In the past, this structural approach may have been relegated to the realm of the arcane or the academic. There is a widespread belief that exploitable inefficiencies within the fixed income market persist due to regulatory and/or functional limitations.
ACKNOWLEDGMENTS
Martin Fridson, CFA and Cecilia Fok provided invaluable insight and direction for the credit analysis chapter (Chapter 9 of Level II). Dennis is an accomplished author who has written several books published by the CFA Institute for the CFA program.
INTRODUCTION
PARENTAGE
One of the hallmarks of curriculum development at the CFA Institute is its extensive use of practitioners at all stages of the process. The results of the forums were presented to 70,000 CFA charter holders for verification and confirmation of the knowledge thus derived.
BENEFITS
The most experienced professional understands that the nature of capital markets requires a commitment to continuous learning. A number of the concepts on these pages were not present a decade or two ago when many of us were starting out in business.
CONVENTIONAL WISDOM
Furthermore, the concepts herein give a true sense of the kind of work that can be found on a daily basis managing portfolios, conducting research or related endeavors. There is no better way to make such a critical decision than to be prepared by reading and evaluating the gospel of the profession.
THE TEXTS
Armed with a thorough understanding of the emerging risks, the professional investor is much better equipped to anticipate and understand the challenges facing our central bankers and markets. CFA Institute, as a long-term participant in the investment profession and as a non-profit association, is pleased to offer you this opportunity.
NOTE ON ROUNDING DIFFERENCES
There are instances in the book where it was necessary to save space when I cut and pasted a large spreadsheet. For example, suppose that I specified in the spreadsheet that Column (3) is only shown to two decimal places rather than seven decimal places.
FEATURES OF DEBT SECURITIES
- INTRODUCTION
- INDENTURE AND COVENANTS
- MATURITY
- PAR VALUE
- COUPON RATE
- PROVISIONS FOR PAYING OFF BONDS
- CONVERSION PRIVILEGE
- PUT PROVISION
- CURRENCY DENOMINATION
- EMBEDDED OPTIONS
- BORROWING FUNDS TO PURCHASE BONDS
Thus, for our hypothetical floater, when the 3-month T-bill rate exceeds 8.5%, the coupon rate is capped at 9%. If an issuer exercises this right, the issuer is said to ``call the bond''. The price that the issuer must pay to withdraw the issue is referred to as the call price or redemption price.
RISKS ASSOCIATED WITH INVESTING IN BONDS
- INTEREST RATE RISK
- YIELD CURVE RISK
- CALL AND PREPAYMENT RISK
- REINVESTMENT RISK
- CREDIT RISK
- LIQUIDITY RISK
- EXCHANGE RATE OR CURRENCY RISK
- INFLATION OR PURCHASING POWER RISK
- VOLATILITY RISK
- EVENT RISK
- SOVEREIGN RISK
This means that the price will decrease by 2 points or 2.22% of the initial price of 90. As you can see, duration is a measure of the bond's price sensitivity to a change in yield.
OVERVIEW OF BOND SECTORS AND
INSTRUMENTS
SECTORS OF THE BOND MARKET
The external bond market is called the international bond market, the overseas bond market, or, more popularly, the Eurobond market.1 In this book, we will use the term Eurobond market to describe this sector of the bond market. Some market observers refer to the foreign bond market as the foreign bond market and the Eurobond market. Aglobal bonds is a debt obligation that is issued and traded on the foreign bond market of one or more countries and on the Eurobond market.
SOVEREIGN BONDS
The inflation-adjusted principal at the end of the first six-month period is found by multiplying the original par value by (1+the semi-annual inflation rate). In our example, the inflation-adjusted principal at the end of the first six-month period is $101,500. However, the Treasury has structured TIPS so that they are redeemed at the greater of the inflation-adjusted principal amount and the initial par value.
SEMI-GOVERNMENT/AGENCY BONDS
B = amount borrowed (ie original loan balance) r = monthly mortgage interest rate (annual interest rate divided by 12) n = number of months of mortgage loan. The cash flow of the bridge depends on the cash flow of the underlying mortgage pool. The CMO described in Exhibit 8 has a simple set of cash flow distribution rules.
STATE AND LOCAL GOVERNMENTS
Unlimited general tax debt is a stronger form of general obligation collateral because it is secured by the issuer's unlimited taxing power. Unlimited general tax debt is supposed to be secured by the full faith and credit of the issuer. The allocation of funds from the state's general tax revenues must be approved by the state legislature.
CORPORATE DEBT SECURITIES
If the reference rate is outside the range, the coupon rate is zero for that period. If the 1-year Treasury rate is outside the range, the coupon rate is zero. This means that Doylestown Bank agrees to pay the holder of the bankers' acceptance $900,000 on the maturity date.
ASSET-BACKED SECURITIES
The installment sales are assets on the balance sheet of XYZ Corp., shown as ``installment sales receivable.'' However, suppose that XYZ Corp. may create another corporation or legal entity and sell the installment sale receivables to that entity. If the transaction is done properly, SPV Corp. owns the installment sales debtors, not XYZ Corp.
COLLATERALIZED DEBT OBLIGATIONS
The disadvantage of external credit enhancement is that it is subject to the credit risk of a third-party guarantor. Essentially, external credit enhancement exposes the investor to event risk, as a downgrade of one entity (a third-party guarantor) may result in a downgrade of the asset-backed security. If the asset manager violates any of the restrictions, the debt securities may be downgraded and it is possible for the trustee to begin making principal payments to the senior debt securities holders in the CDO structure.
PRIMARY MARKET AND SECONDARY MARKET FOR BONDS
In a CDO structure, an asset manager is responsible for managing the portfolio of assets (ie the debt obligations in which it invests). The funds to purchase the underlying assets (ie the bonds and loans) are obtained by issuing a CDO. The syndicate that offers the lowest yield (ie, the lowest price to the issuer) wins the entire $400 million bond issue and re-offers it to the public.
UNDERSTANDING YIELD SPREADS
INTEREST RATE DETERMINATION
The indicators the Fed watches closely include nonfarm payrolls, industrial production, housing starts, motor vehicle sales, durable good orders, National Association of Purchasing Management deliveries and commodity prices. The discount rate is the rate at which banks can borrow against collateral in the Fed's discount window. An increase in the discount rate makes the cost of funds more expensive for the banks; the cost of funds is reduced when the discount rate is lowered.
U.S. TREASURY RATES
However, over-the-counter and off-the-shelf Treasury securities are traded with different levels of liquidity. Specifically, the spot issue has a higher interest rate risk (duration) due to the lower coupon rate. Theories of the term structure of interest rates What information does the yield curve reveal?
YIELDS ON NON-TREASURY SECURITIES
The last four columns in Exhibit 5 show Lehman Brothers' estimate of the option-adjusted spread for the 30-year Ginnie Mae passes shown in the exhibit—the option-adjusted spread on February 8, 2002, and for the preceding 90-day period ( i high, low and medium). After adjusting for prepayment risk (ie, the included option), the measured spread from the option-adjusted spread is significantly smaller, 63 basis points. A Lehman Brother study found that one factor that affects liquidity (and thus yield spreads) is the size of an issue—the larger the issue, the greater the liquidity relative to a smaller issue and the greater the liquidity, the lower the yield. spread.10.
SWAP SPREADS
The swap rate will then be 6%, found by adding the swap spread of 50 basis points to the 5-year Treasury yield of 5.5%. The following table shows the payment made by the fixed rate payer to the fixed rate payers for various values of 3-month LIBOR:14. Thus, the swap spread is a spread of the global cost of short-term borrowing over the treasury rate.
INTRODUCTION TO THE VALUATION OF DEBT
SECURITIES
GENERAL PRINCIPLES OF VALUATION
The amount paid by the buyer to the seller in such cases is the present value of the cash flow. The present value of each cash flow, assuming each cash flow is discounted at an annual discount rate of 8%. 5Note that when calculating the full price, the present value of the next coupon payment is calculated.
TRADITIONAL APPROACH TO VALUATION
The number of days used depends on the day counting convention for the security in question. For government bonds with coupons, the day counting convention used is intended to determine the actual number of days between two dates. The number of days in the coupon period is the actual number of days between March 1 and September 1, namely 184 days.
THE ARBITRAGE-FREE VALUATION APPROACH
The sum of the current values is the arbitrage-free value for the Treasury bill. Stripping and the Arbitrage-Free Valuation Key in the process is the existence of the Treasury bill market. The spot rate used to discount the cash flow of a non-Treasury security may be the Treasury spot rate plus a constant credit spread.
VALUATION MODELS
This term structure is called the benchmark spot rate curve or zero-coupon benchmark rate curve. This spot rate curve is used to value securities that have the same credit rating and are in the same market sector. EXHIBIT 10 Calculating the Value of a Hypothetical 8% 10-Year Non-Treasury Non-Arbitrage Using the Spot Rate Comparison Curve.
YIELD MEASURES, SPOT RATES, AND FORWARD
RATES
SOURCES OF RETURN
For a bond held to maturity, there will be a capital gain if the bond is purchased below its par value. If the same bond is sold before its maturity date or before it is called, a capital gain will arise if the yield exceeds the purchase price. For a callable bond, a capital loss occurs if the price at which the bond is called is less than the purchase price.
TRADITIONAL YIELD MEASURES
Since a semiannual interest rate of 2.8% makes the present value of the cash flows equal to the price, 2.8% is the yield on first call. The yield to put is the interest rate that will make the present value of the cash flows to the first sale date equal to the price plus accrued interest. Additionally, the yield to sit assumes that the bond will be posted on the first sale date.
THEORETICAL SPOT RATES
Since the reference point for calculating the Z spread is the theoretical point rate curve, that curve is shown in the exhibit. The main factor that causes any change is the shape of the Treasury yield curve. Thus, with this steeper spot rate curve, the difference between the Z spread and the nominal spread is 52 basis points.
FORWARD RATES
Letf represents half the forward rate (expressed as BEY) on a 6-month Treasury bill available six months from now. For example, suppose the 6-month forward rate is required four years (eight 6-month periods) from now. The graph of short-term forward rates is called the short-term forward rate curve.
INTRODUCTION TO THE MEASUREMENT OF
INTEREST RATE RISK
THE FULL VALUATION APPROACH
EXHIBIT 1 Illustration of the full valuation method to estimate the interest rate risk of a bond position for three scenarios. EXHIBIT 2 Illustration of the full valuation method to estimate the interest rate risk of a two-bond portfolio (without options) for three scenarios assuming a parallel shift in the yield curve. EXHIBIT 3 Illustration of the full valuation method to estimate the interest rate risk of a two-bond portfolio (without options) for three scenarios assuming a non-parallel shift in the yield curve.
PRICE VOLATILITY CHARACTERISTICS OF BONDS
When the price/yield ratio is plotted for any option-free bond, it displays the form shown in Exhibit 5. The shape of the price/yield ratio for any option-free bond is called asconvex. The convex curve given by a–ais the price/yield ratio for an option-free bond.
