I/Y = 3, PMT = 4, FV = 100) CPT PV = 108.5302
(vs. 108.425 for annual)
- quarterly: (N = 20, I/Y = 1.5, PMT = 1, FV = 100) CPT PV = 91.4156
(N = 20, I/Y = 1.5, PMT = 2, FV = 100) CPT PV = 108.5843
Note: discount bonds PV ↓ as periodicity ↑
premium bonds PV ↑ as periodicity ↑
Yield-to-Maturity - if PV is known (i.e. bond’s market price),

YTM can be calculated
- YTM is the IRR of the bond’s cash flows
investor holds the Page 3

bond to maturity
Yield-to-Maturity - assumes - calculate
all cash flows are
received on the specified dates - identify
e.g./ 4 yr., 5% annual bond @ 105
N = 4, PMT = 5, PV = -105, FV = 100 all coupon payments can
CPT I/Y = 3.634% be reinvested at the same rate
- if semi-annual
N = 8, PMT = 2.5, PV = -105, FV = 100
CPT I/Y = 1.82265 /semi-annual period 2 = 3.645315%
- if quarterly the greater the
N = 16, PMT = 1.25, PV = -105, FV = 100 periodicity, the
CPT I/Y = .912705 x 4 = 3.6508 higher the YTM
- if monthly
N = 48, PMT = , PV = -105, FV = 100
x 12 = 3.6545
CPT I/Y = .30454
Page 4
LOS a, b
Bond Prices/
- calculate
· 4 relationships 1/ PV inversely related to I/Y
- identify
- bond price is inversely related to the market
discount rate
2/ given the same coupon & time to maturity: (inverse effect)
%’age price when market rates increase is less than
price - called a ‘convexity effect’ when rates decrease
- in other words, bond prices increase by

more when rates drop than they drop
market rate in price when rates rise
3/ for the same time to maturity:

lower coupon bond is more price sensitive than a higher
coupon bond when rates change
(coupon effect)
Bond Prices/ Page 5

LOS a, b
· 4 relationships 4/ for the same coupon rate:
- calculate
longer-term bond is more price sensitive than a - identify
(maturity effect) shorter-term
- generally bond
4.95% ↑ as r ↓ 1%
4.60% ↓ as r ↑ 1%
convexity effect
all rise all drop
coupon effect
longer term bonds = higher price vol. lower coupon = higher note: maturity effect
price vol. does not hold for low
coupon, LT-bonds @
maturity effect a discount
Page 6
- calculate
- identify
pulled to par constant yield-price

over time trajectory
- bond prices change as

time passes even if
nothing else changes
10 yr., annual bonds, r = 8%
Page 7
Bond Prices/ LOS c
b) using multiple discount rates - define
- spot rates rates that correspond to a bond’s cash flow - calculate
dates
rather than using the same discount rate, each cash flow
is discounted by its associated spot rate
PV referred to as the bond’s yields-to-maturity on zero-
‘no arbitrage value’ coupon bonds maturing at
the date of each cash flow
e.g./
PV = ( . ) ( . ) ( . )
3 yr., 5% annual bond
r(1) = 2% r(2) = 3% r(3) = 4%
(N = 3, PMT = 5, PV = -102.96, FV = 100) CPT I/Y = 3.935% (YTM)
(N = 3, PMT = 5, FV = 100, I/Y = 3.935) CPT PV = 102.96
Page 8
Prices and Yields/ LOS d
- when a bond is between coupon dates, its price has - calculate
2 parts the flat price - PVflat sum = PVfull
accrued interest - AI
dirty price
- dealers quote PVflat (a.k.a. - the clean price)

- AI the proportional share of the next coupon payment belonging
to the seller
= where T = # of days between PMT
= # of days since last PMT to the settlement
date
- 2 conventions to count days:
- most common for gov’t. bonds - typically corporate bonds
e.g./ May 15 & Nov. 15 coupon dates, settlement on June 27

Page 9
Prices and Yields/ LOS d
- calculate
this is not PVflat

e.g./ 5% semi, maturity date = Feb 15, 2024, act./act., settles May 14/2015
r = 4.8%
Feb 15 Aug 15 Feb 15 Feb. 15 - Aug. 15
T = 181 T = 184 13 + 31 + 30 + 31
-
-
+ 30 + 31 + 15 = 181
= + + + =
N = 18 Aug. 15 - Feb. 15
= .
PMT = 2.5 16 + 30 + 31 + 30
= ×( . )
I/Y = 2.4 + 31 + 31 + 15 = 184
= .
= × . FV = 100 = .
= . CPT PV = 101.4479 - 1.21547
= 101.408853
Page 10
Prices and Yields/
LOS d
e.g./ 6% corporate semi, settles Jun 18/2015 - calculate
coupon dates Mar./Sept. 19 June 18
matures Sept. 19/2026 Mar 19 Sept 19 Mar 19
r = 6.2% *
-
Step #1. 30/360 day count Step #3. Calculate PV

N = 23 Sep 19/15
T = 11 + 30 + 30 + 30 + 30 + 30 + 19 = 180 2 × (16 - 26)
= 11 + 30 + 30 + 18 + 89 PMT = 3
11 yrs.
FV = 100 CPT PV = 98.372607
I/Y = 3.1
Step #2. AI
AI Step #4. Calculate PVfull
= . ×( . )
= .
Step #5. Calculate PVflat

= . − . ̇
= .
Page 11
Prices and Yields/ LOS e
· Matrix Pricing - for fixed rate bonds without an active - describe
market, or not yet issued no market price to calculate
YTM
- estimate PV and r based on prices of more frequently
traded comparable bonds (i.e. similar tenor, coupons, credit quality)
e.g./ 3 yr., 4% semi corporate

Step #1: find comparable
bonds
2% 3% 4% 5% Coupon
Step #2. Calculate YTM for
2 98.50 102.25
3.786% 3.821% 3.8035% each
3 (N = 4, PMT = 1.50, PV = -98.50,
FV = 100) CPT I/Y etc…
4 Step #3: find avg. YTM/term
5 90.25 99.125 Step #4: Interpolate the
4.1885%
4.181% 4.196% yield
Page 12
Prices and Yields/ LOS e
e.g./ 3 yr., 4% semi corporate - describe
2% 3% 4% 5% Coupon
2 98.50 102.25
3.786% 3.821% 3.8035%
3
3 yrs. . + ( . %−
4 . %)
= . ̇
5 90.25 99.125
4.1885%
4.181% 4.196% Step #5: Find PV
Note: if the bond were floating instead: (N = 6, I/Y = .
̇
, = ,
spread = 3.93183 - YTM on gov’t. 3 yr.-semi = )
if gov’t. YTM = 2.75% CPT PV = 100.191
spread = 118.183 bps
usually a different yield spread for each maturity & credit rating
term structure of credit spreads

Page 13
Yield Measures/
LOS f, g, h
1/ Fixed rate bonds - yield measures typically are - calculate
annualized and compounded (if > 1 yr.) - interpret
e.g./ 5-yr. zero @ 80 Periodicity
annual 80 = 1 r = 0.04564
semi-annual 80 = 2 r = 0.022565 2 = 0.04513
quarterly 80 = 4 r = 0.011220 4 = 0.04488
monthly 80 = 12 r = 0.003726 12 = 0.044712
Note: 4.564% = 2.2565 compounded semi-annually
= 1.1220 compounded quarterly
= .3726 compounded monthly
the effective annual rate
· Semi-annual bond basis yield or semi-annual bond equivalent yield
= yield/semi-annual period 2
2.2565 2 = 4.513%
Page 14
Yield Measures/
LOS f, g, h
1/ Fixed rate bonds - calculate
periodicity conversions: - interpret
e.g./ 3 yr., 5% semi @ 104 (BEY)

(N = 6, PMT = 2.5, PV = -104, FV = 100) CPT I/Y = .01791
quarterly equivalent (EAY)
monthly equivalent
compounding more frequently at a

3.582% 3.566% 3.556%
lower rate = compounding less
(2) (4) (12)
frequently at a higher rate
Page 15
Yield Measures/ e.g./ 5 yr., 4.5% semi @ 98 LOS f, g, h
annual YTM ? (N = 10, PMT = 2.25, PV = -98, FV = 100) - interpret
CPT I/Y = .0247826 2 = 4.95652%
(semi-annual bond basis)
convert to quarterly
convert to annual
- effective
annual
yield
· Street convention YTM that ignores the possibility that
a PMT date could be a weekend or holiday
· True yield takes any delayed PMT into consideration
Page 16
Yield Measures/ LOS f, g, h
· government equivalent yield quoted for a corporate bond - interpret
restates to
results in a more accurate ‘spread over
benchmark’ measure
· current yield (income or running yield) =
· simple yield =
Embedded options/ 7 yr., 8% annual @ 105, callable after 4 years

yield measures: 102 in 4 years
yield to first call (FV = 102, PV = -105, PMT = 8, N = 4) 101 in 5 years
yield to second call (FV = 101, N = 5) 100 in 6 years
yield to third call (FV = 100, N = 6)
call schedule
YTM (FV = 100, N = 7)
lowest = yield to worst
Page 17
Embedded options/ - pricing involves an option pricing - interpret
model + assumption about future interest rate volatility
Option-adjusted price = Option free bond - value of call option
or/ (+ value of put option)
used to calculate the
option-adjusted yield
2/ Floating rate bonds
- reference rate is usually a short-term money market
rate (i.e. Libor)
- determined at the beginning of the period, paid at the end
(in arrears)
Fixed-Coupon price
price Floating Coupon
Page 18
2/ Floating rate bonds - common day count conventions - calculate
- interpret
· yield spread over the reference rate quoted margin credit related
· required margin spread required by investors to may even be
reflect changes in credit quality negative (sub-Libor
- changes usually come from changes in the issuer’s credit
FRN with quoted margin = 50 bps with no changes in risk
credit risk, required margin = 50bps
between PMT dates for a
premium
PMT PMT change in the reference
PV
rate but PV pulled to
-
PV = 100 PV = 100 discount

par as PMT date nears
QM - quoted margin
DM - discount margin · if QM = DM PV = 100 on reset date
QM > DM PV > 100 and QM < DM PV < 100
Page 19
2/ Floating rate bonds - calculate
- interpret
( + )× ( + )× ( + )×
+
= + + ⋯+
+ + +
+ + +
e.g./ 2 yr. FRN, pays 6-mos. Libor + 50 bps, required spread = 40 bps
1.25%
Index = .0125
N = 4
QM = .005
DM = .004 PMT = ( + )×
=
(. +. )×
=
.
=.
+ . +. .
I/Y = = = =. %
FV = 100
CPT PV = 100.196 QM > DM PV > 100
Page 20
2/ Floating rate bonds - calculate
e.g./ 5 yr. FRN, pays 3-mos. Libor, QM = 75 bps, PV = 95.50 - interpret
(DM = ?)
1.10%
N = 20, FV = 100, PV = -95.50, PMT =
CPT I/Y = .7045% (.007045 4) - .0110 = DM

DM = 171.8 bps
e.g./ 4 yr. FRN pays 3-mos. Euribor + 125 bps @ 98 (DM = ?)
N = 16 2% (. )
PMT =
+ +.
× = × =.
FV = 100
CPT I/Y = .009478
PMT = .8125 (.009478 4) - Index = DM
PV = -98 = .017912
or/ 179.12 bps
Page 21
3/ Money market instruments - calculate
· annualized, but not compounded instead - interpret
rates of return are stated on a simple interest basis
either discount rates or add-on rates

(T-bills, CP, BA) (CDs, repos)
· Discount rates interest
earned
91-day T-bill, $10M, DR = 2.25% periodicity FV, not PV

360-day yr. DR will
understate the rate of
return to the investor and
the cost of funds to the
borrower
Page 22
LOS f, g, h
Yield Measures/
- calculate
3/ Money market instruments - interpret
· Add-on rates
e.g./ 180-day BA, AOR = 4.38, 365-day yr., $10M periodicity
Note: compounded interest

simple interest (money market yields)
Sell after 45 days when AOR = 4.17%

, , . −
= =$ , , implies AOR =
+ ×.
Page 23
Yield Measures/ DR vs. AOR LOS f, g, h
3/ Money market instruments 360 vs. 365 - calculate
- convert all the AOR with 365d to compare: - interpret
e.g./ 90-day CP, DR = 5.76%, 360-day yr. vs. 90-day CD, AOR = 5.9%, 365 d/yr.
BEY - bond equivalent yield AOR for 365d
- all 180 day A. = × − ×. = .

A - DR = 4.33, 360d − .
= = . %
B - DR = 4.36, 365d .
C - AOR = 4.35, 360d B. = × − ×. = .
− .
D - AOR = 4.45, 365d = = . %
.
ok!
C. = × − ×. = .
. −
= = . %
Page 24
Maturity structure of interest rates/
LOS i
yield
- define
maturity structure
for bonds with the - compare
or
same · currency · credit risk
yield term structure
· liquidity · tax status
curve
· same coupon (reinvestment
time to risk held constant)
-
-
-
-
-
-
-
maturity
· government bond spot curve YTMs for zero-coupon bonds for a
(a.k.a. zero or strip curve) full range of maturities
upward sloping normal longer maturities have higher YTMs
downward sloping inverted
- no coupon no reinvestment risk, but/ most bonds have coupons
need a term structure for coupon paying bonds, but/ older bonds
may have different tax/liquidity status use on-the-run bonds,
but/ there is limited data for the full range of maturities
interpolate between dates
Page 25
Maturity structure of interest rates/ LOS i
- typically stated on - define
a semi-annual bond basis - compare
- observed yields on recently issued ‘on-the-run’

coupon paying bonds
- 1 mos., 3 mos., 6mos. money market, all converted
-
-
-
-
-
- gov’t. bond yield to BEY (semi-annual basis)

curve, coupon bonds Par Curve - sequence of YTMs such that each
- bond is priced at par
- - par rates are derived from spot rates
- +
spots PMT = 5.263%
- =
.
1 yr. - 5.263%
- +
= + PMT = 5.606
- 2 yr. - 5.616% . ( . )
+
3 yr. - 6.359%
-
-
-
-
-
= + +
. ( . ) ( . )
PMT = 6.306
4 yr. - 7.008%
etc…
Page 26
LOS j
· Forward curve based on forward rates - define
agreed on today, received/paid in the future - calculate
quoted as ‘when, what’
e.g./ 2y5y an agreement on a rate, when in 2 years
f(2,5) more common what a 5 yr. rate
- implied forward rates are calculated from spot rates
spots f(3,1) 3.65% f(3,1)
3 yr. = 3.615%
-
4 yr. = 4.18%
4.18%
semi-annual
bond basis
Page 27
LOS j
forward - define
spot - calculate
par par
spot
forward
- forward curve is a series of 1 yr. forward rates f(1,1), f(2,1), f(3,1),

etc…
- forward rates are also referred to as break-even
rate or no-arbitrage rates
· Pricing/ - using spots

- 3 yr. annual
+
- using forwards + +
( + ) ( + )( + ( , )) ( + )( + ( , ))( + ( , ))
Page 28
Yield Spreads/ LOS k
- compare
microeconomic - calculate
factors - interpret
in bps - issuer and the bond

itself
can affect credit risk
as well
macroeconomic
factors
- general economic growth,
business cycle, fiscal and
varies across financial markets monetary policy
fixed rate bonds often use gov’t. benchmark security (usually the
most recently issued ‘on the run’ security) G-spread
floating typically an interbank rate (e.g. Libor)
Page 29
· U.S., UK, Japan spread over the benchmark for fixed - compare
rate securities is the G-spread (risk free) - calculate
· EUR benchmark is EUR interest swap rates I-spread - interpret
spread over the standard swap rate in any currency

(risky)
fixed Libor swap rates
- for both the G-spread & I-spread, all cash flows are discounted
at the same rate
- z-spread a constant spread over a government spot curve (or
swap
zero volatility spread zero interest rate volatility
curve)
option adjusted spread = z-spread - option value (in bps)
Page 30
e.g./ 6% annual corporate, 2 yrs. to maturity @ 100.125 - compare
2 yr., 4% annual gov’t. bond @ 100.750 - calculate
r(1) = 2.10% r(2) = 3.635% - interpret
1. G-spread: corporate bond YTM = 5.932%

(N = 2, PMT = 6, FV = 100, PV = -100.125)
gov’t. bond YTM = 3.605
(N = 2, PMT = 4, FV = 100, PV = -100.175)
G-spread = 5.932% - 3.605% = 2.327% or 232.7 bps
2. Z-spread demonstrate that Z-spread = 234.22 bps

Introduction to Asset-Backed Securities
a. explain benefits of securitization for economies and financial markets;
b. describe securitization, including the parties involved in the process and the
roles they play;
c. describe typical structures of securitizations, including credit tranching and

time tranching;
d. describe types and characteristics of residential mortgage loans that are

typically securitized;
e. describe types and characteristics of residential mortgage-backed securities,

including mortgage pass-through securities and collateralized mortgage
obligations, and explain the cash flows and risks for each type;
f. define prepayment risk and describe the prepayment risk of mortgage-

backed securities;
g. describe characteristics and risks of commercial mortgage-backed securities;
h. describe types and characteristics of non-mortgage asset-backed securities,

including the cash flows and risks of each type;
i. describe collateralized debt obligations, including their cash flows and risks;
j. describe characteristics and risks of covered bonds and how they differ from
other asset-backed securities.
Benefits of Securitization
Regulated Institutions Economy Financial Markets

· cost savings · greater credit · access to liquid
avoid capital availability investment &
maintenance req. (banks are not payment streams
lower reserve limited by capital or otherwise unavailable
requirements risk concentration) · assets of SPV have
lower deposit · less concentration bankruptcy remoteness
insurance premiums risk - will carry
· additional source of higher credit rating
funding (lower cost) Investors than originator
SPV typically rated · higher risk-adjusted · wide choice of
higher than originator returns investment profiles
· increased loan · diversification
origination
Securitization
Page 1
Physical
Bond
asset
Investors
General
Debenture
claim
Auto
pool Asset-Backed
Home Investors
of Security
assets
Credit Card
Receivables
Student Loans
credit sensitive
Page 2
buy a
Customer product Consumer Co. originator
may also be
makes a flow, through
credit criteria (- fee) servicer
loan
(underwriting standards) cash · collecting
sells
· repossessing
loans
sell
· liquidating
securities Consumer Asset
Investor (ABS) special
Trust (SPV)
interest purpose
+ cash vehicle
principal
Page 3
Seller originator of the loans (Consumer Co.)
Issuer/Trust SPV (Consumer Asset Trust)
Servicer Collections, etc. (Consumer Co.)
Others Lawyers, Underwriters, Accountants, Rating Agencies,
Trustees
Documents
Prospectus ‘waterfall’ – priority and amounts of
payments
· service fees · admin. fees
· principal · interest
Purchase Agreement (Seller SPV)
Waterfall Structure
Servicing Agreement (Servicer & SPV)
Bonds Issued
Page 1
Asset1 Senior tranche
Asset2 $80M
Libor + 60 bps
Asset3
SPV
Assetn Mezzanine tranche
$15M credit
Principal Libor + 250 bps tranching
$100M
Equity tranche
$5M
Libor + 1000 bps
redistributes credit risk
Page 2
Assets Senior tranche (80%) – easy to sell
an ABS of an ABS
Mezzanine tranche (15%)
Senior tranche (65%)
- hard to sell
‘AAA’
Equity tranche (5%)
Mezzanine tranche (25%)
‘BB’
retained by originator
Equity tranche (10%)
or sold to hedge fund
‘C’
End Result: the mezzanine tranche is

80% + 65%(15%) repackaged with other mezzanine
= 89.75% of asset tranches
pool is rated ‘AAA’ ‘AAA’ – easy to
sell
Page 3
e.g./
Bond Class Par Value
A1 $ 40M
A2 30M each would have different
A3 20M terms to maturity and yields
A4 10M
Sequential – pay
- each bond class receives periodic interest
- However: principal is repaid as follows:
- all principal to A1 until paid in full
- next is A2 until paid in full
etc…
· Redistributes prepayment risk Called ‘Time Trancing’
or
‘Prepayment Trancing’
e.g./ Page 4
Bond Class Par Value
A1 $ 35M
A2 28M
AAA time
A3 15M
+ credit tranching
A4 12M
BB B (subordinate) 7M
C C (subordinate) 3M
$100M
Class (or tranche) A suffers no loss if defaults < $10M

- Class C absorbs losses first
referred to as ‘first piece loss’
SPV vs. Originator
Originator Co. Balance Sheet

Loans stay on
to Cash …
·
Originator Co.’s
finance ·
Balance Sheet
·
sells bonds Loans
Versus
Originator Co.
SPV sells securities
Balance Sheet Loans lower
Cash … higher rating
·
·
·
- loans leave Originator Co’s
Loans
Balance Sheet (legally segregated)
Residential Mortgage Loans

Page 1
Property maturity 30 yrs.
Conventional
Lender
Credit of Mortgage
Borrower + morg. insurance
perhaps Loan-to-Value (LTV)
payments to Ratio =
lender · principal
· interest
May include prepayments:
payments made in payment in full

excess of regular
payments partial payments curtailments
Page 2
· Prepayments amount & timing of cash flows is not known
with certainty (prepayment risk)
t= 0 t = 30
5 yrs.
-
-
· if repaid in full or if
· lockout period prepayment > some certain amt.
· penalty period = penalty
(usually X months interest)
· Interest Rate Determination
· Fixed Rate, Level Payment, Fully Amortizing
ceiling
· Adjustable Rate Mortgages (ARMs)
floor
· Others: Initial Period Fixed Rate, then floating
: Teaser + Reset
: Convertible (Fixed Floating) or reverse
Amortization Schedule Page 3

e.g. Fixed Rate, Level Payment, Fully Amortizing
6% equal payments last payment,

of interest + balance = $0
Principal
i.e. 30-yr., $200K @ 6%
Balance Principal Int. Amortized
N = 30 12 = 360 1 – $ 200,000 199.10 1000 $199,800.90
FV = 0 2 - 199,800.90 200.10 999 199,600.80
PV = 200,000 etc…
·
I/Y = .5% ·
·
CPT PMT = -1,199.10
360 - $1,193.10 $ 1,193.10 6 0
Principal Page 4
Interest-service fee
par value of security holder

30 yrs. collateral
gets net interest or
t =0
net coupon
· Rights of Lender in a Foreclosure
recourse non-recourse
- borrowers walk away
· all assets of the
borrower can be used
to make the lender
whole
Residential MBS
3 ‘credit guarantee’ sectors: MBS guaranteed by -

1) federal agency
- Government National Mortgage Association
(Ginnie Mae or GNMA)
2) government sponsored agencies
agency MBS
- Federal National Mortgage Association
(Fannie Mae or FNMA)
- Federal Home Loan Mortgage Corporation
(Freddie Mae or FHLMC)
3) private entities
non-agency MBS
- Banks
Mortgage Pass-Through Securities
mortgage rate – fees = pass through rate Page 1

mortgage1
pool securities sold to investors
mortgagen pass through
principal
monthly payments +
interest
less servicing
principal and other fees
interest · To be included in the pool, each
prepayments mortgage must meet certain
penalties underwriting standards
· size
not all mortgages have
· docs required
the same rate conforming
· max LTV
· insured versus non-conforming
Not all mortgages have the same rate or time left Page 2
e.g. Mortgage Balance Weight Rate Time Left

1 $125k 22.12% 7.5% 275
2 85k 15.04% 7.2% 260
3 175k 30.97% 7% 290
4 110k 19.47% 7.8% 285
5 70k 12.39% 6.9% 270
$565k 100% 7.28% 279 months
· Weighted-average coupon rate (WAC)

WAC = .2212(7.5%) + .1504(7.2%) + .3097(7%) + .1947(7.8%)
+ .1239(6.9%) = 7.28%
· Weighted-average maturity (WAM)
WAM = .2212(275) + .1504(260) + .3097(290) + .1947(285)
+ .1239(270) = 279 months
Measuring the Prepayment Rate (Speed) Page 3

- Single Monthly Mortality Rate (SMM)
e.g.
Beg. Bal33 = $358,326,766
Sched. Prin.33 297,825
Prepay33 1,841,347
- based on historical observations if SMM is assumed, the

of actual activity in month 33 PrepayAmt33 = SMM33 (Beg.Bal33
– Sched.Prin33)
Conditional PrePayment Rate (CPR) Page 4

the annualized SMM
CPR = 1 – (1 - SMM)12 1 – SMM what is
NOT being
1 – what is NOT being prepaid
prepaid for the year (1 – SMM)12 – for the
= what is being prepaid for year
the year
6% of beg. yr. principal
i.e. SMM = .005143
will be prepaid during
CPR = 1 – (1 - .005143)12
the year over and
= 1 – (.994857)12
above regular principal
= .06 or 6%
payments
PSA Prepayment Rate referred to as 100% PSA Page 5
or 100 PSA
Public
Securities
Association
6%
t=0 30
· assumes CPR of .2% in month 1 + .2% each additional month

up to 6% (30 months) 6% thereafter
0 PSA = no prepayments
100 PSA = prepayments at the same speed as the benchmark
less than 100 = slower more than 100 = faster
Page 6
Cash Flow Construction
if t < 30, then CPR = 6%
t ≥ 30, then CPR = 6%
for month 5, CPR = .06 = .01 or 1% annual

and CPR = 1 - (1 – SMM)12
for month 5, PSA = 165

Note: Applied to CPR, not SMM
CPR = .06 = .01
165 PSA = 1.65(.01) = .0165
Page 7
e.g. $400M, 7.5% Pass-through, WAC of 8.125%, WAM = 357 months
100PSA 165PSA MH SPV SH
Months
from Months Beg.
now Seasoned Balance SMM PMT Principal
1 4 $400,000,000 .000669 2,975,868 2.5M 267,535
2 5 399,464,995 .001106 N = 357
399,390,077 PV = 400M
FV = 0
I/Y = .
Prepayment Total Principal Cash Flow

267,470 535,005 3,035,005
442,389 709,923 3,209,923
Page 8
Weighted Average Life
PSA Speed 50 100 165 200 300 400 500 600

Average Life 15.11 11.66 8.76 7.68 5.63 4.44 3.68 2.78
depends on prepayment assumption

= if mortgage rates drop, refinancing ↑, Prepayments ↑
PSA Speed ↑, Average Life ↓
Called Contraction Risk
= if mortgage rates rise, refinancing ↓, Prepayments ↓
PSA Speed ↓, Average Life ↑
Called Extension Risk
Pre-payment Risk Page 9
Contraction Risk Extension Risk
decreasing rates arises increasing rates

from
· shorter average life results · longer average life

· greater cash flows in · minimum cash flows
price will not rise by Adverse price will fall at

as much as an Condition # 1 about the same rate
option-free bond as an option-free bond
lower re-investment Adverse lower cash flow for

of cash flow Condition # 2 re-investment
Collateralized Mortgage Obligation – CMO
Pool of Bond Class 1

Page 1
Pass-through Note: Prepayment
time
Bond Class 2 risk is not eliminated,
Mortgage tranches
Securities Bond Class 3 only redistributed
Collateral · different maturities

· different yields
Sequential-Pay Tranches
all Principal payments Bond Class 1
when fully paid, then Bond Class 2
etc…
each Bond Class will get paid interest as per
contractual agreement
$400M, 7.5% pass-through, WAC = 8.125%, WAM = 357 months Page 2
Principal Paydown Window

A month 1 month 81
@ 165 PSA
B month 81 month 100
C month 100 month 178
D month 178 month 357
Original average life was 8.76 years @ 165 PSA

(of the collateral)
average life shorter than average life of collateral
A 3.42
- protection from extension risk
B 7.54
(provided by C & D)
C 11.58
average life longer
D 22.29
- protection from contraction risk
(provided by A & B)
Planned Amortization Class (PAC) & Support Tranches Page 3

e.g. $400M, 7.5% pass-through, WAC = 8.125%, WAM = 357 months
- assumptions of an
upper & lower PSA Month @90 PSA @300 PSA Min. Pr. PMT
1 508,169 1,075,391 508,169
lower PSA – 90 2 569,843 1,279,412 569,843
3 631,377 1,482,194 631,377
initial PAC collar/bond
· · · ·
· · · ·
· · · ·
· · · ·
· · · ·
upper PSA – 300 211 949,482 213,309 213,309

213 946,083 209,409 209,409
· offers both contraction
& extension risk etc…
(two-sided prepayment support tranches get
protection) $ over min. Pr. PMT
Page 4
Floating-rate tranches - collateral pays a fixed rate
Solution: the CMO still gets a fixed -$ interest amount
split into a floating & inverse floating portion
e.g. $96.5M @ 7.5% (Total int. = 95.5 .075 = $7,237,500)

FL – 72, 375,000 (75%) 1-month Libor + 50 bps
IFL – 24,125,000 (25%) K[– L (1 – month Libor)]
leverage
max int. occurs when Libor = 0%
FL $361,875 So, Libor @ 3.75%
IFL 6,875,625 = 28.5% (k) FL 4.25%
24,125,000 IFL 28.5 – 3(3.75) = 17.25%
IFL floor = 0%, FL cap rate = 9.5%
Page 5
Which tranche in a CMO structure is most suitable for:
1. Investor concerned about contraction risk

sequential pay last tranche
2. Investor looking for stable average life

slow
PAC tranche
fast
3. Investor expecting rates to fall
Inverse floater
4. Investor ok with prepayment risk for high expected

return support tranche (of PAC)
Non-Agency Residential MBS
Agency Prepayment risk – conforming mortgages Page 1
- Explicit/Implicit Gov’t guarantee

Non-agency Credit + Prepayment risk
- can include non-conforming loans
Cash flows waterfall (credit tranching)
realized losses (priority of claims)
subordinate before senior
forecasting requires assumption about default rates as well
as prepayment rates
Credit Rating usually require credit enhancements
Internal: senior/subordinate structure
i.e. A - senior $ 90M
B – sub. 7M – provides credit support for A
C – sub. 3M – provides credit support for B & A
Internal Credit Enhancements Cont. Page 2

Reserve Funds
cash reserve funds part of underwriting profits deposited
in a fund
excess spread accounts WAC = 8%, service = .25%
net passthrough = 7.25% 50 bps excess spread
Overcollateralization $105M SPV sells $100M
External Credit Enhancements

Financial guarantee by a third party
- typically monoline insurance co. - securities said
to be ‘wrapped’
up to a specified amt.
i.e. $100M security issue, 5% guarantee
Covers first $5M in losses
Commercial MBS
Income pool of RMBS Page 1
producing commercial CMBS

CMBS
assets mortgages
· apt. buildings
· office prop. non-recourse loans
· malls credit analysis involves
· industrial parks analysis of cash flows
etc…
on a loan-by-loan basis
debt-to-service coverage ratio loan-to-value ratio
higher = better
can be
‘gamed’
Page 2
if DSC & LTV ratios are not sufficient for a rating,

subordination is used
rating agencies will require sequential retirement
losses from defaults will be charged
against lowest priority tranche
(first loss piece, equity tranche,
residual tranche)
Call Protection at loan level
1) prepayment lockout 2-5 yrs.
2) defeasance borrower purchases securities as
collateral to cover remaining principal balance + an
amount to substitute for what the yield would have been
(Defeasance premium)
Page 3
Call Protection – con’t.
3) Prepayment penalty points i.e. 5-4-3-2-1
if borrower wishes to prepay in Year 1, must pay 105%
2 104%
etc…
4) Yield maintenance charges
a.k.a. – make whole charge if refinanced to get lower rate,
borrower must make ‘yield’ whole
at structure level Credit Tranching
Balloon Maturity Provisions – at end of term of loan

- borrower may not be able to - refinance
- lender will mostly likely - sell balloon risk
extend the loan - pay ‘extension risk’
Auto-Loan Backed Securities

Page 1
· typically issued by: - financial subsidiaries of auto manufactures
- commercial banks often below
- independent finance companies market rates
Prime
high credit quality secured Moody’s
begin to repay Pr. + i immediately < 3%
short-term in nature losses
originated by fin. subs. of auto manufacturers
Sub-Prime > 7%
- not as clear as home loans (near prime 3-7%
Cash Flows – Principal + interest + prepayments (amortizing loans)
sale & trade-ins

repossession and sale (business cycle related)
Prepayments loss or destruction (insurance)
early retirement
refinancing minimal
Page 2
all ALB Securities have some form of credit
enhancement
A - senior
Credit tranching B - mezzanine
C - equity (subordinate)
Reserve Account $5M on $100M
Overcollateralization $100M issued against $105M
Excess Interest - 8.5% - 1% = 7.5% but pays

WAC – servicing 6.75%
.75% excess
spread
Credit-Card Receivable-Backed Securities
Page 1
Visa/MC/Amex
SPV Securities
Sears/Target
receivables interest (monthly, quarterly)

fixed or floating
· finance charges (50% - uncapped)
cash flow
· fee
to SPV
· principal
Note: Non-Amortizing finance charges

(18 mos. - 10 yrs.)
lockout period fees
revolving period principal
-
= 0 *
· any principal payments received are retained by the trustee

and re-invested in additional receivables to maintain the size
of the pool
Page 2
Payment Structure:
Pass-through principal paid to security holders on a
pro-rata basis
Controlled Amortization PAC structure
Bullet payment entire amount of FV
Gross Portfolio yield – chargeoffs = Net Portfolio yield

(finance charges + fees) (bad debts)
Early Amortization Triggers

3 month average excess spread ≤ 0 - the AAA first
- no more reinvestment AA next
etc…
Collateralized Debt Obligations (CDO)

asset (collateral) Page 1
· U.S. high yield corporates
manager
· structured financials (MBS/ABS) senior
· emerging market bonds asset securities mezzanine
· bank loans pool equity
· distressed debt
if only
if only
bonds (CBO) loans (CLO)
Asset Manager: buys/sells assets to generate cash flows

has restrictive covenants (cap. gains, interest)
ability to pay interest pmts. to tranches depends
on the performance of the assets
interest payments
cash flows come from maturing assets
sale of assets
Page 2
fixed-rate
bonds
SPV floating rate payments
some floating (one or more tranches)
rate loans interest rate
swaps (fixed-for floating)
e.g. $100M CDO, fixed @ 11%, mgmt. fee = $640k
Senior $80M Libor + 70 bps 8% Libor

Collateral Swap
Mezzanine 10M 9% 6.4M
Equity 10M $11M
4.6M
In Out 640k Mgmt. Fee

Libor + 4.6M Libor + 560k Senior
900k Mezzanine
2.5M Equity assumes no
defaults.
Page 3
ramp-up period – mgr. buys assets
t = 0 t = 1 yr. 5 yr. …. n
-
assets sold
reinvestment period securities retired
(revolving) – proceeds are reinvested
capture
CDO
spread
cash CDO remove assets synthetic CDO
from sponsor BS.
Arbitrage* Balance* Arbitrage* Balance*
Driven Sheet Driven Driven Sheet Driven
Cash Flow Market Cash Flow * motivation active

CDO Value CDO CDO mgmt.
Covered Bonds
Page 1
- senior debt obligations issued by a financial institution and
backed by a segregated pool of assets
(commercial or residential mortgages)
asset pool (remains on issuer’s balance sheet)
- offer dual recourse
financial institution
- one bond class per cover pool
- issuer must replace any prepaid or non-performing asset until
maturity of the covered bonds
- usually carry lower risk and lower yields than ABS
3 major redemption regimes

1/ hard bullet covered bonds - payments have to be made according
to the covered bonds original schedule
- if not paid on the Standard Maturity Date (SMD), investors
gain access to the cover pool
Page 2
3 major redemption regimes
2/ soft bullet covered bonds - pmts. must also be made according
to the covered bond’s original schedule
- if not, does not trigger default - extension period of
typically 12 months granted, creates a new
Final Maturity Date (FMD)
- if not paid then, investors gain access to the cover pool
3/ Conditional pass-through covered bonds (CPT) - pmts. must

also be made according to the original schedule
- if not, does not trigger default - covered bonds go
into pass-through mode
- cash flows and sales of assets are then
passed through to the covered bond investors as
they occur
Understanding Fixed-Income Risk and Return
a. calculate and interpret the sources of return from investing in a fixed-rate bond;
b. define, calculate, and interpret Macaulay, modified, and effective durations;
c. explain why effective duration is the most appropriate measure of interest rate
risk for bonds with embedded options;
d. define key rate duration and describe the use of key rate durations in measuring
the sensitivity of bonds to changes in the shape of benchmark yield curve;
e. explain how a bond’s maturity, coupon, and yield level affect its interest rate
risk;
f. calculate the duration of a portfolio and explain the limitations of portfolio

duration;
g. calculate and interpret the money duration of a bond and price value of a basis
point (PVBP);
h. calculate and interpret approximate convexity and distinguish between

approximate and effective convexity;
i. calcuate the percentage price change of a bond for a specified change in yield,
given the bond’s approximate duration and convexity;
j. describe how the term structure of yield volatility affects the interest rate risk of
a bond;
k. describe the relationships among a bond’s holding period return, its duration,
and the investment horizon;
l. explain how changes in credit spread and liquidity affect yield-to-maturity of a

bond and how duration and convexity can be used to estimate the price effect of
the changes;
m. describe the difference between empirical duration and analytical duration.

Sources of Return - Fixed Rate Bond

Page 1
Coupon payments + principal (on scheduled dates)
Reinvestment of coupon
Capital gain/loss
Example: 10-year, 8% annual @ 85.503075

YTM = 10.40%
(PV) r = 0.104
8 8(1.104)9 Total coupons $80

Interest-on
t=0 t=1 t=2 t=10 interest 49.970678
8 8(1.104)8
Principal 100
229.970678
8 85.503075 = (1.104)10
129.970678
Page 2
YTM assumes 1) held to maturity
2) No default
3) Coupons re-invested at same rate of interest
Now assume same bond But sold after 4-years
t=0 t=4 t=10

FV(coupons) = 8(1.104)3 + 8(1.104)2 + 8(1.104) + 8 = 37.347111
PV of 6-year, 8% annual with YTM = 10.40% = 89.668770
Total Return = = 85.503075 r = 10.40%

· horizon yield
Assumes coupons re-invested at 10.40%
Bond is sold on the constant-yield price curve
Page 3
100 -
carrying value purchase price + amortized amt.
Capital gain
of the bond (85.503075) of the discount
Capital loss OR
“ “
89.668770
“ “ premium
80 -
-
5 10
Now: Assume interest rates rise 100 bps (10.40% 11.40%)
9 yrs.
8 11.4%
.
-
-
t = 0 t = 1 t = 10 .
.
(85.503075)
.
.
.
136.380195
100
r = 10.7%
Now: Assume interest rates rise 100 bps (10.40% 11.40%) Page 4
Sold after 4 years FV of coupons at t = 4 37.899724 (+)
PV of 6-yr. bond at t = 4 85.780408 (-)
89.668770 – 85.780408 = 3.888362

Capital loss
Now: Assume interest rates fall 100 bps (10.40% 9.40%)

Buy-and-Hold Sold after 4-years
r = 10.10% r = 0.1117
· lower re-investment · lower re-investment of coupon

of coupon · Capital gain on sale of bond
interest rate risk interest rate risk
Interest Rate Risk
Duration measures the sensitivity of the bond’s full Page 1
price to changes in the bond’s own yield

or, more generally, changes in the
benchmark rate
- assumes all other variables are held constant
represents approx. amount of time a

➞
PV bond would have to be held for the
market discount rate to be realized
e.g. 10-yr. 8% annual @ 85.503075, YTM = 10.4%
r Duration = 7.0029 if rates ↑
- several types of bond duration/ Page 2
yield duration curve duration

- sensitivity of price to - sensitivity of price to
own YTM benchmark yield
gov’t yield curve

e.g./ Macauley spot curve
modified forward curve
money ➞ par curve (often used)
price value for a (PVBP) - used with complex bonds
basis point and also with financial
assets/liabilities that
will require an have int. rate risk but are
option pricing model not bonds
e.g./ effective
Macaulay Duration/ Page 3
closed-form/ c = coupon
Page 4
annualized
modified duration/ e.g./ (AnnModDur)
interpretation/ - provides an estimate of the %’age

price change for a bond given a change
in its YTM (linear estimate)
➞
% ≈− × annual yield
e.g./ if r = 11.4% instead of 10.4%

requires
a
r = 9.4% instead of 10.4%
convexity
adjustment
Page 5
So… if MacDur is known,
- if MacDur is not known, we can approximate ModDur
PV
Price-Yield Curve for small yield
PV- ➞
ApproxModDur
PV0 =
AnnModDur
PVt -
ApproxMacDur
line tangent to
Price-Yield Curve = ApproxModDur
YTM
r + (1+r)
Page 6
e.g./ 10-year, 8% annual @ 85.503075, YTM = 10.4%
up 25 bps down 25 bps

10 N 10
8 PMT ➞8
100 FV 100 vs.
10.65 I/Y 10.15
84.161819 + PV - 86.87388 6.3432
if rates ↑ 50bps
Effective Duration/ Page 7
- used for complex bonds with embedded options
Value of the embedded - requires on option

PV- Call option pricing model for
➞ (PV ) -
PV0
(thus, Macaulay &
Non-Callable Bond
PVt modified duration are
useless)
Callable Bond
- r +
Effective Duration/ Page 8
- for a callable bond/ · may be called if
credit
decreases credit duration
spread
or ➞
benchmark decreases curve duration
yield
- also used for FRNs, MBS, DBPP (retirement obligations)
homeowner’s have a
call option
Q: Does a curve = yield? Page 9
i.e./ EffDur = ModDur on a fixed-rate, non-callable

bond?
curve is
ModDur vs. EffDur
based on
6.3492 6.0046
spot curve par curve
- when par curve is shifted, spot curve is

also shifted, but not in a parallel
manner
- flatter the par curve

- shorter the bond EffDur ModDur
- close price is to par
Key Rate Duration

Page 1
EffDur assumes a parallel shift in LOS d
the yield curve - define
- if the yield curve shifts in a non-parallel manner, - describe
a portfolio’s EffDur cannot be used to estimate
r
2<
· key-rate duration is the duration
at a specific maturity on the yield
➞
curve
for a non-parallel shift in
r- the yield curve, key-rate
bps duration must be used to
estimate
r-
-
-
-
-
-
-
-
-
-
-
-
-
-
-
-
Maturity
r Page 2
LOS d
- define
- describe
r-
Key Rate Duration
r-
➞
yield
-
-
-
-
-
-
-
-
-
-
-
-
-
-
-
Maturity
curve
11 maturities
- a key rate durationi is

calculated for each = EffDur
EffDur
maturity
Page 3
+ + + [ − ( − )]
( ) = − − Dmac = f (c, r, N, t)
× [( + ) − ] +
c, r, N - constant
D zero coupon
bond
Discount
(N – 1) each date Perpetuity
Premium
➞
45°
time – to time – to
-
-
coupon
-
-
-
maturity maturity
payment
=
dates D↑
low coupon bond higher D
more interest rate risk
low YTM = higher D
larger weights
Example/ Page 4
C PV YTM
A 10 yr. 58.075279
annual
-
B 20 yr. 10% 51.304203 20%
C 30 yr. 50.210636
-
-
+/- 1 bps
A B C
PV0 = 58.075279 PV0 = 51.304203 5.063
PVt = N = 10 PMT = 10 ➞ PVt = N = 20 PMT = 10
FV = 100 I/Y = 20.01 FV = 100 I/Y = 20.01
CPT PV = 58.047598 CPT PV = 51.277694
PV_ = N = 10 PMT = 10 PV_ = N = 20 PMT = 10
FV = 100 I/Y = 19.99 FV = 100 I/Y = 19.99
CPT PV = 58.102981 CPT PV = 51.330739
Approx.Mod.Dur. = 5.169
Page 5
PV
PV_ option-pricing
model
PV_
PV ➞
Non-Callable Bond
r Benchmark
Yield
Duration of a Bond Portfolio
2 ways to calculate: Page 1

1) weighted average of time to receipt of the
aggregate cash flows
2) weighted average of the individual bond durations
in the portfolio
such that
and where m = periodicity
Page 2
e.g. A B C
$25M $25M $50M
Coupon 9% 11% 8%
TTM 6yrs. 8yrs. 12yrs.
YTM 9.1% 9.38% 9.62%
MV $24,886,343 $27,243,887 $44,306,787
MacDur 4.761 5.633 7.652
Bp = $96,437,017 Avg.ModDur➞=
semi-annual coupons
MacDur – annualized
so…if YTM ↑ 20bps
6.0495 0.002 = 0.0121
or 1.21% decline
Page 3
Money Duration measure of price change in
currency terms
Money Dur. = Ann.ModDur PVfull
per 100 of versus actual
PVfull ≈ - MoneyDur yield par value face value
e.g. PVfull = 100.940243
if YTM ↑ 100 bps
Ann.ModDur = 6.1268
PVfull = - (618.44178 0.01)
MoneyDur. = 6.1268 (100.940243)
➞ = 6.184417 ≈ 6.1268%
= 618.44178
Price Value of a Basis Point (PVBP)

PVfull for 1bp
a.k.a. PVO1
DVO 1 (U.S.)
or
basis point value BVP = MoneyDur 0.0001
Page 4
e.g. FV = $10M 1. Calculate money duration
coupon = 4.5%
Money Dur. = Ann.ModDur PVfull
PVfull = 99.65
= .
YTM = 5.2617% × . = .
.
MacDur = 2.4988 +
➞
2. Calculate PVfull for 1bp ↑ in YTM
BPV = MoneyDur. 0.0001
= 242.62 0.0001 = 0.024262 /100 of par value
0.024262 = $2,426.20 drop in MV for 1bp.

Page 5
Price PV due to duration – primary effect
PV due to convexity – secondary effect for
large bps
Convexity
∆ ∆
YTM Adjustment
due to duration due to convexity

first-order effect second-order effect
if bp+ (neg.) + (pos.)
if bp- (pos.) + (pos.)
Closed Form - Approx.Con. =
Page 6
e.g. 7.25% annual, YTM = 7.44% Recall: pg. 410, R54, Eq. (6)
Maturity Apr. 4/2029
Settles Jun. 27/2014
1. Calculate PVfull: PMT = 7.25, r = 0.0744, , PV0 = 99.95678

2. Calcuate Approx.ModDur & Approx.Con. for 1bp 0.0001
PV+ 1.0744 1.0745➞= 99.869964
PV- 1.0744 1.0743 = 100.043703
−( )−( ) ( )+( )−( )
. = = . . .= = .
( ) ( )
3. Calculate % PVfull for yield = +100 bps.

% PVfull =
=
=
Page 7
4. Compare est. % PVfull with actual % PVfull if YTM 8.44%
Actual - 8.1794%
Est. - 8.155% 2.44 bps. off
vs. ModDur only of – 8.6907%
Page 8
Recall: MoneyDur. =
Well, money convexity results in,
first-order second-order effect

effect
➞
when bond’s cash
flows do not change
when bond’s cash

flows change
both pos.
neg. convexity
convexity callable
Yield Volatility Page 9
YTM
% ≈ (− . × )+ . × ( )
≈ Duration + Convexity
25 bps
impact/basis point change
Yield Volatility = # of ‘basis points’ change

time-to-
maturity
· non-parallel ➞
shifts Investment Horizon
Duration gap = MacDur – Investment horizon
if: duration gap < 0 coupon re-investment risk
dominates market price risk
- risk is to lower rates
> 0 market price risk dominates
coupon re-investment risk
- risk is to higher rates
Credit & Liquidity Risk

Corporate Bonds Page 10
Benchmark
+ Spread
rate
Inflation real credit

liquidity
expectations rate risk
➞
Inflation Real Rate Credit Liquidity
Duration Duration Duration Duration
typically interaction effects

i.e
credit quality
Conditions leading to a benchmark rate
liquidity
may lead
to a…
Empirical Duration
Page 1
Analytical duration arrived at by mathematical formulas
- assume yields and spreads are uncorrelated
Empirical duration determined from market data

= + where = benchmark
interest rate
e.g./
10 yr. EUR bond returns = + (10 yr. bond)
or (10 yr. Eurobor swap rate)
IG largely driven by interest rate

movements
HY - wide spreads behave like equities

- narrow spreads behave like IG
Fundamentals of Credit Analysis
a. describe credit risk and credit-related risks affecting corporate bonds;
b. describe default probability and loss severity as components of credit risk;
c. describe seniority rankings of corporate debt and explain the potential

violation of the priority of claims in a bankruptcy proceeding;
d. compare and contrast corporate issuer credit ratings and issue credit ratings
and describe the rating agency practice of “notching”;
e. explain risks in relying on ratings from credit rating agencies;
f. explain the four Cs (Capacity, Collateral, Covenants, and Character) of

traditional credit analysis;
g. calculate and interpret financial ratios used in credit analysis;
h. evaluate the credit quality of a corporate bond issuer and a bond of that
issuer, given key financial ratios of the issuer and the industry;
i. describe macroeconomic, market, and issuer-specific factors that influence

the level and volatility of yield spreads;
j. explain special considerations when evaluating the credit of high yield,

sovereign, and non-sovereign government debt issuers and issues.
Fundamentals of Credit Analysis
LOS a, b (3p) Credit Risk (describe)
LOS c (5.5p) Capital Structure, Seniority Ranking, Recovery Rates (describe,

explain)
LOS d, e (9p) Rating Agencies, Credit Ratings (compare, contrast, describe)
LOS f (7p) Credit Analysis: Corporate Debt (explain)
LOS g, h (10.5p) Ratio Analysis (calculate, interpret, evaluate)
LOS i (8p) Risk v Return: Yields and Spreads (describe)
LOS j (14p) High Yield, Sovereign, Non-Sovereign (explain)
2 1 Page 1
credit risk risk of loss from non-payment LOS a, b
- describe
1 default risk (default probability - POD) - risk of non-payment
- issuer fails to make full and timely payments of
principal + interest
2 loss severity (loss given default - LGD) - the amount of the

loss given that the issuer has defaulted
(principal + any accrued interest)
($ or %)
∴ ( )= ×
% or $ (1 - Recovery Rate)
% of principal recovered
for IG (investment grade) bonds investors focus on POD

for HY (high yield) bonds investors focus on LGD
Page 2
Credit-related risks:
LOS a, b
1) Spread risk spread above risk-free rate - describe
credit
2) Credit migration risk (downgrade risk)
spread
lower credit rating = wider spread = lower price illiquidity
premium
higher POD = higher ( )
3) market liquidity risk illiquidity = wider spread

higher risk for smaller issuers whose debt trades
infrequently
LOS c
Issuer’s debt may not all have the same seniority - describe
ranking (i.e. priority of payments) - explain
- rank of seniority will affect recovery rates in default
Page 3
mortgage (first, second…) LOS c
Secured Senior Secured - pledge of specific property - describe
- explain
liens (first, second, etc…)
- pledge of specific assets
Unsecured Senior Unsecured - most common

(general claim Senior Subordinated
on assets after Subordinated
all senior ranks) Junior Subordinated
even low ranking debt may be cheaper than issuing equity, prevents
dilution of existing shareholders, less restrictive than issuing
senior debt, and may be adequate market demand
Page 4
Recovery Rates all creditors at the same level of the
LOS c
capital structure are treated as one class - describe
30yr - explain
i.e. senior unsecured all equal in claim
10yr
(pari passu - on equal footing)
3yr
- recovery rates vary be seniority class (rating)

- also vary significantly by industry and by when they occur in the credit
top - higher recovery rates + lower POD
cycle
- recovery rates
are averages (bus. cycle)
bottom - lower recovery rates + higher POD

Typical priority of claims:
secured paid out from specific property/assets
- if that is not enough, balance becomes senior unsecured
unsecured (in order of ranking) before equity (priority may not always
be followed)
Page 5
Rating agencies: Moody’s, S&P, Fitch
LOS d
- compare
- contrast
all public debt is rated - describe
underwriters won’t issue, and
investors won’t buy, debt that is
not rated
ratings provide comparability of the
relative credit riskiness of all
bond issuers and issues
IG issuers are better able to access

debt markets at lower rates
- may add: positive, stable, negative

and/or ‘On Review for Downgrade’
‘On Credit Watch for Upgrade’
Page 6
Issuer vs. Issue Ratings:
LOS d
- compare
corporate family rating addresses an issuer’s overall - contrast
corporate credit rating creditworthiness - describe
issuer credit rating - typically applies to senior unsecured
Notching senior secured (issuer rating +1 or 2 notches)
Issuer senior unsecured
subordinated (issuer rating -1 or 2 notches)
higher the issuer rating, the smaller the notching
- issuers can have debt with different ratings and LGD

- may even be structurally subordinated
2 Parent - debt
SnP clause sub. 1 sub. 1 cash flows service this debt first
debt debt before 2 flowing to the parent
Page 7
1/ Credit ratings can change over time LOS e
upgrades/downgrades credit migration - explain
2/ Credit ratings tend to lag the market’s pricing of credit risk
bond investors must anticipate changes rather than
wait for a credit rating change
HY credit rating assesses POD, but LGD may indicate other pricing
3/ Rating agencies may make mistakes (MBS, CDOs in 2007/08)
4/ Some risks are too difficult to capture in credit ratings
- environmental, social risks
LOS f
4 Cs of credit analysis/ - explain
- assessment of an issuer’s ability to pay sources, predictability
credit quality of the company and sustainability of cash flows
fundamentals of the industry
Page 8
LOS f
1/ Capacity - ability to make debt payments on time - explain
begin with industry structure ananlysis Porter’s 5 forces model
an industry is more profitable and thus has lower
credit risk when the following are in place:
i/ threat of entry higher entry barriers
ii/ power of suppliers multiple suppliers
iii) power of buyers many buyers
iv) threat of substitutes no good or cost competitive substitutes
v) rivalry among competitors few competitors, high industry growth
low barriers to exit
Industry fundamentals
i) cyclical or non-cyclical - cyclical is more economically sensitive
- more volatile revenues and cash flows
Page 9
1/ Capacity Industry fundamentals LOS f
i) cyclical inherently risker (e.g. auto, steel, cons. discret.) - explain
cyclical companies should carry lower debt than non-cyclicals
ii) growth prospects - better prospects, more sustainable cash flows

- better recovery rates
iii) published industry research - secondary research/statistics
Company fundamentals
a) competitive position - market share, cost structure
b) track record/operating history
c) management’s strategy and execution
2/ Collateral - refers to the quality and value of the assets

- typically emphasized more with lower credit quality issuers
Page 10
LOS f
2/ Collateral - when POD rises to a sufficient level, asset - explain
values are considered
- financial statement signals mix of tangible vs. intangible
Dep. vs. CAPEX
- market-based signals MVequity vs. BVequity
3/ Covenants - terms and conditions of the debt issue
- what mgmt. must do and is limited from doing
affirmative negative or restrictive

- in the trust deed or bond indenture
- violations are a breach of the contract and may be considered default
- during weak economic/market conditions, new corporate bond issues
tend to have stronger covenants
4/ Character - mgmt. strategy track record of executing
- use of aggressive accounting/tax policies
- history of fraud
- previous poor treatment of bondholders (past credit downgrades)
Page 11
LOS g, h
Profitability and cash flow measures/ - calculate
(operating profit) - interpret
EBITDA op. income + Dep./Amort. - evaluate
FFO NI from cont. ops. + Dep./Amort. + Deferred taxes + NCC
FCF before dividends NI + NCC - WCInv - CAPEX
FCF after dividends
Leverage measures/
Debt = interest bearing liabilities + underfunded PO (has an implied
+ operating leases interest cost)
Debt/Capital Debt + Sh. Equity

- lower = lower credit risk
- generally used for IG issuers
Debt/EBITDA - higher = higher leverage
∴ more credit risk
Page 12
Leverage measures/
LOS g, h
FFO/Debt higher = better ability to pay debt - calculate
(FCF after dividends)/Debt higher = better - interpret
- evaluate
Coverage measures/ - measures ability to cover interest payments
EBITDA/Interest expense
EBIT/Interest expense or payments
- higher coverage = better
Issuer liquidity/ assessment of access to liquidity

- cash on B.S.
- net WC. (positive)
- operating cash flow example #6
- committed bank lines (untapped)
- Debt coming due and committed CAPEX (over next 12-24 months)
Page 13
LOS i
Yields and Spreads/ - describe
macro
level and
market volatility
of spreads
issuer
Corp. yield - nominal = credit spread
real credit risk

( ) liquidity
maturity pr.
tax issues
spreads narrow Page 14

Spreads affected by: LOS i
1/ Credit cycle - describe
2/ Broader economic conditions spreads widen
3/ funding availability in the financial sector
dealers unwilling to hold inventories will decrease liquidity and
widen spreads
4/ general market supply and demand
demand > supply = narrower spreads
5/ financial performance of issuer
better (higher FCF, higher coverage) = narrower spreads
Price Impact/ spread risk the effect on prices for a ∆spread
Ex. #9 PV = 100 YTM = 4.75% ModDur = 7.9 Convexity = 74.9
Spreads ↑ 50 bps %∆ = (− . × . )× . (. ) =− . %
High Yield/ typically due to: Page 15

LOS j
higher leverage levels
- explain
weak/limited operating history
limited or negative free cash flow greater risk of
highly cyclical business default
poor mgmt.
more attention paid
lack of scale or competitive advantages
to recovery analysis
declining industry
Special considerations/
1/ Issuer liquidity - far more critical for HY
- may not have the ability to roll over debt when it comes
due
- may not be able to issue equity if a private company
2/ financial projections - forecasts under multiple scenarios
- use of stress testing
Page 16
High Yield/ Special considerations LOS j
3/ Debt Structure - secured down to junior subordinated - explain
(typically convertible bonds)

- lower the ranking, lower the recovery rate, and the
lower the credit rating
- calculate leverage at each level of the capital structure
- HY with a lot of secured debt referred to as having
a ‘top-heavy’ capital structure less capacity to add bank
debt
(example #10)
4/ Corporate Structure - parent vs. subsidiary

- any structurally subordinated debt?
- leverage ratios should be calculated at each
debt-issuing entity level as well as on a consolidated
basis
High Yield/ Special considerations Page 17

LOS j
5/ Covenant analysis - explain
change of control put - in the event of an acquisition,
bondholders have the right to require the issuer to buy
back their debt at par (or slight premium)
- for IG requires not just acquisition, but credit downgrade after the
fact
Restricted payments - limits how much cash can be
paid to shareholders over time
Limitations on liens and additional indebtedness
- limits how much secured debt an issuer can take on
- protects unsecured bondholders
Restricted vs. Unrestricted subsidiaries
offers guarantees to parent level debt - parent debt on equal

- eliminates structural subordination standing with
subsidiary’s debt.
Page 18
High Yield/ Special considerations LOS j
5/ Covenant analysis - explain
maintenance covenants - typical of bank credit agreements
e.g. debt/EBITDA < x times
6/ Equity-like approach to high yield analysis

HY has a higher correlation to equity than IG
HY has less interest rate sensitivity to rate hikes
IG ↓
- as economy improves, rates ↑
HY ↑ since spreads tend to
Sovereign Debt/ contract by more
external offerings (USD or EUR)
internal offerings (issued in local currency)
- easier to service
- defaults do occur
Page 19
Sovereign Debt/ should assess:
LOS j
1) ability to pay - explain
2) willingness to pay - sovereign immunity generally cannot force
a sovereign to pay since immunity prevents them from being sued
Institutional assessment
Economic assessment - growth prospects
Fiscal soundness
Monetary policy - mandates, credibility, flexibility
Non-Sovereign Debt/ - municipalities

- general obligation bonds (unsecured)
- revenue bonds - issued for specific project financing (DSCR)
- municipalities must balance their budgets
- analysis focuses on regional employment, tax base, population growth,
business attractiveness
Defining Elements
Review - 1
Features/ Issuer · supranational orgs.
sovereign
· government non-sov.
state
· corporate prov.
quasi
GSEs
Maturity vs. Term to Maturity (tenor)

- overnight to 30+ years
< 1 yr. - money market
at time of issuance
> 1 yr. - capital market
par
Par value · face/maturity value
discount < 100
premium > 100
Coupon rate/frequency - stated rate paid annually

- plain vanilla/conventional - fixed rate
- FRNs - floating rate notes - reference rate + spread
- zero-coupon - issued at a discount, matures at par
Review - 2
Features/ coupon in one
Currency - dual currency bonds
- principal in another
- currency option bonds
- bondholder chooses currency of each
coupon PMT
Credit Enhancement
subordination (senior 85%, junior 15%)
Internal
over-collateralization
excess spread
External Surety Bond/Guarantee

Letter of Credit
Covenants - affirmative - what an issuer must do

- negative - what an issuer will not do
- limits on debt, restrictions on dividends, restrictions on M & A,

negative pledges (i.e. nothing senior)
Review - 3
Bond - legally binding contract form of bond
- need Bond Indenture (a.k.a. trust deed) obligation of
- trustee - fiduciary for Bondholders issuer
- legal identity of issuer, legal form rights of
bondholders
Source of repayment proceeds/
· supranational - repayment of previous loans
· government - full faith & credit (taxes usually)
· corporate - cash flows (CFO)
· securitized - principal + interest PMTs of
securities held
Asset/Collateral Backing/
secured (bonds)
· Senior ranking
unsecured (debentures)
Review - 4
Asset/Collateral Backing/ collateral trust bond
· collateral quality equipment trust certificate
MBS/ABS
like
covered bonds securitization
Legal/Regulatory/Tax/
· Domestic - issuer, country, currency all match
· Foreign - country & currency match, issuer does not
· Eurobond - issued outside jurisdiction of any
country
- named after currency of denomination

(Eurodollar, Euroyen)
Review - 5
Legal/Regulatory/Tax/
Tax · Interest normal income
· Capital gain long-term - cap. gains tax rate
short-term - usually income
· Zero-coupon - all interest (implied each yr.)
Discount Bond - implied interest each yr.

Premium Bond - implied capital loss each yr.
Structure of Cash Flows/

· plain vanilla - interest + principal (bullet bond)
at end
fully - interest + pr. each PMT

· amortizing bond
partially - interest + pr. each PMT +
balloon PMT at maturity
Review - 6
Structure of Cash Flows/
· Sinking Fund - some %’age of bond put aside each yr.
annual
· Fixed rate semi-annual · Floating rate
quarterly - reference + spread
· Step-up coupon variable (margin)
- coupon increases over time
· Credit-linked coupons · may have · cap - no higher
↓↑ with credit quality · floor - no lower
· PIK bonds - payment in kind
(w/toggle) (e.g. shares) · may be inverse floater
· Deferred Coupons - no PMTs for first - if Libor ↑, coupon ↓
few years, higher PMT after
· Index-Linked Bonds
e.g. equity index/inflation
Review - 7
Structure of Cash Flows/ coupon
· inflation adjustments or
principal (zeros)
Contingency Provisions/ PMT ↑ as principal increases
- embedded options (capital indexed bonds)
call risk
Callable bond - benefits issuer, holder
reinvestment risk
(higher coupon/lower price)
· Make whole call = PV of
Putable bond - benefits holder
· American - always callable/putable

· European - 1 call/pull date
· Bermuda - many call/put dates
Review - 8
Contingency Provisions/
Convertible Bonds/ into common shares (call option)
- benefits holder
e.g./ $20/sh.
conversion price = $/share
ratio = FV/conv. pr. = = shares
value = Pt ratio
if Pt < $20
premium = Bt - (Pt ratio)
- below parity
parity Bt = (Pt ratio)
if Pt > $20 - above
- forced conversion - if Pt > $20 for a parity
specified # of days, company calls bonds
at a lower price
Warrants
- not an embedded option
Issuance, Trading, Funding
Review - 1
Markets/
gov’t./gov’t. related supranational
Issuer
financials sov./non-sov.
corporate quasi.
non-financials largest
structured products
(securitized) smallest
investment grade (Baa3 or BBB – or higher)
Credit Quality
non-investment grade – high yield, speculative
(more risk)
Maturity < 1 yr. – money market
at issuance
> 1 yr. - capital market
Currency – determines what county’s interest rate determines price
Domestic
legal, regulatory, tax regime of ‘issued-in’
Geography Foreign
country
Eurobond
Review - 2
Markets/ emerging
Geography developed 5 currencies
fixed 35 rates 7 time
Coupon
floating LIBOR - London Interbank Offered Rate periods
- unsecured loans between banks
for up to 1 yr.
Primary Market (first time issuance)
Public Offering - underwritten offering (firm commitment)
- buys whole issue, assumes inventory risk
· issuer determines funding - typically Investment Bank or syndicate
needs
· selects underwriter
· structures the offering marketing
· announcement date end of subscription obtain ‘anchors’
period grey market (forward mkt.
· gauge demand for upcoming issues)
Review - 3
· Pricing Day - last day to commit
· Issuing Phase - sales made, money transfers
· Closing Date - about 14 days later
Best efforts Offering - investment bank acts as agent/broker

- commission only
- no risk of ownership
Issuance/ Auctions - typically Descending price auction for gov’t.
price bonds
bids solicited then ranked
quantity
e.g./ Sell $50M - each pay their bid until issue is

cuml. sold
.1560 12 12 or/ Modified Dutch - each bidder pays
.1565 8 20 the same price at which the
.1570 16 36 issue clears
.1575 18 50 · non-competitive bids - pay the clearing
only 14 filled all pay this or avg. $
price
Review - 4
Primary Market (Con’t.) (first time issuance)
non-underwritten one/few
Private Placement
unregistered buyers
Secondary Market/ (already issued)
- dealer market - can act as principal/agent
(OTC)
- dealer acts as market maker · very
- exchange listed: very limited little retail
trading
Settlement/
T + 1 - gov’t/quasi gov’t. (capital market)
T + 3 - corporate
same day - all money market
Review - 5
Sovereign Bonds/ Treasuries Bill - money market (pure
Note < 10 yr. discount)
coupon
Bond > 10 yr.
bearing
- most recently issued - on the run
- most actively traded
- unsecured - full faith and credit only
- risk-free AAA (Fitch, S&P) Aaa (Moody’s)
(local currency)
- fixed rate (most common) - some floating (country
- may be inflation-linked (Linkers) specific)
Non-Sovereign Bonds/ - higher yields

- lower credit rating
- perhaps favourable tax treatment
Review - 6
Supranational Bonds/ typically plain vanilla
- must act as benchmark for countries w/
non-liquid bond markets
Quasi-gov’t./ - agency bonds

- not repaid by the gov’t. but by the GSE itself
Corporate/ Private - typically floating may be securitized at

Public some point
Commercial Paper - short term, unsecured
- usually issued by financial companies (or very large
- overnight to 1 yr. - EuroCP non-fin.)
to 270 days - U.S. CP
1
prime paper - P/A/F
Ratings 2
non-prime
3
Review - 7
Commercial Paper
- retired by rolling over - issuer usually maintains
backup LOC
U.S. CP/ EuroCP/ (issued internationally)
· discount basis (par) · interest bearing (par + interest)
· settles same day · settles T + 2
Corporate Notes/ 1 yr. < short ≤ 5 yrs.

notes
5 yrs. < med. ≤ 12 yrs.
long > 12 yrs. - bonds
· fixed or floating
coupons Contingency Provisions
- annual, semi, quarterly
· callable
- secured, unsecured
· 1-30 yrs. · putable
Serial maturity - portion matures · convertible
Principal each yr.
term maturity
Review - 8
Short-Term Funding/ demand
Deposits
Retail savings
Banks
Wholesale money market savings
(short-term)
· Central Bank Funds
- overnight lending/borrowing
· Interbank Market
overnight funds
- banks lending to each other
term funds
+25 bps
target
central bank
funds rate
-25 bps
non-negotiable
· Certificates of Deposit
negotiable
Review - 9
Repurchase Agreement/
- sale of a security w/agreement to buy back
$ repurchase
A B A B $ < value of
securities term security
$(1 + repo rate)
· 1 day repo margin
- overnight repo
· more - term repo
· to maturity - repo to maturity (of the security)
Reverse Repurchase Agreement/

- the above, seem from B’s perspective
Fixed Income Valuation

Review - 1
N PMT I/Y PV FV
- all bonds priced on 100 point system (i.e. 100%)
100 - par coupon = mkt. rate

greater than 100 - premium coupon > mkt. rate
Less than 100 - discount coupon < mkt. rate
inverse relationship as r ↑, prices ↓, as r ↓, prices ↑
for the same coupon & TTM, | | as r ↓ > | | as r ↑

- prices are more volatile to the upside
for the same TTM, the lower coupon bond will be more
price volatile than a higher coupon bond
for the same coupon, longer-term will be more price volatile
Review - 2
Spot Rates/ rather than using one r for all PMTs
(Zn)
- also called
zero rates
will be the period 1 period 2 period n
no-arbitrage price spot spot spot
Flat, Accrued & Full Price/ pricing bonds between coupon dates
n = # of PMTs
× PMT PMT PMT
x
− PV
− .
Review - 3
Matrix Pricing/ for fixed rate bonds w/ no/little
secondary market (or not yet issued)
- use liquid comparables (credit quality)

e.g. 3 yr., 4%
Coupon
3% 4% 5%
2 X X - avg. YTM 2 yr.
TTM 3 X - 3 yr. Interpolate for
4 3 yr. YTM
5 X X - avg. YTM 5 yr. - then calculate PV
estimated 3 yr. YTM - 3 yr. Treasury rate = required yield spread

maturity
- will be a different yield spread for each
credit rating
Review - 4
Yield Measures/ periodicity - # of coupon payments/yr.
e.g./ 6% coupons/yr.
60 1 annual - effective annual rate
2 30 2 semi - semi-annual bond basis yield
4 15 4 quarterly (bond equivalent yield)
12 5 12 monthly
e.g./ 3 yr., 5% semi @ 104 , r = 3.582%
APR4 = 3.566%
as m ↑, APRm ↓ APR - annual percentage

rate
Review - 5
Yield Measures/
· street convention – yield measure that neglects
weekends/holidays
· true yield – accounts for delays in PMTs caused by
weekends/holidays
· government equivalent yield – restates a YTM to an
YTM
· current yield –
· simple yield
Embedded Options
Callable · yield to first (second, third) call
· yield to worst
· YTM
Review - 6
Embedded Options/ typically require an options pricing
model (Level2)
PV = option adjusted price + value of embedded option

- call
+ put
Floating Rate Notes/ · coupon tied to short-term rate (Libor)

· paid ‘in arrears’ quarterly or
semi-annual
· reference rate + quoted margin (QM)
(spread)
PV = 100 if QM = DM
· required rate discount margin (DM) PV > 100 if QM > DM
credit risk DM PV < 100 if QM < DM
on a PMT
date
PMT Review - 7
Floating Rate Notes/ ( + )× ( + )×

= + +…
+ +
+ +
(1 + r) (1 + r)2
e.g./ 4-yr. quarterly, Libor + 125 bps @ 98

find DM if Libor = 2%
CPT I/Y = .009478
N = 16 PV = -98 FV = 100 .009478 =
PMT =
DM = 0.017912 or 179 bps
Money Market Securities/
discount basis = × − .×
simple interest basis
add-on basis =
+
DR = discount rate AOR – add-on rate .
Review - 8
Money Market Securities/ =
= × − . + .×
rearrange/
− = + .×
=
(1 + r)
hence DR is understated = ×
−
e.g./ 90-day, 360 DCC, DR = 5.76% AOR = 5.925%

[w/365 DCC]
Term Structures/ a) gov’t. bond spot curve (· YTM on zeros)
YTM (one issuer, same credit Q, same currency)
upward flat
inverted
· all else
constant
normal
TTM
Review - 9
Term Structures/
b) gov’t. bond yield curve – coupon paying
Note: short end of curve 1 mos., 3 mos., 1 yr. …
money mkt.
c) Par Curve – obtained from the - converted to BEY
spot curve
- each maturity is priced to par
d) Forward Curve 1y1y – 1 yr. from now, one yr. rate
2y1y – 2 yrs. from now, one yr. rate
1 yr. rate implied forward rate

IFR1,1
(1 + r1)(1 + IFR1,1)
- given a spot curve,
-
-
= (1 + r 2)2 a forward curve can be
2 yr. rate
derived
taxation Review - 10
Yield Spreads/ Benchmark + Spread liquidity
macro factors credit risk
· typically some gov’t. yield (most recently issued)
G-Spread – spread above gov’t. I-Spread – spread above swap rate

corp. YTM rate Z-Spread – spread over gov’t. spot
- gov’t. YTM rate
e.g./ · 6% annual corporate, 2 yrs. TTM
@ 100.125
· 2 yr., 4% annual gov’t. @ 100.75
· 1 yr. spot = 2.10% 2 yr. spot = 3.65%
TTM G-Spread/ corporate YTM = 5.932%
Term Structure of
gov’t. YTM = 3.605 (2.327%)
Credit Spreads
(N = 2, PMT = 4, FV = 100, PV = -100.75)
Asset-Backed Securities
Benefits SPV will typically have higher credit Review - 1

rating than originator
(of Securitization) source of funding greater credit
increased loan origination
availability
bankruptcy remoteness
less concentration risk
higher risk-adjusted returns
Mortgages
Pool
Auto Loans
of ABS/MBS Investors
CC Receivables
Student Loans Assets
have a claim
has a claim
originator
Customer Consumer Co.
sells loans
Investor SPV - separate legal entity
AAA Review - 2
senior tranche
mortgages SPV $80M
BB
$100M mezzanine tranche credit
15M tranching
C
equity tranche
losses occur from 5M
the bottom up - all principal goes to senior tranche
first, then mezzanine, then equity
· equity tranche
- usually retained by originator senior 65%
· mezzanine tranche pooled with other
mezzanine 25%
mezzanine tranches
(an ABS of ABS) equity 10%
Sequential Pay ABS/

A1
senior different - each receives interest, but all principal
A2 goes to A1, then A2, then A3
TTM &
A3 - time tranching – redistributes prepay. risk
YTM
A4
Review - 3
Rating
A1 C absorbs all losses
AAA A2 time tranching first
A3 credit
“first piece loss”
B B tranching
C C
- if no credit risk, there would be no subordination (agency debt

- gov’t. guarantee)
Residential MBS (RMBS)
- payments = principal + interest + prepayments
Loan-to-Value Ratio = PMT in partial PMTs

full (curtailment)
· credit quality of borrower important
prepayment risk
mortgage holder
· lockout period Review - 4

Pre-payment Risk/ · penalty period
-
5 yrs. 30 yrs.
Interest Rate/ · fixed rate, level payment, fully amortizing
ceiling
e.g./ · adjustable rate mortgage (ARM)
floor
30-yr., 200K, 6%
N = 360 FV = 0 PV = 200,000 I/Y = .5
CPT PMT = -1199.10
(P) Principal
Amortization PMT 1 1199.10 199.10 1000 199,800.90
schedule PMT 2 1199.10 200.10 999 199,600.80
recourse mortgage – lender can go after assets of borrower

for any short fall
non-recourse – lender’s claim ends at the property backing
the mortgage
agency MBS Review - 5

Guarantees/ 1) federal agency
- no credit risk
2) government sponsored agencies
- prepayment risk
3) private entities – non-agency MBS (credit + prepay.
risk)
· conforming – size, LTV, documentation, insured
· non-conforming w – weight
- weighted average coupon rate (WAC) = r – interest rate
on mortgage
n - # of mortgages
- weighted average maturity (WAM) = T - months
Prepayment Rate (speed) remaining
· prepayments/month
based on historical
PrepayAmt.t = SMMt (Beg. Bal.t – Sched. PMTs) observations
Conditional Prepayment Rate: CPR = 1 – (1 – SMM)12 – annualized SMM
Review - 6
0 no prepayments
PSA Prepayment Rate
100 same speed as benchmark
e.g./ month 5 CPR = 1% · CPR of .2%/month up to 6%
(PSA = 100) · 6%, month 30 onwards
& = −( − )
= −( − )
Weighted Average Life/ how long an MBS lasts assuming

interest rates stay at current levels
- if r ↓, refinancing ↑, Prepayments ↑, PSA Speed ↑, Avg. Life ↓

- contraction risk: lower reinvestment of CF
- if r ↑, refinancing ↓, Prepayments ↓, PSA Speed ↓, Avg. Life ↑

- extension risk: lower CF for reinvestment
Review - 7
CMO/Collateralized Mortgage Obligation/
Bond Class 1
pool of
Bond Class 2 time tranching
MBS
· different maturities
· does not eliminate etc… · different yields
prepayment risk
protection from
extension risk ‘waterfall’
protection from (principal distribution)
contraction risk
Planned Amortization Class (PAC) + Support tranches/
offers both contraction & get $ over minimum

extension risk Principal payments
Non-Agency Credit Risk/ credit tranching
- internal credit enhancements reserve funds
overcollateralization
Review - 8
Non-Agency Credit Risk/
external credit enhancement – Guarantee - Ins. Co.
(wrapped)
Commercial MBS (CMBS)/ income producing assets pool of
CMBS
credit analysis of cash
flows of each loan non-recourse
Auto Loan Backed Securities/ - short-term, pr. + + prepayments
- all have some form of credit enhancement
Credit Card Receivable Backed Securities/
- finance charges + interest + Principal
Principal
-
lockout/revolving period – all PR. reinvested in new loans

Review - 9
Collateralized Debt Securities/
asset mgr.
selects senior
asset
mezzanine
Debt pool
equity
Securities
ramp-up (buy assets)

-
-
0 1 yr. Principal
revolving
repayment
period
Review - 10
Call Protection/ results in CMBS trading more like a
corporate bond
1) prepayment lockout 2-5 yrs.
2) defeasance – borrower purchases securities as collateral

to cover remaining principal balance + an
amount to substitute for what yield would have
been (defeasance premium)
3) prepayment penalty points YR.

5 4 3 2 1
105% 104% etc…

of prepayment amt.
4) yield maintenance charge
- make whole charge (yield) if refinanced
Fixed-Income Risk & Return

Review - 1
Sources of Return 1) Coupon Payments - credit risk
2) Reinvestment of Coupon
interest rate
3) Capital gain/loss
risk
- YTM assumes/ · held to maturity
· no default
· coupons reinvested at YTM rate
Constant-yield Price Curve
100 - if r ↓:
carrying value purchase price - lower reinvestment
Cap. gain of bond + amortized discount of coupon BUT cap.
gain
(or - amort. of if r ↑: - higher
Cap. loss premium) reinvestment of coupon
BUT cap. loss
-
Review - 2
Duration/ measures the sensitivity of the bond’s full
price to changes in r
· represents approx. amt. of time a bond would

have to be held for the YTM to be realized
PV
e.g. Duration = 5 yrs. if r ↑,
r
Macauley
· yield duration modified
YTM
money
PVBP
gov’t. yield curve used with
· curve duration - effective benchmark spot yield curve complex
yield forward curve bonds
par yield curve · financial
assets/liab.
Review - 3
Duration/
i.e. if semi annual

must be annualized
then ÷ 2
- linear estimate
if r ↓ PV ↑ (requires a convexity
r↑ PV ↓ adjustment)
- for small yield:

Approx.ModDur ≈ Ann.ModDur
Approx.MacDur = Approx.ModDur (1 + r)
for complex bonds – requires an option pricing model
Review - 4
Duration/ assumes a parallel shift in yield curve
· EffDur - for a callable bond, may be called if
· credit spread decreases (credit duration)
also used for · benchmark yield decreases (curve duration)
FRNs, MBS, DBPP
· yield is based on spot curve
· curve is based on par curve, so…
- flatter the par curve
- shorter the bond EffDur ≈ ModDur
- closer the price is to par
Key Rate Duration/
- duration at a specific maturity on the

- a key rate dur. can yield curve
be calculated for each · to get , must use
maturity Key Rate Duration
maturities
-
-
-
-
-
-
-
-
-
-
Review - 5
Key Rate Duration/ - each key
rate may
have a
different rate
11 of
these
maturities
-
-
-
-
-
-
-
-
11 maturities
Properties of Duration/
D
D c, r, N constant zero coupon bond (D=TTM)
discount bond
perpetuity
premium bond
TTM
PMT PMT
Review - 6
Properties of Duration/
D - as TTM ↑, Duration ↑
- as coupon ↓, Duration ↑ more interest
- as YTM ↓, Duration ↑ rate risk
TTM
Duration of a Bond Portfolio/
1) weighted average of time to receipt of the
aggregate cash flows (requires CF yield
– not practical)
2) weighted average on individual
bond Durations
&
Review - 7
Money Duration/ MoneyDur. = Ann.ModDur PVfull
PVfull = -MoneyDur. yield
e.g./ PVfull = 100.940243 MoneyDur. = 618.44178

Ann.ModDur = 6.1268 if YTM ↑ 100 bps, PVfull = -618.44178 .01
= -6.1844178/100
Price Value of a Basis Point (PVBP)/
( )−( ) of par
= PVfull for 1 bp value
Convexity Adjustment/
first order effect second order effect
1st order 2nd order

if bp+ neg. pos.
bp- pos. pos.
Review - 8
Money Convexity/
first order second order

effect effect
Duration GAP/
(MacDur. – Investment Horizon)
< 0 - coupon reinvestment risk dominates market price risk
- risk is to lower rates
> 0 - market price risk dominates coupon reinvestment risk
- risk is to higher rates
Yield Volatility/ YTM
25 bps -
TTM
Credit Analysis
Review - 1
Default Risk E(loss) = P(default)
Credit Risk
loss severity
(1 - Recovery Rate)
- spread credit quality
liquidity = x
+ size of debt
benchmark default (credit migration risk) i.e. downgrades
Priority of Claims/ first lien/mortgage

all become
2nd
senior unsecured
secured 3rd
if not paid in full
senior secured
senior unsecured
unsecured senior subordinated all rank
subordinated ‘pari passu’
junior subordinated
Recovery Rates vary by/ seniority

industry
stage of business cycle
Review - 2
high quality AAA to AA-
Ratings/ · investment grade
upper medium A+ to A-
(default premium & low medium BBB+ to BBB-
liquidity premium small)
· non-investment grade low grade BB+ to C

default D
- also/ Positive – Stable – Negative
Notching/ company rating on senior unsecured

each debt issue will also have a rating
· Investment grade · issue rating +/- 1 notch the issuer rating
· Non-investment grade · issue rating -up to 2 notches the issuer
rating
2 bonds with equal ratings
different outlook
may have very different prices
different recovery rates
4 C’s of Credit/ an assessment of ability to pay Review - 3

- credit quality + industry fundamentals
① Capacity/ – ability to pay on time

A. Industry analysis (e.g. Porter’s 5-forces)
high credit risk few buyers/suppliers, low barriers, many
substitutes, fragmented
B. cyclical vs. non-cyclical, growth prospects
C. Company Fundamentals – leverage, solvency
Profit & Cash Flow Leverage Coverage

- EBITDA Debt/Capital EBITDA/Int. Exp.
- FFO Debt/EBITDA
EBIT/Int. Exp.
- FCF – before Div. FFO/Debt
4 C’s of Credit/ Review - 4

② Collateral/ (1 - Recovery Rate)
estimates of MV of assets
③ Covenants/ affirmative
negative
④ Character/ mgmt. track record, soundness of strategy
Credit Risk/ liquidity premium + risk spread
spread + benchmark
affected by/ · credit cycle
· economic conditions
· market performance
· supply and demand
return impact from ≈ (− × )+ ×( )

spread changes
Review - 5
Special Considerations in Credit Analysis/
1) High Yield – more interested in loss severity
(1 - Recovery Rate)
- greater focus on liquidity
- ‘top-heavy’ cap. structure loss given
= high % of debt as secured default
parent - debt
structural
debt
sub sub sub subordination Hold Co.
restricted
unres. vs.
debt debt debt res. res.
sub sub sub unrestricted
debt debt debt subsidiaries
restricted by
debt agreement at Hold Co. level
- covenant analysis
· restricted PMTs to shareholders, restrictions
on liens, etc…
Review - 6
Special Considerations in Credit Analysis/
2) Sovereign Debt - ability to pay
- willingness to pay (sovereign
immunity – investors can’t force PMT)
3) Municipal Debt · general obligation bonds

- unsecured
- municipalities must balance their
budgets
· revenue bonds (installment debentures)
- for specific projects

2022 LI FixedIncome

Uploaded by

Document Information

Original Description:

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

2022 LI FixedIncome

Uploaded by

Copyright:

Available Formats

Last Revised: 05/06/2021

Level I - Fixed Income

Fixed-Income Securities: Defining Elements 2

Fixed-Income Markets: Issuance, Trading, and Funding 15

Introduction to Fixed-Income Valuation 26

Introduction to Asset-Based Securities 42

Understanding Fixed-Income Risk and Return 64

Fundamentals of Credit Analysis 80

© markmeldrum.com. All rights reserved.

Fixed-Income Securities: Defining Elements

a. describe basic features of a fixed-income security;

b. describe content of a bond indenture;

c. compare affirmative and negative covenants and identify examples of each;

e. describe how cash flows of fixed-income securities are structured;

f. describe contingency provisions affecting the timing and/or nature of cash

Fixed-Income Securities: Defining Elements

Bond a contractual agreement between the issuer & bondholders

Structured special purpose entities (securitization ABS, MBS)

money market securities - maturities, at issuance, < 1 yr.

3/ Par Value a.k.a. principal amount, principal value, future value,

- bonds can have any par value 100 - par bond

- dual-currency bonds coupon payments in one currency

yield-to-maturity (yield-to-redemption, redemption yield)

inverse relationship between price and YTM

par bond coupon rate = YTM

issuer appoints trustee typically a financial institution with

Negative - what an issuer will not do

Restrictions on debt max debt ratios, min. Interest Coverage Ratios

unsecured assets for future collateral

- common element ensure issuer will not take any actions

- regulated by the market the bonds are issued in

favourable ordinary income

- MBS each payment

- reduces credit risk

balloon payment required = $200

Coupon payment structure/ ➁ annual

coupon = reference rate + spread (margin) uncertain cash

· inflation adjustment can be made to either coupon

principal = $1,000 coupon =

- bonds with warrants attached warrants

e.g./ if core Tier 1 capital falls below some

Fixed-Income Securities: Issuance, Trading, and Funding

a. describe classifications of global fixed-income markets;

b. describe the use of interbank offered rates as reference rates in floating-rate

c. describe mechanisms available for issuing bonds in primary markets;

d. describe secondary markets for bonds;

e. describe securities issued by sovereign governments;

f. describe securities issued by non-sovereign governments, quasi-government

g. describe types of debt issued by corporations;

h. describe structured financial instruments;

i. describe short-term funding alternatives available to banks;

Issuance, Trading, Funding

· structured finance – securitization (MBS, ABS)

- highest/lowest 25% discarded

EUR JPY SGD HKD INR

· Foreign issues of ‘issued-in’ country

primary dealers accepts the rate determined

· multiple price auction each bidder pays their price

Sovereign bonds/ LOS e

· Types/ 1/ Fixed-rate bonds – by far the most common

· Quasi-government: agency bonds

· Supranational: supranational bonds highly rated

- private debt can be customized to the borrowers need, can be