CFA 2018 Level 1 Fintree Fixed Income ebook 8

(1)

TM

JuiceNotes

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FinTree

eBook 8

® TM

CFA Level 1 JuiceNotes 2017

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(2)

Afﬁrmative

covenants

Negative

Actions that borrower promises to perform

Eg. Make timely interest and principal payments

Prohibitions on the borrower

Eg. Restrictions on additional borrowing

Issuers of bonds

Bond maturity

Coupon payments

Currencies

A legal contract between the issuer (borrower) and investor (lenders) is called bond indenture

It deﬁnes obligations of and restrictions on the borrower

Covenants - Provisions in the bond indenture

Par value

Corporations - Financial companies & nonﬁnancial companies

Sovereign governments (national) - Issued by national government entities. Eg. US T-bills

Original maturity < 1 Yr - Money market securities

Payments could be annual, semi-annual, quarterly or monthly

Dual-currency bond - Coupon payment in one currency and principal repayment in another

Bond price < Par value - Trading at discount Bond price > Par value - Trading at premium Original maturity > 1 Yr - Capital market securities

Zero coupon bonds - Make no interest payments. Bonds are issued at discount and redeemed at par

Currency option bond - Bondholder has a choice of two currencies

Nonsovereign governments (local) - Issued by non national government entities. Eg. California state bonds Quasi-government entities - Agencies that are owned and sponsored by governments. Eg. postal services Supranational entities - Issued by organizations that operate globally. Eg. World Bank, IMF etc.

Perpetual bonds - No maturity. Make periodic interest payments but do not promise to repay the principal

Coupon is always calculated on Par value Also referred to as the face value/maturity value/redemption value/principal value

Fixed-income Securities: Defining Elements

LOS a

LOS b

LOS c

Basic features of a ﬁxed-income security

Content of bond indenture

FinTree

(3)

Considerations that affect the issuance and

trading of ﬁxed-income securities

LOS d

Domestic bonds Foreign bonds Eurobonds Global bonds

-They are issued in issuer’s home country and currency Issued by foreign issuers but denominated in the currency of the country where they trade

Issued outside a country and denominated in a currency other than that of the countries in which they trade Eurobonds that trade in a country other than the country that issues the currency the bond is denominated in and in Eurobond market

LOS e

Structure of CFs of ﬁxed income securities

Issuing entities

Sources of Repayment

-Collateral and Credit Enhancements

Taxation

-Government, corporations etc.

Securitized bonds - Bonds issued by special purpose entities (SPEs)

Sovereign bonds - Repaid by the tax receipts of the issuing country

Nonsovereign government bonds - Repaid by general taxes, revenues of a speciﬁc project or fees dedicated to bond repayment

Corporate bonds - Repaid from cash generated by the ﬁrm’s operations

Unsecured bonds (debentures) - Represent a claim to overall assets and cash ﬂows of the issuer

Interest income - Taxed at the same rate as ordinary income. For municipal bonds is usually tax-exempt Secured bonds - Backed by a claim to speciﬁc assets. Reduces default risk. They are senior to unsecured bonds

Capital gains - Taxed at capital gains tax rate

Collateral - Those speciﬁc assets used in issuing secured bonds

Covered bonds - Similar to Asset backed securities (ABS) but the underlying assets remain on the B/S of the issuing company

Credit enhancement - Internal or external Internal credit enhancement methods

-Overcollateralization, excess spread, dividing bond issue into tranches and cash reserve fund

External credit enhancements - Surety bonds, bank guarantees and letters of credit

Bullet structure

-Typical bond structure

Amortizing structure

-Periodic interest payments and principal value at maturity

Balloon payment - Final interest payment + Principal at maturity

Part of principal is paid at each payment date

Fully amortizing structure - Equal payments

Partially amortizing structure - Balloon payment of remaining principal at maturity

(4)

Sinking fund provision

-Their interest rate is dependant on market rate (reference rate) FRN coupon = Reference rate (LIBOR) + margin

Requires the issuer to retire a portion of a bond issue at speciﬁed times

Variablerate note Interest rate cap

Interest rate ﬂoor

Inverse ﬂoater(FRN)

-Margin is not ﬁxed

Stepup coupon bonds

Creditlinked coupon bond Paymentinkind (PIK) bond

Deferred coupon bond

Indexlinked bond

-Coupon rate increases over time according to a predetermined schedule

If credit quality Coupon rate (Double Jeopardy Bonds)È Ç

Allows the issuer to make coupon payments by increasing principal amount of the outstanding bonds

Coupon payments do not begin until a period of time after issuance

Coupon payments and/or a principal repayment is based on a commodity index, equity index or some other index

Inﬂation-linked bonds - Most common type

Principal protected bonds - Indexed bonds that do not pay less than their original par value at maturity

Limit on how high the coupon rate can rise

Minimum rate that investor receives

Coupon rate when reference rate Ç È

Beneﬁts the issuer (borrower)

Beneﬁts the lender (investor)

Floating-rate notes

Other coupon structures

LOS f

Contingency provisions affecting the timing and/or

nature of cash ﬂows of ﬁxed-income securities

Ê Contingency provision - An action that may be taken if contingency actually occurs These provisions in bond indentures are referred to as embedded options

Ê Callable bonds - Issuer can buy back the bond from bondholder (value to the issuer)

Ê Putable bonds - Bondholder can sell the bond back to issuer (value to the bondholder)

Ê Convertible bonds - Option to exchange the bond for shares (value to the bondholder) Owners of these bonds have downside protection. Often referred to as hybrid security Even if the share price increases to a level where the conversion value is signiﬁcantly above the bond’s par value, bondholders might not convert the bonds to common stock because the

interest yield > dividend yield on common shares received through conversion. For this reason, many convertible bonds have call provision

Ê Warrants - Holder of a warrant has right to buy the ﬁrm’s common shares at a given price over a given period of time

Ê Contingent convertible bonds (CoCos) - Bonds that convert from debt to common shares automatically if a speciﬁc event occurs

(5)

Most widely used reference rate is London Interbank Offered Rate (LIBOR)

Characteristics of US LIBOR

è It is a rate at which one bank lends another bank

è For short term

è Currency is USD

è Issued out of US è It is an add-on rate

è No compounding of interest rate

è Different LIBOR exist for different maturities

è 360 day convention is used

Reference rate must match the frequency of the coupon

Eg. If a bond’s interest rate is reset twice a year, appropriate reference rate is 6-month LIBOR

Markets where previously issued bonds trade Most bonds are traded in dealer markets (OTC markets)

Liquid issues - Difference between bid-ask price is narrower

Less liquid issues - Difference between bid-ask price is wider

Public offering Private placement Underwritten offering Best efforts offering

-Bonds are sold to the public

Bonds are sold only to qualiﬁed investors Entire bond issue is purchased by the investment bank (underwriter)

Investment bank does not commit to purchase the whole issue

Type of

issuer qualityCredit maturityOriginal structureCoupon Currency Geography Indexing statusTax

Government, corporation

etc.

Money market, capital market

securities

Index-linked bonds USD, Euro etc.

BBB and above - Investment grade

bonds BB and below -

Junk bonds

Fixed rate or

ﬂoating rate markets - Less Developed riskier Emerging markets

- More riskier

Municipal bonds - Tax exempt, lower

yield

Fixed-income Markets: Issuance, Trading And Funding

LOS a

LOS b

LOS c

LOS d

Classiﬁcations of global ﬁxed-income markets

Use of reference rates in ﬂoating-rate debt

Mechanisms available for issuing bonds in primary markets

Secondary markets

(6)

Settlement cycle: Government bonds - T+1 Corporate bonds - T+2 or T+3

LOS e

LOS f

LOS g

LOS h

Securities issued by sovereign governments

Securities issued by

Types of debt issued by corporations

Short-term funding alternatives available to banks

Sovereign (national) governments issue bonds that are backed by the taxing power Sovereign governments may issue the bonds denominated in their own currency or

foreign currency

Backed by taxing authority (local) or revenues from a

speciﬁc project

Yields are marginally higher than those of

sovereign bonds High credit quality,

liquid

Bilateral loan - Loan given by only one

bank

Syndicated loan - Loan given by a group of

banks

It is a short term unsecured debt issued

by creditworthy companies It is used to fund

working capital

Term maturity structure - All bonds mature on the same

date Serial maturity structure - Bonds mature on different

dates

Customer deposits Certiﬁcates of deposit (CDs) Central bank funds market Interbank funds

-Short-term funding source

Another short-term funding source. CDs mature on speciﬁc dates. Negotiable CDs can be sold Banks may buy or sell excess reserves deposited with their central bank Funds loaned by one bank to another

(7)

Repurchase agreements

LOS i

One party sells a security to a counterparty with a commitment to buy it back at a later date at a speciﬁed (higher) price

Repo rate - Annualized percentage difference between selling and buying price

Repo margin (haircut) - Difference between the market value and the amount loaned

Reverse repo - Bond dealer lends funds instead of borrowing

Eg.

Repo margin will be lower if,

Ÿ Borrower has high credit quality

Ÿ Higher quality of collateral

Ÿ Maturity is shorter

Ÿ Security is in short supply and high demand

Repo rate will be lower if,

Ÿ Collateral is delivered

Ÿ Higher quality of collateral

Ÿ Maturity is shorter

Ÿ General interest rates are lower

Sells a security @ 93 (Market Value = 97)

Promise to buy back @ 96 after 3 months Bond

dealer

Bond dealer

Lender

Repo margin = 97 − 93 = 4

Repo rate = ₉₃3 = 3.22%

(8)

Face value - 1000 Calculate price of the bond

Spot rates - 1-Yr - 4% 2-Yr - 5% 3-Yr - 6% 4-Yr - 7% Calculate the bond price when

Maturity = 4 Yrs Coupon rate = 10% YTM = 12% Face value = 1000

ª If Coupon rate > YTM - Premium bond

ª If Coupon rate < YTM - Discount bond

ª Price-yield relationship is convex

ª Longer maturity - Price is more sensitive to a change in yield

Accrued

interest

(Dirty price)

Full price

Flat price

(Clean price)

It is the quoted price of a bond

Full Price − Accrued interest

Can be calculated using actual/actual convention (govt.

bonds) or 30/360 convention (Corp. bonds)

Transaction price

Includes accrued interest

MV of bond is PV of future CFs discounted at current YTM (Yield-to-maturity)

YTM = 15% Face value = 1000 Coupon rate = 20%

Introduction To Fixed-Income Valuation

LOS a

LOS b

LOS c

LOS d

Calculating bond price using YTM

Relationship b/w bond price, coupon rate, maturity and YTM

Calculating bond price using spot rates

60

57.69 54.42 50.37 808.66

+

(9)

Matrix pricing

Yield measures

LOS e

LOS f

Method of estimating YTM of the bonds that are not traded Rating must be same but coupon rate does not have to be same

Eg. Determine YTM of a non traded BB rated, 5% annual-pay bond that has 4 years remaining until maturity

YTMs of similar bonds are:

BB rated, 3 year annual-pay, 6% coupon bond - 5.5% BB rated, 6 year annual-pay, 7% coupon bond - 6.5%

YTM of non traded bond = 5.5 + 0.33 = 5.83%

For annual coupon bond

Effective earning yield = Yield to maturity

Street convention

-Yield to call (YTC) Yield to worst (YTW)

Yield calculated using the stated coupon payment dates

True yield - Yield calculated after considering weekends and holidays

For semi-annual coupon bond

Effective earning yield > Yield to maturity

Current yield

-Current yield = Simple yield = Discount amortized =

Current yield = 11.76% Simple yield = 13.33%

Simple yield

-Annual coupon + Disc. amort. − Prem. amort. Bond price

Eg.

Annual coupon bond Semi-annual coupon bond

Street convention yield > True yield

Face value = 1000 Coupon rate = 10% Market value = 1020

Callable in four years at 103 Lowest of YTM and YTCs is called YTW YTC - FV = 1030 PMT = 100 N = 4 PV = −1020 I/Y = 10.01%

Face value = 1000 Coupon rate = 15% Maturity = 8 yrs. Market value = 800

Semi-annual bond

Face value = 1000 Coupon rate = 10% Maturity = 10 yrs. Market value = 850

Semi-annual bond

Face value = 1000 Coupon rate = 10% Maturity = 10 yrs. Market value = 900 FV = 1000 PMT = 150 N = 8 PV = −800 Maturity = 10 yrs. Market value = 870 FV = 1000 PMT = 85 N = 20 PV = −870

CPT I/Y = 10.03 x 2 = 20.06

2

EAY = (1 + 10.03) − 1 = 21.06% EAY > YTM

(10)

Floating-rate note yields

Money market instrument yields

ª FRN yield = LIBOR + Quoted margin

ª Coupon rate for the next period is set using the current reference rate (LIBOR) for the reset period

ª Values of FRNs are more stable than those of ﬁxed-rate debt of similar

maturity because the coupon interest rates are reset periodically

ª Issuer with more credit risk - Quoted margin is higher

ª Issuer with less credit risk - Quoted margin is lower

ª Required margin (discount margin) - Margin that brings FRN to its par value

ª Credit quality - Quoted margin > Required marginÇ

When this happens we say that FRN is trading at premium

ª Credit quality - Quoted margin < Required marginÈ

When this happens we say that FRN is trading at discount

ª Yield can be quoted on discount basis or add-on basis

ª These may be 360-day or 365-day

ª US T-bills - Quoted as discount bond and is based on 360-day convention

ª Libor and bank CDs - Quoted as add-on yield

ª Appropriate yield measure for money market instruments - Bond equivalent yield

LOS g

Yield curve

Displays yields for different maturities

Spot curve

Yield curve for single payments in the future

Displays yields for same maturities Constructed from the spot curve

Par curve

Forward curve

Maturities

Maturities Maturities

Maturities Yields

Coupon rates Forward rates

Spot rates

(11)

Calculating forward rates using spot rates

Eg. Spot = 20%7 Calculate 2-yr forward rate, 5 years from now

Formula

It is the difference between yields of two bonds

Benchmark spread - Yield spread relative to a benchmark bond

G-spread - Yield spread relative to a government bond

Interpolated spread (I-spread) - Yield spread relative to a swap rate

Option adjusted spread

Z - spread eg.

Spot rates (treasury) - Year 1 - 10%, Year 2 - 11%, Year 3 - 12%, Year 4 - 15%

Z-spread is determined by trial and error method

860 = _{(1 + 10% + z-spread)}100 1+ _{(1 + 11% + z-spread)}100 2 + _{(1 + 12% + z-spread)}100 3+ _{(1 + 15% + z-spread)}1100 4

Bond - A Bond - B

(With call option)

Face value = 1000

Coupon rate = 10%

YTM = 15%

Maturity = 5 Yrs

Market Value = 832

Face value = 1000

Coupon rate = 10%

YTM = 16.48%

Market Value = 790

YTM = 16.48%

Option risk Option adjusted

yield

15% 1.48%

(12)

Trust may issue ABS in several classes (tranches)

Waterfall structure - Each tranche of ABS is paid sequentially

SPE is a separate legal entity and buyers of ABS do not have claim on other assets of the bank

Securitization is a process in which an entity (SPE) purchases ﬁnancial assets such as mortgages, loans etc. and sells them in the form of securities to investors

Primary beneﬁts:

Œ Reduction in funding costs

Increase in the liquidity of ﬁnancial assets

Other beneﬁts:

ª Provides higher risk-adjusted returns for investors

ª Investors’ legal claim to the mortgages is stronger

ª After securitization securities are actively traded

ª Banks are able to lend more because the bank receives proceeds when its

ﬁnancial assets are securitized

ª Securatization has led to ﬁnancial innovation

ª Provides diversiﬁcation and risk reduction compared to purchasing whole loans

Introduction To Asset-backed Securities

LOS a

LOS b

LOS c

Beneﬁts of securitization

Securitization process

Typical structures of securitizations

Receives cash Mortgages, loans are sold

Mortgages and loans (assets) are removed from

the B/S

May use cash proceeds to make more loans

Known as ‘trust’ and is set up speciﬁcally for buying these loans and selling ABS

to investors Services the loans

Principal and interest payment received on loans is used to pay

servicing fees to the servicer and then to ABS owners

Servicer

Bank

Special purpose

_{entity (SPE)}

è In ‘tranches’ structure - Some tranches bear more risk while other bear less

è Credit tranching (senior/subordinate structure) - Losses are ﬁrst absorbed by the tranche

with lowest priority

è Time tranching - First tranche receives all principal repayments from underlying assets up to the principal value of the tranche

(13)

Residential mortgage loans

LOS d

Collateral of the loan is residential real estate

If LTV, then borrower’s equity Ç È

For lenders,

ª Loans with low LTVs is less riskier (because borrower loses more in case of default)

ª If the property value is high compared to the loan amount, lender is more likely to recover the amount loaned if borrower defaults

Characteristics of residential mortgage loans:

ª Maturity - Typically 15-30 yrs

ª Interest rate - Fixed rate, adjustable rate or convertible

ª Amortization - Fully amortizing, partially amortizing or interest-only ª Prepayment provisions - Some loans have prepayment penalty

ª Foreclosure - Non-recourse and recourse loans

Prime loans - Mortgages with high LTV ratios, made to borrowers of high credit quality

Subprime loans - Mortgages to borrowers of lower credit quality

Loan-to-value ratio (LTV) - _{Value of collateral real estate}Loan amount x 100

LOS e & f

Residential mortgage backed securities (RMBS)

ª Agency RMBS - Issued by GNMA, FNMA and Freddie Mac. Agency RMBS are

mortgage pass-through securities. Generally high quality.

ª Non-agency RMBS - Issued by private companies. Non-agency RMBS typically include credit enhancement

ª Collateralized mortgage obligations (CMOs) - Collateralized by pools of RMBS. They are structured with tranches

ª In sequentialpay CMO

-Ÿ First tranche to be paid principal has most contraction risk Ÿ Last tranche to be paid principal has most extension risk

ª Planned amortization class (PAC) tranches - A PAC tranche is structured to make predictable payments, regardless of actual prepayments. PAC tranches have both reduced contraction and extension risk

ª Prepayment risk - Uncertainty about timing of the principal CFs from the ABS

ª Contraction risk - Risk that loan principal will be repaid more rapidly than expected (when interest rates decrease)

ª Extension risk - Risk that loan principal will be repaid more slowly than

expected (when interest rates increase)

(14)

Commercial mortgage backed securities (CMBS)

Non-mortgage ABS

Collateralized debt obligations (CDOs)

LOS g

LOS h

LOS i

ª CMBS are backed by income-producing real estate properties such

as shopping malls, ofﬁce buildings, apartments etc.

ª RMBS loans are repaid by homeowners whereas CMBS loans are repaid by real estate investors

ª CMBS are typically structured as non-recourse loans

ª There is a two level call protection (loan level and structural level)

ª Two key ratios to assess credit risk

Œ Debt-to-service-coverage ratio

Loan-to-value ratio

ABS may backed by ﬁnancial assets other than mortgages. Eg. Auto loan ABS and credit card ABS

Auto loan ABS

Credit card ABS

ª Backed by credit card

receivables

ª Non-amortizing (revolving

debt)

ª Have a lockout period

during which only interest is paid

ª Backed by automobile loans ª Typically fully amortizing ª Shorter maturities than

RMBS

è Collateral is a pool of debt obligations that is managed by a collateral manager

è Collateralized bond obligations (CBOs) - When collateral securities are corporate and emerging market debt

è Structured ﬁnance CDOs - Collateral is ABS, RMBS, other CDOs and CMBS è Collateralized loan obligations (CLOs) - Backed by leveraged bank loans

è Synthetic CDOs - Collateral is portfolio of credit default swaps (CDS) on structured securities RFR + Selling CDS

è CDOs have 3 tranches - Senior bonds, mezzanine bonds, and subordinated bonds

(15)

Macaulay duration

Maturity = 4 yrs

Spot = 10% 1

Spot = 15% 2

Spot = 20% 3

Spot = 25%4

An investor always earns at YTM, if he holds the bond till maturity and reinvests at YTM

Interest rate risk (market price risk) - Uncertainty about bond’s price

Reinvestment risk - Uncertainty about income from reinvestment of coupon payments

Shorter investment horizon - Interest rate risk > reinvestment risk Longer investment horizon - Interest rate risk < reinvestment risk

Increase in YTM decreases the bond price but increases reinvestment income

Macaulay

duration

Effective

duration

Weighted average maturity of a bond portfolio

Weights are based on discounted CFs

Macaulay duration -∑ Weights x Maturities

Appropriate measure of risk for bonds with embedded options (callable/putable)

Effective duration -V − -V− +

2 × V × ∆ yield curve0

Œ Coupon and principal payments Reinvestment of coupons

Ž Capital gain/loss if bond is sold before maturity

Understanding Fixed-Income Risk And Return

LOS a

LOS b

Sources of return from ﬁxed-rate bond

Modiﬁed

duration

Approx. measure of %∆ in bond’s price for a 1% change

in YTM

Modiﬁed duration

-Macaulay duration (1 + YTM)

Maturity Cash ﬂow Disc. CF Weights Weighted avg.

1 150 136.36 16.83% 0.17

2 150 113.42 14.04% 0.28

3 150 86.8 10.74% 0.33

4 1150 471.04 58% 2.32

Total 807.63 3.1

V =− Higher bond price V =+ Lower bond price V =0 Base price For ZCBs, Macaulay duration = Bond maturity

For Fixed coupon bond, Macaulay duration < Bond maturity

Macaulay duration > Modiﬁed duration

Modiﬁed duration can also be calculated as

-V − -V− +

2 × V × %∆ in yield0

(16)

Modiﬁed duration

= 6.15

Eg #2

Face value = 1000 Coupon rate = 10%

YTM = 10% 11%

941

1064 1000

9% + 1%

− 5.9% − 1%

+ 6.4%

Modiﬁed duration = 6.4 + 5.9₂

Interpretation - If yield changes by 1%, bond price will change by 6.15%

LOS c

Why effective duration is the most appropriate measure

of interest rate risk for bonds with embedded options ?

Embedded options have uncertain future CFs, because of which PV calculations for bond value based on YTM cannot be used

LOS d

LOS e

Key rate duration (partial duration)

Effect of maturity, coupon and yield on duration

Parallel shift in yield curve Nonparallel shift in yield curve

Duration Key rate duration

Yield Yield

Bond price Bond price Key rate duration - Measure of sensitivity of price of a bond to a change in spot

rate for a speciﬁc maturity. It captures shaping risk.

Variable Effect

Maturity Ç Duration Ç

Coupon Ç Duration È

YTM Ç Duration È

Callable bond - Lesser duration when yields È

Putable bond - Lesser duration when yields Ç

Optionality of bond will never increase the duration

Callable bond (Lower duration

at lower yield)

Putable bond (Lower duration

at higher yield)

(17)

Duration of portfolio

LOS f

Calculating weighted average number of

periods until the portfolio’s cash ﬂows

will be received

Calculating weighted average of durations of

individual bonds in the portfolio

Yield measure - Cash ﬂow yield (IRR of the bond

portfolio)

Not useful for a portfolio that contains bonds with

embedded options

Useful for a portfolio that contains bonds with

embedded options Weights are based on full

price of each bond Limitation - For portfolio duration to ‘make sense’

the YTM of every bond in the portfolio must

change by the same amount (parallel shift) This approach is used in

practice

LOS g

_Money

duration

Price value of

a basis point

Aka dollar duration

Money duration -Modiﬁed duration × Full price

Money change in the full price of a bond when YTM changes by

one basis point (0.01%)

Money duration × % ∆ in YTM = Change in bond price (absolute amount)

Eg. Market value = $1050 Modiﬁed duration = 6 ∆ in yield = 50 bps

Modiﬁed duration × Full price

6 × 1050

$6300

(18)

Convexity

LOS h

Face value = 1000 Coupon rate = 10%

YTM = 10% 11%

941

1064 1000

9% + 1%

− 5.9% − 1%

+ 6.4%

Convexity refers to the curvature of a bond’s price-yield relationship

Due to convexity(+ve), bond price increases more for a given change in yield as compared to decrease(%) for same change in yield

Increase in yield causes price to decrease at decreasing rate and Decrease in yield causes price to increase at increasing rate

LOS i

Calculating % ∆ in the full price of a bond

2

% ∆ full price of bond = −Duration(∆Y) + 1/2 × Convexity(∆Y)

LOS j

LOS k

Term structure of yield volatility and duration

Relationship between bond’s HPR, duration and investment horizon

Relationship between maturity and yield volatility Short-term yields may be more volatile than long-term yields

Term structure of yield volatility

-FV = 1000 Coupon = 12.55% YTM = 5%

10 7

3 0

−1583 1000

YTM = 9% _{yield is lower}Realized

Realized yield is lower Realized yield is

close to 5%

Realized yield is close to 5%

Realized yield is higher

YTM = 2%

Reinvestment risk dominates Price risk

dominates

1

2

(19)

How changes in credit spread and liquidity affect YTM

LOS l

10 7

3 0

−1583 1000

Duration gap = −ve

Duration gap = +ve

Duration gap = Zero

Bond’s spread to benchmark curve has two components Credit risk premium and Liquidity premium

Given change in any of these components will have direct impact on YTM

(20)

All debt within the same category is said to rank pari passu. They have same priority of claims

Lower seniority Higher credit risk Higher YTM

_ª

Since bankruptcies are costly and take a long time to settle, strict priority of claims may not be followed

General seniority rankings

First lien Senior secured debt Junior secured debt Senior unsecured debt Senior subordinated debt

Subordinated debt Junior subordinated debt

Seniority ranking - Bond’s priority of claims to the issuer’s assets

LOS c

LOS d

Seniority rankings

Fundamentals Of Credit Analysis

LOS a & b

Credit risk

Expected loss

Recovery rate

Spread risk

Liquidity risk

Downgrade risk

(Credit migration risk)

Possibility of failure of a borrower to make timely and full payments of interest or principal. It has two components

Default risk × loss severity

% of bond value investor receives, if issuer defaults

Possibility that bond’s spread will widen due to downgrade risk or liquidity risk or both

Risk of receiving less than market value

Possibility that spreads will increase because the issuer has become less creditworthy

Default risk - Probability that borrower (issuer) fails to pay interest or repay principal

Loss severity (loss given default) - Value a bond investor will lose if the issuer defaults. 1 − Recovery rate

Issuer credit ratings

Issue credit ratings

Called as Corporate Credit Ratings (CCR)

Based on credit risk of speciﬁc debt issue

Called as Corporate Family Ratings (CFR)

Based on the overall creditworthiness of the company

Issuers are rated on their senior unsecured debt

(21)

It is the practice by rating agencies of assigning different ratings to bonds of the same issuer

Bonds of parent company are subordinate to bonds of subsidiary company

Credit ratings

change over time cannot always judge Rating agencies credit risk accurately

Speciﬁc risks of a company or industry

are difﬁcult to predict and incorporate into

credit ratings

Market prices and credit spreads change much faster

than credit ratings

Notching

Structural

subordination

LOS e

Risks in relying on ratings from credit rating agencies

Credit ratings

are dynamic

Rating agencies

are not perfect

difﬁcult to assess

Event risk is

Credit ratings lag

market pricing

LOS f

LOS g

LOS h

4 Cs of traditional credit analysis

Financial ratios used in credit analysis

Evaluating credit quality

Œ Capacity - Borrower’s ability repay its debt obligations. Three levels of assessment - Industry structure, industry fundamentals and company fundamentals

Collateral - Assets pledged against a debt, available to creditors in case of default. More important for less creditworthy companies

Ž Covenants - Provisions in bond indenture. They protect lenders. Afﬁrmative/negative Character - Management’s professional reputation and the ﬁrm’s history of debt

repayment

Proﬁt and

Cash Flows Leverage Ratios Coverage Ratios

EBITDA

Funds from operations (FFO)

Free cash ﬂow before dividends

Free cash ﬂow after dividends

Debt/capital

Debt/EBITDA

FFO/debt

FCF after dividends/debt

EBITDA/interest expense.

EBIT/interest expense

Indicators of lower credit risk (higher credit rating)

-È Leverage, Interest coverage, and free cash ﬂowÇ Ç

Analyst should consider underfunded pensions and off-balance-sheet ﬁnancing while calculating leverage ratios

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Factors that inﬂuence level and volatility of yield spreads

Special considerations when evaluating different debts

LOS i

LOS j

ª Credit cycle - Credit spreads narrow as credit cycle improves. Credit spreads widen

as credit cycle deteriorates

ª Economic conditions - Spreads narrow as economy strengthens and spreads widen

as economy weakens

ª Financial market performance - Spreads narrow in strong-performing markets,

spreads widen in weak-performing markets

ª Broker-dealer capital - Spreads narrow when broker-dealers provide sufﬁcient

capital, Spreads widen when capital becomes scarce

ª Market demand and supply - Spreads narrow when demand > supply, spreads widen

when demand < supply

Yield spreads on lower-quality issues tend to be more volatile than spreads on higher-quality issues

High yield debt

More likely to default than investment grade

bonds

Analysis should focus on liquidity, projected ﬁnancial performance,

debt structure and debt covenants

Credit risk includes country’s ability and

willingness to pay Credit risk is lower for

bonds issued in country’s own currency

than for bonds issued in foreign currency

Analysis is similar to analysis of sovereign

debt Focus is on local economy and its effect

on tax revenues

Sovereign debt Non-sovereign debt