Fixed Income-I

Fixed Income – I
© EduPristine For [CFA® Program Level-I] (Confidential)

Disclaimer: The content is partially owned by CFA Institute, such as knowledge check, examples, diagrams, etc.
Mapping to Curriculum
 Reading 39: Fixed income securities: Defining elements

 Reading 40: Fixed income markets: Issuance, trading and funding
 Reading 41: Introduction to fixed income valuation

Disclaimer: The content is partially owned by CFA Institute, such as knowledge check, examples, diagrams, etc. 2
Reading 39: Fixed Income Securities – Defining Elements

Learning Outcomes:
The candidate should be able to:

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.

Sources of Capital
Sources of capital
Equity Fixed Income
common stocks and preferred

Senior and subordinate structure
stocks
Partial ownership in issuing

No ownership in the company
company
Dividend and voting rights Fixed cash flows (coupons)
Paid after fixed income in

Paid first in the event of bankruptcy
bankruptcy

Overview of a Fixed-Income Security
150 Basic structure of a vanilla bond
100
50
0
T0 T1 T2 T3 T4 T5 T6 T7 T8 T9 T10
-50
-100
-150

Definition – A bond is a contractual agreement between the issuer and the bondholders. It is the most common
method of raising capital across the globe. The payments are fixed and the investors get preference of claim over
the common shareholders, and hence, this is considered to have a lower risk.
Three important elements:
 Bond’s features includes the issuer, maturity, par value which determine the bond’s scheduled cash flows
and investor’s return (expected and actual);
 Agreement (contract), which is a Contractual agreement between the issuer and the bondholders: legal,
regulatory, and tax considerations; and
 Contingency provisions (options) like callable (right to purchase/redeem), putable (right to sell), and
convertible (right to convert bond into say equity).

Basic features of a bond:

 Issuer: The organization is the entity that issues bonds. Major types of issuers include the following:
• Supranational organizations (such as World Bank or World Trade Organization);
• Sovereign governments (such as India or Switzerland);
• Non-sovereign (local) governments (like Government of Delhi, Government of Maharashtra);
• Quasi-government entities (like Provident Fund or FICCI);
• Companies (Infosys or ITC) and
• Special legal entities that securitize assets to create ABS or MBS (explained later).

Basic features of a bond (contd.)

 Maturity: It is the date when the issuer is obligated to pay the principal amount and redeem the bond (by
paying principal amount). The tenor is the time remaining until the bond’s maturity date.
• Money market securities: These bonds have maturity of one year or less. For example – treasury bill and
commercial papers
• Capital market securities: Bonds with maturity of more than an year are capital market insecurities. For
example – an AA+ rated corporate bond issued by Apple Inc. for 5 years
• Perpetual bonds: Bonds issued with no stated maturity are called perpetual bonds. In India, there are various
companies like Indian Railway Financial Corporation (IRFC), Tata Power, State Bank Of India (SBI) and Tata
Steel which have issued such bonds
 Par value: The face value of the bond paid to the bond holders on maturity. It is the amount that the issuer
agrees to repay the bondholders on the maturity date. It is also known as principal value, or simply par, face
value, nominal value, redemption value, or maturity value.
For example – A 10-year $100 bond with the coupon payment of 5% trading at a market value of $98 would
mean that you can buy the bond at $98 today which will be redeemed at $100 (par value) at maturity.


 Coupon rate and frequency: This is the interest rate (also called coupon) that the issuer promises to pay
every each year until the maturity date. For example – a bond with a coupon rate of 8% and a par value of
$500 will pay periodic interest of $40 if the coupon payments are made annually. The coupon payment
becomes $20 if they are made semi-annually, $10 if they are made quarterly, and $3.3 if monthly.
• Plain vanilla bond or conventional bond – This is the instrument A bond that pays a fixed interest rate (as
explained in the example above). The coupon payment does not change during the bond’s lifetime.
• Floating-rate notes or floaters – In this case, the coupon payment has two components - a reference rate and
a spread.
‒ A reference rate is a benchmark rate like LIBOR (London interbank offered rate). It is a benchmark rate
that some of the world's leading banks charge each other for short-term loans.
‒ The spread, also called margin, is typically the constant rate added to the reference rate. It is expressed in
basis points (bps) and 100 bps is equal to 1%. The higher the issuer’s credit quality, the lower the spread
and vice-versa.
‒ Important: The relevant interest rate is the interest rate accrued during the period and not the end of period
interest rate.
 Zero coupon bonds – Such Bonds that are issued at a discount and redeemed at par are called zero coupon
bonds. For example, if the par value is $1,000 and the purchase price is $930, the implied interest is $70.


 Currency denomination: Bonds can be issued in any currency, however a large number of bond issues are
made in either euros, or US dollars to increase its attractiveness. Based on the currency, bonds can be
divided into various categories as discussed below:
• Dual-currency bonds – Bonds that make coupons payments in one currency and pays the par value in another
currency are dual-currency bonds.
• For example – Let us consider a scenario where an Indian company needs to finance a long-term project in
Japan that will take several years to become profitable. The Indian company could issue an INR/Yen dual-
currency bond. The coupon payments in INR can be made from the cash flows generated in India, and the
principal can be repaid in Yen using the cash flows generated in the Japan after the project becomes profitable.
• Currency option bonds – They give bondholders the right to choose the currency in which they want to receive
the interest payments and principal repayments.

Yield Measures
 Current yield or running yield: It is equal to, when the bond’s annual coupons are divided by the bond’s
price (expressed as a percentage).
 Yield to maturity or yield to redemption: Yield to maturity is the internal rate of return on a bond’s
expected cash flows. This internal rate is the discounted rate that equates the present value of the bond’s
expected cash flows with the bond’s price. Bond’s price is inversely proportional to its yield to maturity.

Example Problem
If a bond has a coupon rate of 7%, a par value of $100, and a price of $110, calculate the current yield.

Solution
Current yield = annual coupon / market price of the bond

=7 / 110
=6.4%

Example Problem
Calculate the yield to maturity if a 5-year bond has an annual coupon rate of 8%, a par value of $1000, and a
price of $1010.

Solution
N=5, PMT = 80, FV = 1000, PV = -1010, I/Y = 7.75%

Knowledge Check
1. An example of sovereign bond is a bond issued by:

A. The Niti Aayog
B. The Government of Dubai
C. The Central Government of Philippines
2. The risk of loss resulting from the issuer failing to make full and timely payment of interest is called:
A. Credit risk
B. Systemic risk
C. Interest rate risk
3. If the bond’s price is higher than its par value, the bond is trading at:
A. Par
B. A discount
C. A premium
4. The coupon rate of a floating-rate note that makes payments in June and December is expressed as
six-month Libor + 25 bps. Assuming that the six-month Libor is 3.00% at the end of June 20XX and
3.50% at the end of December 20XX, the interest rate that applies to the payment due in December
20XX is:
A. 3.25%
B. 3.50%
C. 3.75%

Solution
 Solution: 1. C.
The Central Government of Philippines
 Solution: 2. A.
Credit risk.
 Solution: 3. C.
A premium.
 Solution: 4. A.
3.25%.

Legal, Regulatory, and Tax Considerations
 Bond Indenture: Bond indenture or trust deed is the legal contract (legal) that describes three elements,
namely the form of the bond, the obligations of the issuer, and the rights of the bondholders. It contains the
features like the principal value of the bond, the interest rate or coupon rate, the payment dates, maturity
date, and whether the bond issue comes with any contingency provisions (callable or putable).
• Trustee: As it would not be feasible for the issuer to enter into a direct agreement with each bondholder, the
indenture is usually held by a trustee.
‒ It is a financial institution with trust powers and is appointed by the issuer, but it acts in a fiduciary capacity
with the bondholders.
‒ The trustee’s duties are administrative and usually include the maintenance of the required documentation
and records.
‒ In the event of default, the discretionary powers of the trustee increase considerably.

Due Diligence before Buying the Bond
 Legal Identity of the Bond Issuer and its Legal Form

-
 Source of Repayment Proceeds

-
 The Asset or Collateral Backing

-
 The Credit Enhancements

-
 Covenants
-

Legal, Regulatory, and Tax Considerations (Cont.)
Legal identity of the bond issuer and its legal form

Bond Type Legal Issuer Example
Office responsible for managing
Sovereign Bond HM Treasury in UK
national budget
Corporate Bond Corporate legal entity Walmart, Samsung, etc.
SPE (Special purpose entity) in USA
Securitized Bond Separate legal entity SPV (Special purpose vehicle) in
Europe
Source of repayment proceeds
Bond Type Source of Repayment

Sovereign Bond “Full faith and credit” of the National Govt.
1. General taxing authority
Non Sovereign Bond 2. Cash flow of the project
3. Special taxes or fees established
Corporate Bond Issuer’s ability to generate cash flows

Asset or Collateral Backing: Collateral backing helps to reduce credit risk.

Secured bonds are backed by collateral, which are generally assets or financial guarantees. It is pledged to
ensure debt repayment in the case of default. In contrast, unsecured bonds have no collateral, i.e, bondholders
have only a general claim on the issuer’s assets and cash flows.
 Types of collateral backings:
• Collateral trust bonds are backed by securities such as common shares, other bonds, or other financial assets of
the issuer.
• Equipment trust certificates are secured by equipments or physical assets, such as aircraft, railroad cars,
shipping containers, or oil rigs.
• Covered bond are such bonds that are covered Debt obligation backed by a segregated pool of assets called a
‘cover pool’. In case of default, bondholders have claim against both the financial institution and the cover pool.
If the assets included in the cover pool become non-performing, the issuer must replace them with performing
assets.
 Credit Enhancements: Enhancements increase the issue’s credit quality and decrease the bond’s yield.
 Internal credit enhancement: This includes subordination, overcollateralization, and reserve accounts.
• Subordination (credit tranching): It involves creating more than one bond class (tranche) and ordering the claim
priorities between the tranches. This type of protection is also called waterfall structure because in the event of
default, the proceeds from liquidating assets will first be used to repay the most senior creditors.

• Overcollateralization: It involves posting more collateral than is needed to obtain or secure financing. For
example, if at issuance the principal amount of a bond issue is $200 million and the value of the collateral is
$220 million, the amount of overcollateralization is $20 million.
• Reserve accounts or reserve funds: This comes in two forms - a cash reserve fund and an excess spread
account. A cash reserve fund is created deposit of cash that can be used to absorb losses. An excess spread
account is the allocation of any amounts left over after paying out the interest into an account.
 External credit enhancement: This includes bank guarantees and surety bonds, letters of credit, and cash
collateral accounts.
• Bank guarantees and surety bonds – They compensate the bondholders for any losses incurred if the issuer
defaults. The major difference is that the Bank guarantee is issued by a bank, whereas the surety bond is issued
by a rated and regulated insurance company.
• Letter of credit – In this case, a financial institution provides the issuer with a credit line to provide for any cash
flow shortfalls.
• Cash collateral account –The issuer immediately borrows the credit enhancement amount, which is then
invested usually in good quality short-term commercial paper. Since a cash collateral account is an actual
deposit of cash rather than a pledge of cash, a downgrade of the entity will not necessarily result in a downgrade
of the bond issue.

Covenants: An indenture will include two types of covenants, namely affirmative (or positive) and negative
covenants.
Affirmative covenants (administrative in nature): For example, what the issuer will do with the proceeds from
the bond issue, promise to comply with all laws and regulations, maintain its current lines of business, insure and
maintain its assets, and pay taxes as they come due. These types of covenants typically do not impose additional
costs to the issuer or restrict the issuer from operating its business efficiently.
 Negative covenants: These are frequently costly and do materially. These are generally costly to
implement and restrict the issuer’s ability to execute potential business decisions. Examples of negative
covenants include the following:
• Restriction on debt: It is a restriction on issuing any additional debt;
• Negative pledges: Prevents the issuance of debt which is senior to the existing debt;
• Restriction on prior claims: Protect unsecured bondholders by preventing the issuer from using assets that are
not collateralized to become collateralized;
• Restriction on distribution to shareholders: Prevent dividends or share buy-backs;
• Restriction on assets disposal: Limit the amount of assets that can be disposed by the issuer during the bond‘s
tenure. For example, splitting the company;
• Restrictions on risky investments: Limiting risky/speculative investments; and
• Restrictions on M&A: Prevent such activities unless the company is the surviving company or the acquirer takes
over the old bonds with existing/improved terms.

 Legal and regulatory considerations: Fixed-income securities are subject to different legal and regulatory
requirements, which are applicable to fixed income securities depending on where they are issued and the
traded place of issuance and trade, as well as who holds them.
 Domestic bonds: Bonds issued by domestic companies that are incorporated in that foreign countries are
domestic bonds. For example, bonds issued by Infosys Inc. in India
 Foreign bonds: Bonds issued by domestic entities that are incorporated in another country are foreign
bonds. For example, bonds issued by Infosys Inc. in the US
 Eurobonds: This bond market helps bypass the legal, regulatory, and tax constraints imposed by the
government on bond issuers and investors, particularly in the US.
• They are named after the currency in which they are denominated. Their naming convention is such that
Eurodollar and Euro-yen bonds are denominated in the US dollars and Japanese yens, respectively.
• They are usually unsecured and less regulated.
• They typically are bearer bonds where the trustee does not keep records of who owns the bonds.
• For example – A Saudi Arabian company issuing bonds in UAE in US dollars.

 Tax considerations: Tax treatment vary between different countries.

• The income portion of bond investment is taxed according to the income slabs at ordinary income tax rate,
while capital gains are taxed at different tax rates.
• There could also be a difference in the long-term and short-term capital gains tax rates.
• If a bond is issued at a discount, an additional tax consideration called original issue discount is applicable.
It is the difference between the par value and the original issue price (profit for the buyer). In some countries,
like the US, instead of taxing it in one go, a prorated portion of the discount must be included in the interest
income every tax year.

Example Problem
Assume that a company issues bonds in the hypothetical country of New Zealand. There is an original issue
discount tax provision in New Zealand’s tax code. The company issues a 10-year zero-coupon bond with a par
value of $1,000 and sells it for $800. What will be the tax treatment of this issue?

Solution
An investor who buys the zero-coupon bond at issuance and holds it until maturity, most likely has to include $20
in his taxable income every tax year for 10 years and need not declare a capital gain at maturity.

Example Problem
A South African company issues bonds denominated in pound sterling that are sold to investors in the United
Kingdom. What kind of bonds are they?

Solution
The bonds being discussed in the given scenario are Eurobonds.

Structure of a Bond’s Cash Flows
 Principal Repayment Structures: The mode of paying back the bond is an important consideration. Any
kind of provision that periodically retires a portion of the principal amount is a way to reduce credit risk.
• Bullet bond: When the complete principal amount is paid at maturity, it is a bullet bond.
• Amortizing bond: A fully amortized bond is characterized by a fixed periodic payment (like EMI) schedule that
reduces the bond’s outstanding principal amount to nil by the maturity date.
• A partially amortized: Such a bond also makes fixed periodic payments, but only a portion of the principal is
repaid by the maturity date. A balloon payment is made at the maturity to retire the bond.
• Sinking fund arrangement: It is another procedure that can be used to achieve the same goal of periodically
retiring the bond’s principal outstanding. For example, assume a 20 year bond with notional principal of $200
million. The sinking fund arrangement calls for 7% of the outstanding principal amount to be retired in the Years
10 through 19, with the outstanding balance paid off at maturity in 20th year.
For example, assume a 20 year bond with the notional principal of $200 million. The sinking fund arrangement calls
for 7% of the outstanding principal amount to be retired in Years 10 through 19 with the outstanding balance paid off
at maturity in the 20th year.

Structure of a Bond’s Cash Flows (Cont.)
Bullet Bond Partially Amortized Bond

Example
Outstanding Outstanding
Investor Interest Principal Investor Interest Principal
Year Principal at the Year Principal at the
Cash Flows Payment Repayment Cash Flows Payment Repayment
End of the Year End of the Year
0 -$1,000.00 $1,000.00 0 -$1,000.00
1 60.00 $60.00 $0.00 1,000.00 1 201.92 $60.00 $141.92 $858.08
2 60.00 60.00 0.00 1,000.00 2 201.92 51.48 150.43 707.65
3 60.00 60.00 0.00 1,000.00
3 201.92 42.46 159.46 548.19
4 60.00 60.00 0.00 1,000.00
4 201.92 32.89 169.03 379.17
5 1,060.00 60.00 1,000.00 0.00
5 401.92 22.75 379.17 0.00
Fully Amortized Bond
Outstanding Principal at the

Year Investor Cash Flows Interest Payment Principal Repayment
End of the Year
0 -$1,000.00
1 237.40 $60.00 $177.40 $822.60
2 237.40 49.36 188.04 634.56
3 237.40 38.07 199.32 435.24
4 237.40 26.11 211.28 223.96
5 237.40 13.44 223.96 0.00

 Coupon Repayment Structures: A coupon is the interest payment that the bond issuer makes to the
bondholder.
• Fixed rate bonds – (Discussed earlier)
• Floating rate bonds – (Discussed earlier)
• Step-Up Coupon Bonds – The coupon which may be fixed or floating, increases by specified margins at
specified dates.
• Credit-Linked Coupon Bonds – The bond in which coupon changes with a change in the bond’s credit rating.
For example, assume a bond maturing in 2020. It has a coupon rate of 9%, but the coupon will increase by 50
bps for every credit rating downgrade.
• Payment-in-Kind Coupon Bonds – These bonds typically allow the issuer to make the interest payments
through issuer to pay interest in the form of additional bonds rather than cash payment. For example, they are
used in financing companies that have a high debt burden, such as companies going through a leveraged
buyout.

 Deferred Coupon Bonds (split coupon bond) – This kind of bond pays zero coupons for initial few years,
but then pays a higher coupon for the remainder of its life. The advantage of investing in a deferred coupon
bond is that these bonds are typically priced at significant discounts. They are also very helpful in managing
taxes.
 Index-Linked Bonds – The coupons or the principal is linked to a specified index like earnings, economic
output, commodities, or foreign currency indices. Inflation-linked bonds are an example of index-linked
bonds. There are different types of inflation linked bonds, which are:
• Zero-coupon-indexed bonds - They pay no coupon, so the inflation adjustment is made via the principal
repayment only. They are issued in Sweden.
• Interest-indexed bonds – The coupons are linked to inflation during the bond’s life.
• Capital-indexed bonds – It pays a fixed coupon rate, but it is applied towards the principal amount that increases
in line with the increases in the inflation. So, both the interest payments and the principal repayment are
adjusted for inflation.
• Indexed-annuity bonds – They are fully amortized bonds with annuity payment (which includes both payment of
interest and repayment of the principal), and increases in line with inflation during the bond’s life.

Bonds with Contingency Provisions
 A contingency refers to some future event or circumstance that is possible but not certain. Some common
embedded options are:
• Callable Bonds: Here the embedded option is the call provision. This type of bond gives the issuer the right to
redeem all or a part of the bond before the specified maturity date, if there is a decline (either from market rates
falling or improvement in issuer’s credit rating) in the interest rates. Investors of callable bonds are presented
with a higher level of reinvestment risk than the non-callable bonds. For the same reason, callable bonds have
to offer a higher yield and consequently sell at a lower price in contrast with similar non-callable bonds.
• Putable Bonds: A put provision gives the bondholders the right to sell the bond back to the issuer at a
predetermined specific price on specified dates if the interest rates rise, and thereby reinvesting in bonds
offering high yields.
• The price of a putable bond will be higher than the price of an bond without the put provision, while the yield on
such a bond will be lower than the similar non-putable bond.
• There are various exercise styles on callable and putable bonds:
‒ American-style (continuously callable/putable - The issuer has the right to call/put bond at any time starting
on the first call/put date.
‒ European-style - The issuer has the right to call/put a bond only once on the call/put date.
‒ Bermuda-style - The right to call/put bonds on pre-specified dates following the call protection period is the
definition of this style. These dates frequently correspond to coupon payment dates.

Knowledge Check
1. Floating-rate notes most likely pay:

A. Annual coupons
B. Quarterly coupons
C. Semi-annual coupons
2. A zero-coupon bond can best be considered a:
A. Step-up bond
B. Credit-linked bond
C. Deferred coupon bond
3. The bonds that do not offer protection to the investor against increases in the market interest rates
are:
A. Step-up bonds
B. Floating rate notes
C. Inverse floating rate notes
4. Assume a hypothetical country, Lemuria, where the national government has issued a 20-year
capital-indexed bonds linked to the domestic Consumer Price Index (CPI). Lemuria’s economy has
been free of inflation until the most recent six months, when the CPI increased. Following the
increase in inflation:
A. A. The principal amount remains unchanged, but the coupon rate increases
B. B. The coupon rate remains unchanged but, the principal amount increases
C. C. The coupon payment remains unchanged, but the principal amount increases
Solution
 Solution: 1. B.
Quarterly coupons
 Solution: 2. C.
Deferred coupon bond
 Solution: 3. C.
Inverse floating rate notes
 Solution: 4. B.
The coupon rate remains unchanged but the principal amount increases.

 Convertible Bonds: It is a hybrid security with both debt and equity features. The bondholder has the right
to exchange the bond for a specified number of common shares of the issuing company. Some additional
features are as follows:
• Ability to convert the bond instrument into equity share and participate in the equity share upside;
• If the share price decline, the price of a convertible bond cannot fall below the price of the straight bond;
• The price of the convertible bond is higher than the similar non-convertible bond;
• The issuer of such bonds also have advantages;
• The first is reduced interest expense as these bonds are issued at lower coupon rates that market;
• Also, it helps to eliminate debt if the conversion option is exercised.

 Conversion price – This is the price per share at which the convertible bond can be converted into shares.
For example the bond can be converted into shares at $25 per share.
 Conversion ratio – This is the number of common shares that each bond can be converted into. For
example, if the par value is $1,000 and the conversion price is $20, the conversion ratio is $1,000 ÷ $20 = 50
common shares per bond.
 Conversion value – It is the current share price multiplied by the conversion ratio. For example, if the
current share price is $26 and the conversion ratio is 50, the conversion value is $26 × 50 = $1250.
 Conversion premium – This is the difference between the convertible bond’s price and its conversion value.
For example, if the convertible bond’s price is $1,010 and the conversion value is $1,250, the conversion
premium is $240.

Summary of Reading 39
1. Important elements of bonds: Features, legal, regulatory, and tax considerations and contingency provisions.
2. Basic features of bonds: Issuer, maturity, par value, coupon rate and frequency, and currency denomination.
3. Issuers: Supranational organizations, sovereign, non-sovereign and quasi governments, and corporates.
4. Yield to maturity: Discount rate IRR or discount rate which equates the present value of the bond’s future
cash flows to its price.
5. Bond indenture: Legal contract that describes the Features of a bond, issuer’s obligations, and the investor’s
rights.
6. Credit enhancement can be internal or external.
7. Amortizing bond is a bond that involves periodic payment of interest and repayment of principal.
8. Floating-rate note or floater is a bond whose coupon is based on some reference rate like LIBOR plus a
spread.
9. Callable bonds provide the issuer the right to buy purchase bonds back before maturity.

Summary of Reading 39 (Cont.)
10. Putable bonds give provide the bondholder the right to sell bonds back to the issuer before maturity.
11. A convertible bond gives the bondholder the right to convert the bond into common shares.
12. Inflation-linked bond is the most common index-linked bond or linker.
13. Step-up coupon bonds are the bonds which pay coupons hat increase by pre-specified amounts on pre-
specified dates.
14. Sinking fund is an approach to the periodic retirement of principal.

Knowledge Check

Knowledge Check
1. Which of the following is not an example of an embedded option?

A. Warrant
B. Call provision
C. Conversion provision
2. The type of bonds with an embedded option that would most likely sell at a lower price than an otherwise
similar bond without the embedded option is a:
A. Putable bond
B. Callable bond
C. Convertible bond
3. The additional risk inherent to a callable bond is best described as:
A. Credit risk
B. Interest rate risk
C. Reinvestment risk

Solution
 Solution: 1. A.
Warrant is not an example of an embedded option.
 Solution: 2. B.
Callable bond is the bond with an embedded option that would most likely sell at a lower price than an
otherwise similar bond without the embedded option.
 Solution: 3. C.
Reinvestment risk is the additional risk inherent to a callable bond.

Knowledge Check
4. The put provision of a putable bond:

A. Limits the risk to the issuer
B. Limits the risk to the bondholder
C. Does not materially affect the risk of either the issuer or the bondholder
5. An example of sovereign bond is a bond issued by:
A. Niti Aayog
B. Government of Dubai
C. Central Government of Philippines
6. The risk of loss resulting from the issuer failing to make full and timely payment of interest is called:
A. Credit risk
B. Systemic risk
C. Interest rate risk

Solution
 Solution: 4. B.
The provision to the putable bonds is that it limits the risk to the bondholder.
 Solution: 5. C.
The bond issued by the Central Government of Philippines is an example of sovereign bonds.
 Solution: 6. A.
Credit risk is the risk of loss resulting from the issuer failing to make full and timely payment of interest.

Knowledge Check
7. If the bond’s price is higher than its par value, the bond is trading at:
A. Par
B. A discount
C. A premium
8. The coupon rate of a floating-rate note that makes payments in June and December is expressed as six-
month Libor + 25 bps. Assuming that the six-month Libor is 3.00% at the end of June 20XX and 3.50% at the
end of December 20XX, the interest rate that applies to the payment due in December 20XX is:
A. 3.25%.
B. 3.50%.
C. 3.75%.
9. Relative to domestic and foreign bonds, Eurobonds are most likely to be:
A. Bearer bonds
B. Registered bonds
C. Subject to greater regulation

Solution
 Solution: 7. C.
If the bond’s price is higher than its par value, the bond is trading at a premium.
 Solution: 8. A.
Reason : The rate applicable for payment for December is the rate at the end of June which is 3%. Hence
payment for December is calculated as = 3% + 0.25% = 3.25%
 Solution: 9. A.
Relative to domestic and foreign bonds, Eurobonds are most likely to be bearer bonds.

Knowledge Check
10. An investor in a country with an original issue discount tax provision purchases a 20-year zero-coupon bond
at a deep discount to par value. The investor plans to hold the bond until the maturity date. The investor will
most likely report:
A. A capital gain at maturity
B. A tax deduction in the year the bond is purchased
C. Taxable income from the bond every year until maturity

Solution
 Solution: 10. C.
The investor will most likely report the taxable income from the bond every year until maturity.

Reading 40: Fixed-Income Markets - Issuance, Trading,
and Funding

Learning outcomes:

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.

Overview of Global Fixed-income Markets
Classification by Type of Issuer: Government Supranational, Corporate, and structured

finance sectors
Classification of fixed income markets
Classification by Credit Quality: Investment grade and non-investment grade
Classification by Maturity: Capital market and money market securities
Classification by Currency Denomination: US Dollar, Euro, Yen
Classification by Type of Coupon: Fixed and floating
Classification by Geography: Domestic bond, foreign bond, and Eurobond markets
Other Classifications of Fixed-Income Markets: Inflation indexed, Municipal bonds,

Classifications
Classifications by
by type
type of:
of: Bonds
Bonds
Supranational,
Supranational, Sovereign,
Sovereign, Non-Sovereign,
Non-Sovereign,
Issuer
Issuer Quasi
Quasi government, corporates, ABS
government, corporates, ABS and
and MBS
MBS
Credit Quality
Credit Quality Investment and
Investment and non-investment
non-investment grade
grade
Maturity
Maturity Money
Money market,
market, capital
capital market,
market, perpetual
perpetual bonds
bonds
Currency Denomination
Currency Denomination Currency in
Currency in which
which bond
bond is
is dominated
dominated
Type
Type of
of coupon
coupon Fixed
Fixed and
and floating
floating rate
rate
Geography
Geography Domestic,
Domestic, Foreign
Foreign and
and Euro
Euro bonds
bonds
Others
Others Inflation
Inflation linked,
linked, tax
tax exempt
exempt etc
etc

 Fixed income indexes: A fixed-income index describes a given bond market or sector, and is used to
evaluate the performance of investments and investment managers. Most fixed income indexes are
constructed as portfolios of securities based on a particular bond market or sector.
• One of the most popular set of indexes is the Bloomberg Barclays Global Aggregate Bond Index. It broadly
represents a broad-based measure of the global investment-grade fixed-rate bond market.
 Investors in Fixed-Income Securities:
• Central Banks: Central banks conduct open market operations are conducted by central banks to implement
monetary policy;
• Institutional investors (pension funds, hedge funds, charitable foundations and endowments, insurance
companies, and banks) are the largest groups of investors in fixed-income securities;
• Sovereign wealth funds, that tend to have very long investment horizons and aim to preserve or create wealth
for future generations; and
• Retail investors attracted by relatively stable prices and steady income production of fixed income products.
 Primary market indexes: These are markets in which issuers initially sell bonds to investors to raise capital
for the first time. A bond can be issued via public offering or via private placement, in which only a selected
investor purchases the bonds.

Primary and Secondary Bond Markets
 Public Offerings: The three most common mechanisms of bond issuance are as follows:
 Underwritten offering – It is also called as firm commitment offering in which the investment bank
guarantees the sale of the entire bond issue at a pre-decided price that is negotiated with the issuer.
• Best effort offering – Here, the investment bank only serves as a broker. It just tries to sell the bond issue at
the negotiated offering price as best as it can for a commission. Here, the investment bank has less risk and
lesser incentive to sell the bonds compared with underwritten offering.
• Auction – It is a bond issuing mechanism that involves bidding. Most sovereign bonds are sold to the public via
a public auction.
• Shelf registration – This process allows certain authorized issuers to offer additional bonds to the general
public without having to prepare a new and separate offering circular each time a new bond issue comes. In fact,
the issuer prepares a single document, that describes a range of future bond issuances.
 Private Placements: It is a non-underwritten, an unregistered offering of bonds that are sold only to one
investor or a small group of investors (large institutions).
Secondary Bond Markets: In this market, the existing securities are traded among investors. The main
participants in this market are large institutional investors and central banks. Moreover, the presence of retail
investors in secondary bonds markets is limited, compared with secondary equity markets. There are two main
structures for the secondary markets is: An organized exchange and an over-the-counter market.
Sovereign Bonds: These bonds are issued primarily for fiscal reasons by national governments. It is undertaken
when tax revenues are insufficient to cover the expenditures.

Non-sovereign Government, Quasigovernment, and Supranational Bonds
 Non-Sovereign Bonds: Bonds issued by provinces, regions, states, and cities are called non-sovereign
government bonds or non-sovereign bonds. There are three sources of paying interest and repaying the
principal:
 Quasi – Government Bonds: Bonds issued by organizations established by national governments are
called quasi-government bonds. Examples of quasi-government entities include Federal National Mortgage
Association (‘Fannie Mae’), the Federal Home Loan Mortgage Corporation (‘Freddie Mac’), and the Federal
Home Loan Bank (FHLB). In India, examples include the provident fund department and NITI Aayog.
 Supranational Bonds: Such bonds are issued by multilateral agencies, such as International Bank for
Reconstruction and Development (the World Bank), the International Monetary Fund (IMF).

Corporate Debt
 Corporate Debt: The two sources of debt for corporates are loans from banks and loans from financial
markets. The sources debt for corporates are as follows:
 Bank Loans and Syndicated Loans:
• Bilateral loan – When the loan is given to a single borrower is bilateral loan. It is the primary source of debt
financing for small and medium-sized companies.
• Syndicate loan – It is a loan from a group of lenders, called the ‘syndicate’, to a single borrower.
• Commercial Paper: It is a short-term, unsecured promissory note issued by corporates in the public market or
via a private placement.
 Corporate Notes and Bonds: Companies regularly issue bonds and notes via private placements and
public securities markets.
• Maturities: The short-term refers to maturities of five years or less, intermediate term to maturities longer than
five years and up to 12 years and long-term to original maturities longer than 12 years.
• Medium term note (MTN):
This instrument helps in filling the funding gap between commercial paper and long-term bonds.
• Coupon payment structures: There is a range of coupon structures in corporate notes and bonds, such as
fixed rate, floating rate, zero coupon, deferred coupon and payment in kind coupon bonds.

Structured Financial Instruments
Structured Financial Instruments: The different types of structured financial instruments are as follows:
 Capital Protected Instruments: We can attempt to explain this instrument with the help of an example. Let us
suppose that an investor has $1,000 to invest. The investor buys zero-coupon bond for $990 that will pay off
$1,000 one year from now. From the $10 left-over, the investor buys a call option that will expire in one year.
The investor will receive $1,000 when the zero-coupon bond on maturity and may also gain from the upside
potential of the call option, if any.
 Yield Enhancement Instruments: A credit-linked note (CLN) is an example of a yield enhancement
instrument. A CLN is a type of instrument that pays regular coupons but whose redemption value depends
on the occurrence of a credit event (rating downgrade or the default of an underlying asset).
 Participation Instruments: These instruments allow investors to participate in the return of an underlying
asset. Floating-rate bonds is one of the best examples of participation instrument.
 Leveraged Instruments: As the name suggests, these instruments are created to magnify returns and offer
the possibility of high payoffs from small investments. One of the examples of leveraged instruments is an
inverse floater which is an opposite of a traditional floater. A general formula for an inverse floater’s coupon
rate is: Inverse floater coupon rate = C – (L × R) where C is coupon rate, L is leverage and R is interest rate.

Short-term Funding Alternatives Available to Banks
Retail Deposits: It includes funds from both individual and commercial depositors. The several types of retail
deposit accounts are demand deposits or checking accounts.
Short-Term Wholesale Funds: It includes reserve funds, interbank funds, and certificates of deposit as
explained below:
 Reserve Funds: All banks place reserve balance with the central bank to ensure sufficient liquidity if
depositors want to withdraw funds. When the banks cannot borrow from anywhere else, they turn to the
central bank for short-tem funding. At that time, reserve funds provide liquidity buffer and the central bank
can act as a lender of the last resort.
 Interbank Funds: It is the market of loans and deposits between banks. The maturity of such loans ranges
from overnight to one year. The rate of interest could be fixed or based on a reference rate like LIBOR.
 Certificate of Deposit: It is a certificate that represents a specified amount of funds on deposit for a
specified maturity and interest rate. There are two types of CDs negotiable and non-negotiable. In case of a
non-negotiable CD, the deposit plus the interest are paid at maturity. If the depositor withdraws funds prior to
the maturity date, a penalty is imposed. On the contrary, a negotiable CD can be sold to another investor
prior to the maturity date. Most of the CDs are short-term with the maturity of less than one-year.

 Repurchase and Reverse Repurchase Agreements: A repurchase agreement or repo is the sale of a security
with a simultaneous agreement by the seller to buy it back from the purchaser at a predetermined price and
future date.
 The price at which the dealer repurchases the securities is known as the repurchase price, while the interest
rate on a repurchased agreement is called the repo rate. There are several factors that affect the repo rate:
• Risk of collateral – Repo rates are typically less for highly rated collaterals, such as a US Govt. sovereign bonds
and vice-versa.
• Term – Repo rates are generally high, longer maturity because of higher long-term rates are typically higher than
the short-term rates.
• Delivery requirement – If the collateral is delivered, repo rates are usually lower.
• Supply and demand conditions – If the collateral is scarce or in great demand, the repo rate is lower.
• Interest rates of alternative financing – If the interest rates of alternative financing in the money market are
higher, the repo rate will also be higher.

 Repurchase and Reverse Repurchase Agreements: In repo agreements, the amount lent is lower than the
collateral’s market value. The difference between the market value of collateral and the value of the loan is
known as the repo margin or haircut. The level of margin depends on the following factors:
• Length – The longer the repurchase agreement, the higher the repo margin.
• Quality – The lower the quality of the collateral, the higher the repo margin.
• Credit quality – The lower the creditworthiness of the counterparty, the higher the repo margin.
• Supply and demand conditions – Repo margins are higher if the collateral is in abundant supply, or if there is a
low demand for it.

 Investment-grade and high-yield bond markets are based on the issuer’s credit quality.
 Money market securities: Original maturities range from overnight to one year.
 The coupon rate of floating-rate bonds is based on the reference rate plus a spread.
 Interbank offered rates are sets of rates at which banks could borrow from other banks.
 Fixed-income indexes help investors and investment managers to describe bond markets.
 Two mechanisms for issuing a bonds: a public offering and private placement.
 When an investment bank buys the entire issue, it takes the risk of reselling it to investors or dealers.
 Under best efforts offering, the investment bank serves only as a broker.
 Under shelf registration, the issuer files a single document with regulators that describes and allows for a
range of future issuances.
 Companies raise debt in the following forms – bilateral loans, syndicated loans, commercial paper, notes,
and bonds.
 Commercial paper is a short-term unsecured security that is used by companies for short-term funding.
 Repurchase agreement: Sale of a security (the collateral) with a simultaneous agreement to buy it back at a
predetermined price and future date.
 Sources of financing for financial institutions – retail deposits, central bank funds, interbank funds, large-
denomination negotiable certificates of deposit, and repurchase agreements.

Knowledge Check

Knowledge Check
1. A loan made by a group of banks to a private company is most likely:

A. A bilateral loan
B. A syndicated loan
C. A securitized loan
2. Which of the following statements relating to commercial paper is most accurate? Companies issue
commercial paper:
A. Only for funding working capital
B. Only as an interim source of financing
C. Both for funding working capital and as an interim source of funding
3. Maturities of Euro-commercial paper range from:
A. Overnight to three months
B. Overnight to one year
C. Three months to one year

Solution
 Solution: 1. B.
A loan made by a group of banks to a private company is most likely a syndicated loan.
 Solution: 2. C.
Companies issue commercial paper both for funding working capital and as an interim source of funding.
 Solution: 3. B.
Maturities of Euro-commercial paper range from overnight to one year.

Knowledge Check
4. A bond issue that has a stated number of bonds that mature and are paid off each year before the final
maturity most likely has a:
A. Term maturity
B. Serial maturity
C. Sinking fund arrangement
5. Which of the following are not considered wholesale funds?
A. Interbank funds
B. Central bank funds
C. Repurchase agreements
6. A large-denomination negotiable certificate of deposit most likely:
A. Is traded in the open market
B. Is purchased by retail investors
C. Has a penalty for early withdrawal of funds

Solution
 Solution: 4. B.
A bond issue that has a stated number of bonds that mature and are paid off each year before the final
maturity most likely has a serial maturity.
 Solution: 5. C.
Repurchase agreements are not considered wholesale funds.
 Solution: 6. A.
A large-denomination negotiable certificate of deposit most likely is traded in the open market.

Knowledge Check
7. From the dealer’s viewpoint, a repurchase agreement is best described as a type of:
A. Collateralized short-term lending
B. Collateralized short-term borrowing
C. Uncollateralized short-term borrowing

Solution
 Solution: 7. B.
A repurchase agreement is best described as a type of collateralized short-term borrowing from the dealer’s
viewpoint.

Reading 41: Introduction to Fixed-Income Valuation

Learning outcomes:

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.

Bond Prices and the Time Value of Money
The price of the bond at issue is the present value of the promised future cash flows.
 The market discount rate is used in the calculation to obtain the present value. It is also called the required
yield, or the required rate of return.
 The relationships between bond price, coupon rates, and discount rates are as follows:
• When the coupon rate is less lower than the market discount rate, the bond is priced lower than the discount
below par value.
• When the coupon rate is greater than the market discount rate, the bond is priced at a premium above par value.
• When the coupon rate is equal to the market discount rate, the bond is priced at par value.

Bond Prices and the Time Value of Money (Cont.)
 Yield to maturity (YTM) – The YTM is the IRR on the future cash flows. When the future cash flows are
discounted at that rate, the sum of the present values when future cash flows are discounted at IRR equals
the price of the bond. It is also the implied market discount rate. The rate of return on bond will equal YTM if
these conditions are fulfilled:
 The bond is held by the investor until its maturity.
 The issuer does not default on any of the payments.
 The investor is able to reinvest coupon payments at that same yield.
 Suppose if a four-year, 5% annual coupon payment bond is selling at $105 (premium). The yield-to-maturity
or r is:
 It can also be solved using the time-value-of-money keys on a financial calculator, which will obtain the result
as r = 0.03634 or 3.6%.

Relationships between the Bond Price and Bond Characteristics: The price of the bond changes with
changes in the market discount rate. Following are the four relationships about the change in bond price given
the market discount rate:
 The inverse effect – Bond prices are inversely related to the market discount rate.
 The Convexity Effect – Other things being constant (same coupon rate and time-to-maturity), the price
change in percentage is greater when the market discount rate goes down compared to when it goes up.
 The Coupon Effect – Other things being constant (same time to maturity), a bond with lower coupon bond
has a larger percentage of price change in price than a higher coupon bond when their market discount rates
change by the same percentage.
 The Maturity Effect – Other things being constant (same coupon rate), a bond with a long-term bond
maturity has a greater percentage price change in percentage than a short-term bond when their market
discount rates change by the same percentage.

Exhibit 1. Relationships between Bond Prices and Bond Characteristics

Discount Rates Discount Rates
Go Down Go Up
Coupon Price at Price at Price at
Bond Maturity % Change % Change
Rate 20% 19% 21%
A 10.00% 10 58.075 60.950 4.95% 55.405 -4.60%
B 20.00% 10 100.000 104.339 4.34% 95.946 -4.05%
C 30.00% 10 141.925 147.728 4.09% 136.487 -3.83%
D 10.00% 20 51.304 54.092 5.43% 48.776 -4.93%
E 20.00% 20 100.000 105.101 5.10% 95.343 -4.66%
F 30.00% 20 148.696 156.109 4.99% 141.910 -4.56%
G 10.00% 30 50.211 52.888 5.33% 47.791 -4.82%
H 20.00% 30 100.000 105.235 5.23% 95.254 -4.75%
I 30.00% 30 149.789 157.581 5.20% 142.716 -4.72%

 Constant-yield price trajectory – With the passage of time, the bondholder comes closer to receiving the par
value at maturity. Even if the market discount rate remains the same, bond prices change. The trajectory
shows the bond is ‘pulled to par’ if trading at a premium or a discount.
• The exhibit below shows the constant-yield price trajectories for two bonds, a 4% and 12% annual coupon
payment with 10 years to maturity. The current market discount rate is assumed to be 8%.
140
Price
12%(Premium)Bond
120
100
80
4%(Discount)Bond
60
40
20
0
0 1 2 3 4 5 6 7 8 9 10
Year
Discount Bond 73.160 75.012 77.013 79.175 81.508 84.029 86.751 89.692 92.867 96.296 100.00
Premium Bond 126.84 124.98 122.98 120.82 118.49 115.97 113.24 110.30 107.13 103.70 100.00

 Pricing Bonds with Spot Rates – Spot rates, also known as zero rates are YTM on zero-coupon bonds
maturing at the date of each cash flow. Bond prices determined using the spot rate is sometimes referred to
as the bond’s ‘no-arbitrage value’. If a bond’s price differs from its no-arbitrage value, an arbitrage
opportunity exists.
 Flat Price, Accrued Interest, and the Full Price – Between the coupon payment dates, a bond’s price has two
parts, namely, the flat price (PV Flat) and the accrued interest (AI). The sum of these two parts is the full
price (PV Full), which also is called the invoice or ‘dirty’ price.
𝑷𝑽 𝑭𝒖𝒍𝒍=𝑷𝑽 𝑭𝒍𝒂𝒕+𝑨𝑰
𝐭
𝑨𝑰 = × 𝐏𝐌𝐓
𝐓
Note: It is the flat price that depends on and changes the yield-to-maturity and not the accrued interest.
 Matrix Pricing: Sometimes the bonds are not actively traded. As a result, there is no market price available
on such bonds. The same problem occurs for bonds that are yet to be issued. In such situations, it is
common to use quoted or flat prices of more frequently traded comparable bonds to estimate the market
discount rate. These comparable bonds have similar times-to-maturity, coupon rates, and credit quality, and
this estimation process is called matrix pricing.

Prices and Yields: Conventions for Quotes and Calculations
 Yield Measures for Fixed-Rate Bonds: A fixed rate bond with annualized and compounded yield depends on
the assumed number of periods in the year, called the periodicity of the annual rate. For example, a bond
with semiannual coupons would have a periodicity of two and the quarterly bond would have a periodicity of
four.
 An effective annual rate would have a periodicity of one, because there is just one compounding period in
the year.
 It is important in fixed-income analysis to convert an annual yield from one periodicity to another which can
be done by using the given formula:

Example Problem
Let’s suppose a three-year with 5% semiannual coupon payment corporate bond is selling at a price of 104 with
the YTM equal to 3.582%, quoted on a semi-annual bond basis for a periodicity of two. Convert the periodicity
from two to four and then twelve.

Solution
 Conversion from two to four:
 Conversion from two to twelve:

 Yield Measures for Fixed-Rate Bonds: There are several other types of yield measures for bonds as
follows:
• Street convention – According to this measure, yield-to-maturity is the IRR on the cash flows assuming the
payments are made on the scheduled dates. It neglects weekends and holidays, thereby making the
calculations simpler.
• True yield – The true YTM is the IRR on the cash flows using the actual calendar of weekends and bank
holidays. It delays the time to payment, which means that the true yield can never be higher than street
convention.
• Government equivalent yield – It restates a YTM based on 30/360 day-count to one based on actual/actual
count.
• Current yield – It is the sum of the coupon payments received made by the bond over the year, divided by the
flat price of the bond.
• Simple yield – The sum total of the coupon payments plus amortized share of the gain or loss on bond price,
divided by the flat price of the bond.

Prices and Yields: Conventions for Quotes and Calculations (Cont.)
 Yield Measures for Fixed-Rate Bonds: There are different yield measures used if a bond has embedded
options like callable and putable:
 Yield to worst – It is the lowest of the sequence of yields-to-call and the yield-to-maturity. For example – yield
to first call is 6.975%, yield to second call is 6.956%, yield to third call is 6.953% and yield to maturity is
7.070%. In this case, yield to worst is 6.953%.
 Option adjusted yield – First of all, we find out the option adjusted price by adding value of the embedded
call option to the flat price of the bond. The price of non-callable bond is higher than callable bond as the call
provision reduces the value of a bond from the investor’s perspective. Then the option-adjusted price is used
to calculate the option-adjusted yield.

Prices and Yields: Conventions for Quotes and Calculations (Cont.)
 Yield Measures for Floating-rate Notes: The interest payments on a floater or an FRN, are not fixed.
Instead, they change from period to period depending on the current level of a reference rate (like LIBOR).
• If there is no change in the credit risk of the issuer, the required margin would remain the same. On each
quarterly reset date, the FRN will be priced at par value if the required margin is equal to the quoted margin.
• The required margin usually changes because of changes in the issuer’s credit risk.
• The required margin is called the discount margin and the formula to calculate the same is as follows:

Example Problem
A four-year French floating-rate note pays three-month Euribor (Euro Interbank Offered Rate, an index produced
by the European Banking Federation) plus 1.25%. The floater is priced at 98 per 100 of par value. Calculate the
discount margin for the floater assuming that three-month Euribor is constant at 2%. Assume the 30/360 day-
count convention and evenly spaced periods.

Solution
By assumption, the interest payment each period is 0.8125 per 100 of par value.
The discount margin can be estimated by solving for DM in this equation.
The solution for the discount rate per period is 0.9478%.
Therefore, DM=1.791%.

 Yield Measures for Money Market Instruments: Some important differences in yield measures between the
money market and the bond market:
• Bond YTM are annualized and compounded while in case of money market yield is annualized but not
compounded. It is stated on a simple interest basis.
• Bond YTM can be calculated using standard time-value-of-money analysis and with formulas programmed into a
financial calculator, whereas money market instruments are often quoted using nonstandard interest rates and
require different pricing equations than those used for bonds.
• Bond YTM is usually stated for a common periodicity for all times-to-maturity, whereas money market
instruments have different times-to-maturity or periodicities for the annual rate.
• In general, quoted money market rates are either discount rates or add-on rates:
• Discount rate basis:
• Add on basis:

Example Problem
Suppose that a 45-day T-bill with a face value of $10 million has future value of $10,060,829. Note that FV is a
sale price. With the given data, find the AOR.

Solution
365 10,060,829−10,000,000
AOR= ×
45 10,000,000
© EduPristine
( )(
=0.04934
For [CFA® Program Level-I] (Confidential)
)
Example Problem
Suppose that a 91-day T-bill with a face value of $10 million is quoted at a discount rate of 2.25% for an assumed
360 day year. Find the price of T-bill using the given data.

Solution

The Maturity Structure of Interest Rates
 There are many reasons for the difference in yield-to-maturity on two bonds. Following are the reasons for
such a difference:
 Currency – If the expected inflation of a currency is higher, the bond denominated in that currency would also
have a higher YTM.
 Credit risk – Lower investment grade bond would have a higher YTM.
 Liquidity – A relatively illiquid bond would have higher YTM.
 Tax status – If interest on income is higher, the bond’s expected YTM would also be higher.
 Periodicity – Lower the periodicity, higher the YTM.
 Term Structure – This is a yield curve which depicts relationship between YTM and time to maturity.
 Spot Curve – The YTM on a series of zero-coupon government bonds for a full range of maturities is called
spot curve.
 Par Curve – A par curve is a sequence of YTM such that each bond is priced at par value. The par curve is
obtained from a spot curve. For example, suppose the spot rates on government bonds are 5.263% for one
year and 5.616% for two years. The one-year par rate is:

The Maturity Structure of Interest Rates (Cont.)
 Forward Rates – A forward market is for future delivery of bonds which is different from cash market
settlement. A forward rate is the interest rate on a bond traded in a forward market. Implied forward rates or
forward yields are calculated from spot rates. The following equation explains the relationship between spot
and implied forward rates:

Example Problem
Suppose that the YTM on three-year and four-year zero-coupon bonds are 3.65% and 4.18% respectively, stated
on a semiannual bond basis. Find the “3y1y’ implied forward rate, which is the implied one-year forward yield
three years into the future.

Solution
() ()
6 8
0.0365 ( ) 0.0418
1+ × 1+𝐼𝐹𝑅6,2 2= 1+ , 𝐼𝐹𝑅6,2=0.028 9,×2=0.057 8
2
© EduPristine
2For [CFA® Program Level-I] (Confidential)
Yield Spreads
 Yield Spreads over Benchmark Rates – The yield-to-maturity can be divided into two components – the
benchmark and the spread.
 Benchmark is the base rate, often a government bond yield and
 Spread is the difference between the yield-to-maturity and the benchmark.
Taxation
Spread Risk Premiuim Liquidity
Credit Risk
Expected
Inflation Rate
“Risk-Free”
Benchmark Rate of Return
Expected Real
Rate

Yield Spreads
 Benchmark Spread – The yield spread over a particular benchmark is called benchmark spread. For
example, difference between the 10-year corporate bonds over the 10-year US Treasury benchmark rate.
 G-Spread – The yield spread over government bond is known as the G-spread.
 I-Spread – The difference between yield spread of a bond over the and standard swap rate in that currency
of the same tenor is known as the I-spread or interpolated spread.
 Z-spread – It is the constant spread added to the spot rates. The Z-spread can be calculated with the help of
following equation:
 Option adjusted spread – This spread is calculated by subtracting option value from the Z spread. When
option value is subtracted from the Z spread, it becomes equivalent to an option-free bond.

Example Problem
A 6% annual coupon corporate bond with two years remaining to maturity is trading at a price of 100.125. The
two-year, 4% annual payment government benchmark bond is trading at a price of 100.750. The one-year and
two-year government spot rates are 2.10% and 3.635%, respectively, stated as effective annual rates.
1. Calculate the G-spread, the spread between the yields-to-maturity on the corporate bond and the government
bond having the same maturity.
2. Demonstrate that the Z-spread is 234.22 bps.

Solution
Solution to 1:
The yield-to-maturity for the corporate bond is 5.932%.
The yield-to-maturity for the government benchmark bond is 3.605%.
The G-spread is 232.7 bps: .

Solution
Solution to 2:
Solve for the value of the corporate bond using z1 = 0.0210, z2 = 0.03636, and Z = 0.023422:

 Market discount rate is the rate of return required by investors given the risk of the investment.
 A bond is priced at a premium when the coupon rate is greater than the market discount rate and at a
discount below par value when the coupon rate is less than the market discount rate.
 There is a convex relationship between a bond price and its market discount rate.
 Volatility of a lower-coupon bond is more than the higher-coupon bond, other things being equal.
 Generally, longer-term bond is more volatile than the shorter-term bond.
 Spot rate: The yield-to-maturity on a zero-coupon bond.
 Between coupon dates, the full price of a bond includes flat price and the accrued interest.
 Matrix pricing is used to value illiquid bonds.
 Periodicity of an annual interest rate is the number of periods in the year. When a yield is quoted on a
semiannual bond basis it has a periodicity of two.
 Yield-to-worst on a callable bond is the lowest of all the yields (yield-to-first-call, yield-to-second-call, and so
on).
 Option-adjusted spread (OAS) for a callable bond is the Z-spread minus the theoretical value of the
embedded call option.
 Changes in spreads typically capture microeconomic factors like credit, tax and liquidity.
 Implied spot rates is the geometric averages of forward rates.

Knowledge Check

Knowledge Check
1. A bond offers an annual coupon rate of 4%, with interest paid semiannually. The bond matures in two years.
At a market discount rate of 6%, the price of this bond per 100 of par value is closest to:
A. 93.07.
B. 96.28.
C. 96.33.
2. Consider the following two bonds that pay interest annually:
Bond Coupon Rate Time- to- Maturity
A 5% 2 years
B 3% 2 years
At a market discount rate of 4%, the price difference between Bond A and Bond B per 100 of par value is
closest to:
A. 3.70.
B. 3.77.
C. 4.00.

Solution
 Solution: 1. B.
The bond price is closest to 96.28. The formula for calculating this bond price is:
where:
PV = present value, or the price of the bond
PMT = coupon payment per period
FV = future value paid at maturity, or the par value of the bond
r = market discount rate, or required rate of return per period

Solution
 Solution: 2. B.
The price difference between Bonds A and B is closest to 3.77. One method for calculating the price
difference between two bonds with an identical term to maturity is to use the following formula:
where:
PV = price difference
PMT = coupon difference per period
In this case the coupon difference is (5% – 3%), or 2%.

Knowledge Check
The following information relates to Questions 3 and 4

Bond Coupon Rate Maturity (years)
A 6% 10
B 6% 5
C 8% 5
All three bonds are currently trading at par value.

3. Relative to Bond C, for a 200 basis point decrease in the required rate of return, Bond B will most likely
exhibit a(n):
A. equal percentage price change.
B. greater percentage price change.
C. smaller percentage price change.
4. Which bond will most likely experience the greatest percentage change in price if the market discount rates
for all three bonds increase by 100 basis points?
A. Bond A
B. Bond B
C. Bond C

Solution
 Solution: 3. B.
Generally, for two bonds with the same time- to- maturity, a lower coupon bond will experience a greater
percentage price change than a higher coupon bond when their market discount rates change by the same
amount. Bond B and Bond C have the same time- to- maturity (5 years); however, Bond B offers a lower
coupon rate. Therefore, Bond B will likely experience a greater percentage change in price in comparison to
Bond C.
 Solution: 4. A.
Bond A will likely experience the greatest percent change in price due to the coupon effect and the maturity
effect. For two bonds with the same time- to- maturity, a lower- coupon bond has a greater percentage price
change than a higher- coupon bond when their market discount rates change by the same amount.
Generally, for the same coupon rate, a longer- term bond has a greater percentage price change than a
shorter- term bond when their market discount rates change by the same amount. Relative to Bond C, Bond
A and Bond B both offer the same lower coupon rate of 6%; however, Bond A has a longer time- to- maturity
than Bond B. Therefore, Bond A will likely experience the greater percentage change in price if the market
discount rates for all three bonds increase by 100 basis points.

Knowledge Check
5. A bond with 20 years remaining until maturity is currently trading for 111 per 100 of par value. The bond offers
a 5% coupon rate with interest paid semiannually. The bond’s annual yield- to- maturity is closest to:
A. 2.09%.
B. 4.18%.
C. 4.50%.

Solution
 Solution: 5. B.
The formula for calculating this bond’s yield- to- maturity is:
where:
PV = present value, or the price of the bond
PMT = coupon payment per period
FV = future value paid at maturity, or the par value of the bond
r = 0.0209
To arrive at the annualized yield- to- maturity, the semiannual rate of 2.09% must be multiplied by two.
Therefore, the yield- to- maturity is equal to 2.09% . 2 = 4.18%.

Thank You!
For queries, write to us at: care@edupristine.com

Disclaimer: The content is partially owned by CFA Institute, such as knowledge check, examples, diagrams, etc.

Fixed Income-I

Uploaded by

Document Information

Original Title

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

Fixed Income-I

Uploaded by

Copyright:

Available Formats

Fixed Income – I

© EduPristine For [CFA® Program Level-I] (Confidential)

 Reading 39: Fixed income securities: Defining elements

© EduPristine For [CFA® Program Level-I] (Confidential)

© EduPristine For [CFA® Program Level-I] (Confidential)

The candidate should be able to:

© EduPristine For [CFA® Program Level-I] (Confidential)

Equity Fixed Income

common stocks and preferred

Partial ownership in issuing

Dividend and voting rights Fixed cash flows (coupons)

Paid after fixed income in

© EduPristine For [CFA® Program Level-I] (Confidential)

150 Basic structure of a vanilla bond

© EduPristine For [CFA® Program Level-I] (Confidential)

© EduPristine For [CFA® Program Level-I] (Confidential)

Basic features of a bond:

© EduPristine For [CFA® Program Level-I] (Confidential)

Basic features of a bond (contd.)

© EduPristine For [CFA® Program Level-I] (Confidential)

Basic features of a bond (contd.)

© EduPristine For [CFA® Program Level-I] (Confidential)

Basic features of a bond (contd.)

© EduPristine For [CFA® Program Level-I] (Confidential)

© EduPristine For [CFA® Program Level-I] (Confidential)

© EduPristine For [CFA® Program Level-I] (Confidential)

Current yield = annual coupon / market price of the bond

© EduPristine For [CFA® Program Level-I] (Confidential)

© EduPristine For [CFA® Program Level-I] (Confidential)

N=5, PMT = 80, FV = 1000, PV = -1010, I/Y = 7.75%

© EduPristine For [CFA® Program Level-I] (Confidential)

1. An example of sovereign bond is a bond issued by:

© EduPristine For [CFA® Program Level-I] (Confidential)

© EduPristine For [CFA® Program Level-I] (Confidential)

© EduPristine For [CFA® Program Level-I] (Confidential)

 Legal Identity of the Bond Issuer and its Legal Form

 Source of Repayment Proceeds

 The Asset or Collateral Backing

 The Credit Enhancements

© EduPristine For [CFA® Program Level-I] (Confidential)

Legal identity of the bond issuer and its legal form

Source of repayment proceeds

Bond Type Source of Repayment

© EduPristine For [CFA® Program Level-I] (Confidential)

Asset or Collateral Backing: Collateral backing helps to reduce credit risk.

© EduPristine For [CFA® Program Level-I] (Confidential)

© EduPristine For [CFA® Program Level-I] (Confidential)

© EduPristine For [CFA® Program Level-I] (Confidential)

© EduPristine For [CFA® Program Level-I] (Confidential)

 Tax considerations: Tax treatment vary between different countries.

© EduPristine For [CFA® Program Level-I] (Confidential)

© EduPristine For [CFA® Program Level-I] (Confidential)

© EduPristine For [CFA® Program Level-I] (Confidential)

© EduPristine For [CFA® Program Level-I] (Confidential)

The bonds being discussed in the given scenario are Eurobonds.

© EduPristine For [CFA® Program Level-I] (Confidential)

© EduPristine For [CFA® Program Level-I] (Confidential)

Bullet Bond Partially Amortized Bond

Fully Amortized Bond

Outstanding Principal at the

© EduPristine For [CFA® Program Level-I] (Confidential)

© EduPristine For [CFA® Program Level-I] (Confidential)

© EduPristine For [CFA® Program Level-I] (Confidential)