1 Welcome to the Jungle: Fixed Income Topics November 21, 2004 Zachary Emig MBA Class of 2005 Ross School of Business Finance Club

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Welcome to the Jungle: Welcome to the Jungle: Fixed IncomeFixed Income Topics Topics

November 21, 2004November 21, 2004

Zachary EmigZachary Emig

MBA Class of 2005MBA Class of 2005

Ross School of Business Finance Ross School of Business Finance ClubClub

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Today’s AgendaToday’s AgendaI. What is fixed income?I. What is fixed income?

II. II. DurationDuration

III. III. Yield Curves and Credit SpreadsYield Curves and Credit Spreads

IV. IV. SwapsSwaps

V. V. Securitized ProductsSecuritized Products

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What Is Fixed Income?What Is Fixed Income?Technically, the word “fixed income” means Technically, the word “fixed income” means

a security that has a set payment on a set a security that has a set payment on a set sequence of days; i.e. straight debt.sequence of days; i.e. straight debt.

The way it is used today, it means “any The way it is used today, it means “any financial security that is not related to financial security that is not related to equity (stocks).” This includes:equity (stocks).” This includes:

Treasury Treasury BondsBonds

Foreign Foreign ExchangeExchange

Corporate Corporate BondsBonds

Mortgage Backed Mortgage Backed SecuritiesSecurities

CommoditiCommoditieses

Credit Credit DerivativesDerivatives

Interest Rate Interest Rate OptionsOptions

And much, And much, much, much, more!more!

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Fixed Income Covers a Lot!Fixed Income Covers a Lot!

As you can see, there are many product As you can see, there are many product areas that fall under the fixed income areas that fall under the fixed income umbrella. Which makes sense, becauseumbrella. Which makes sense, because

……Fixed Income rules the world (or at least Fixed Income rules the world (or at least is where most of investor money is at).is where most of investor money is at).

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Market CapitalizationMarket CapitalizationThe US is one of, if not The US is one of, if not thethe, most equity , most equity

friendly country in the world.friendly country in the world.That said, compare market capitalizations:That said, compare market capitalizations:

NYSENYSE $11.7 Trn$11.7 Trn NasdaNasdaqq$3.1 $3.1 TrnTrn

ABS ABS $1.7 T$1.7 T

Munis Munis $1.9 T$1.9 T

Agency Agency $2.7 T$2.7 T

Treasury* Treasury* $3.7 T$3.7 T

CorporateCorporate $4.6 T$4.6 T

MortgageMortgage $8.7 $8.7 TT

What about What about monthlymonthly trading volume: trading volume:Agency MBSAgency MBS

$3.9 T$3.9 T

AgencAgency Debt y Debt $1.5 T$1.5 T

TreasuriesTreasuries $9.6 $9.6 TT

CorporateCorporatess

$0.4T$0.4T

NYSENYSE NasdaqNasdaqNYSENYSE

$0.8 T$0.8 T

NASDAQNASDAQ

$0.6 T$0.6 T

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Market CapitalizationMarket Capitalization•It is very hard to find official capitalization, It is very hard to find official capitalization, volume data on fixed income securities.volume data on fixed income securities.

•For trading volume, took average daily For trading volume, took average daily volumes and multiplied by 20 trading days in a volumes and multiplied by 20 trading days in a month.month.

•Didn’t include: derivative trading volumes Didn’t include: derivative trading volumes (both equity and FI), foreign exchange, (both equity and FI), foreign exchange, commodities (FI).commodities (FI).

•The pointThe point: Both domestically and globally, FI : Both domestically and globally, FI markets dwarf equity markets in capital and markets dwarf equity markets in capital and volume.volume.

http://www.nyse.com/pdfs/movolume0410.pdfhttp://www.nasdaq.com/newsroom/stats/Performance_Report.stmhttp://www.bondmarkets.com/collection.asp?colid=191http://www.bondmarkets.com/story.asp?id=296, ?id=96, ?id=1209, ?id=304, ?id=323, ?id=96, ?id=1209, ?id=304, ?id=323

http://www.nyse.com/pdfs/movolume0410.pdf

http://www.nasdaq.com/newsroom/stats/Performance_Report.stm

http://www.bondmarkets.com/collection.asp?colid=191

http://www.bondmarkets.com/story.asp?id=296

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IV. IV. SwapsSwaps


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DurationDurationOne of the most important concepts to know is One of the most important concepts to know is durationduration, which is basically the sensitivity of a bond’s , which is basically the sensitivity of a bond’s price to interest rate movements.price to interest rate movements.

•There are several closely related versions of There are several closely related versions of duration, but it’s usually defined as the % change in a duration, but it’s usually defined as the % change in a bond’s value for a percentage change in yield bond’s value for a percentage change in yield (measured in basis points).(measured in basis points).

•Duration also represents the weighted average of all Duration also represents the weighted average of all payments of the bond. For zero coupon bonds, payments of the bond. For zero coupon bonds, duration=time to maturity. For coupon paying bonds, duration=time to maturity. For coupon paying bonds, duration will be less than the time to maturity.duration will be less than the time to maturity.

http://www.investorwords.com/1602/duration.htmlhttp://www.investorwords.com/1602/duration.html

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Duration ExampleDuration Example5 year bond, non-callable, 4% annual coupons, $100 5 year bond, non-callable, 4% annual coupons, $100 par.par. T= 1 2 3 4 5

Payment $4.00 $4.00 $4.00 $4.00 $104.00Interest Rate PV at T=1 PV at T=2 PV at T=3 PV at T=4 PV at T=5 Total PV

4.00% $3.85 $3.70 $3.56 $3.42 $85.48 $100.00

Using Using DCFs:DCFs:

T= 1 2 3 4 5Payment $4.00 $4.00 $4.00 $4.00 $104.00Interest Rate PV at T=1 PV at T=2 PV at T=3 PV at T=4 PV at T=5 Total PV

3.90% $3.85 $3.71 $3.57 $3.43 $85.89 $100.454.00% $3.85 $3.70 $3.56 $3.42 $85.48 $100.004.10% $3.84 $3.69 $3.55 $3.41 $85.07 $99.56

Vary the Vary the interest interest rates a rates a bit:bit:Divide the % change in price by the bp change in Divide the % change in price by the bp change in rates:rates:T= 1 2 3 4 5

Payment $4.00 $4.00 $4.00 $4.00 $104.00Interest Rate PV at T=1 PV at T=2 PV at T=3 PV at T=4 PV at T=5 Total PV PV change Rate change Duration

3.90% $3.85 $3.71 $3.57 $3.43 $85.89 $100.45 -0.44% 0.10% 4.444.00% $3.85 $3.70 $3.56 $3.42 $85.48 $100.00 -0.44% 0.10% 4.444.10% $3.84 $3.69 $3.55 $3.41 $85.07 $99.56

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Duration Example (cont.)Duration Example (cont.)Often, a graph of a bond’s price versus yield is Often, a graph of a bond’s price versus yield is helpful to understand duration.helpful to understand duration.

$0

$50

$100

$150

1%

2%

3%

4%

5%

7%

8%

9%

10%

11%

13%

14%

15%

16%

17%

19%

20%

21%

22%

IRs

PV of Cash Flows

$0

$50

$100

$150

1%

2%

3%

4%

6%

7%

8%

10%

11%

12%

14%

15%

16%

17%

19%

20%

21%

23%

IRs

PV of Cash Flows 30yr 4% BondDuration is Duration is essentially the essentially the slope at a point on slope at a point on the P/Y line.the P/Y line.Note that duration Note that duration is different for is different for different bonds.different bonds. 3.50

5.50

7.50

9.50

11.50

13.50

15.50

17.50

19.50

21.50

23.50

1% 2% 3% 4% 5% 6% 7% 8% 9% 10%

11%

12%

13%

14%

15%

16%

17%

18%

19%

20%

21%

22%

23%

Duration (for the 30yr)

Also note that duration changes with interest Also note that duration changes with interest rates; this “2rates; this “2ndnd derivative” is called derivative” is called convexityconvexity; for large swings in rates, it can ; for large swings in rates, it can play a factor in prices.play a factor in prices.

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Real World Use: DV01Real World Use: DV01For convenience, most traders use DV01 For convenience, most traders use DV01 (PVBP): the dollar change in the bond price for (PVBP): the dollar change in the bond price for a 1bp move in yield (very similar to yield).a 1bp move in yield (very similar to yield).

This is the Bloomberg Yield Analysis (YA) for This is the Bloomberg Yield Analysis (YA) for the 10yr Treasury Note.the 10yr Treasury Note.

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DV01 in ActionDV01 in ActionOn Nov. 16, at 8:30, the government published On Nov. 16, at 8:30, the government published the PPI numbers, which came in much hotter the PPI numbers, which came in much hotter than expected.than expected.

The yield on the The yield on the 10yr benchmark 10yr benchmark Treasury Treasury immediately immediately jumped 4.6bpjumped 4.6bpDV01 x 4.6bp = DV01 x 4.6bp = PricePrice

0.08103 x 4.6bp = 0.08103 x 4.6bp = $0.373$0.373

……=12/32nds.=12/32nds.

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DV01 in ActionDV01 in Action

As expected, the price dropped by 37¢ As expected, the price dropped by 37¢ ($12/32).($12/32).

……A trader long $50MM of 10 years just lostA trader long $50MM of 10 years just lost

27¢ x 50,000 = 27¢ x 50,000 = $18,637$18,637. Ouch.. Ouch.

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IV. IV. SwapsSwaps


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Yield CurvesYield CurvesGenerically, a “yield curve”, is simply a plot of Generically, a “yield curve”, is simply a plot of the current yields at different maturity points.the current yields at different maturity points.

When speaking of When speaking of thethe yield curve, yield curve, most traders most traders mean the US mean the US Treasury yield Treasury yield curve, since curve, since Treasuries are the Treasuries are the “riskfree” “riskfree” benchmark for all benchmark for all debt instruments.debt instruments.

Bloomberg command: YCRVBloomberg command: YCRV

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Yield QuestionYield QuestionBy the way, what is yield?By the way, what is yield?

I would answer that it is the periodic discount I would answer that it is the periodic discount rate that, when applied to every payment in a rate that, when applied to every payment in a bond’s cash flow, returns the exact same price bond’s cash flow, returns the exact same price as the current market price.as the current market price.

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Credit SpreadCredit SpreadIn the FI world, many products are traded on a In the FI world, many products are traded on a “spread” off the Treasury yield curve.“spread” off the Treasury yield curve.

The The credit credit spreadspread is the is the difference in AAA difference in AAA corporate debt corporate debt yields and yields and Treasury yields; it Treasury yields; it is a real-time is a real-time measurement of measurement of the credit risk the credit risk tolerance of the tolerance of the market.market.

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Breakeven InflationBreakeven InflationComparing the Treasury curve versus the TIPS Comparing the Treasury curve versus the TIPS (Treasury Inflation Protected Securities) yield (Treasury Inflation Protected Securities) yield curve reveals the breakeven inflation level curve reveals the breakeven inflation level expected by the market.expected by the market.

A word of caution on A word of caution on TIPS: they are a fairly TIPS: they are a fairly new product, and do new product, and do have some liquidity have some liquidity issues that could lead to issues that could lead to mispricing.mispricing.

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Swap SpreadSwap SpreadOther interesting spreads to observe: Agency Other interesting spreads to observe: Agency spread and swap spread.spread and swap spread.

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IV. IV. SwapsSwaps


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Swaps: At their most basicSwaps: At their most basicAs their name implies, swaps are simply As their name implies, swaps are simply contractual agreements between two contractual agreements between two counterparties to exchange different cash counterparties to exchange different cash flows.flows.The number of swaps are greatly expanding. A The number of swaps are greatly expanding. A truncated list:truncated list:

•Currency swapsCurrency swaps

•Interest rate swapsInterest rate swaps

•Credit Default SwapsCredit Default Swaps

•Volatility SwapsVolatility Swaps

•Total Return SwapsTotal Return Swaps

ISDA:ISDA:

For interest rate swaps, For interest rate swaps, rate options, and currency rate options, and currency swaps, at mid-year 2004, swaps, at mid-year 2004, the notional amount the notional amount outstanding was:outstanding was:

$164.49 $164.49 TrillionTrillionhttp://www.isda.org/statistics/recent.html#2004midhttp://www.isda.org/statistics/recent.html#2004mid

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Interest Rate SwapsInterest Rate SwapsInterest rate swaps (often called Interest rate swaps (often called vanilla vanilla swapsswaps) are simply exchanges of a fixed rate ) are simply exchanges of a fixed rate of interest for a floating rate, both paid on a of interest for a floating rate, both paid on a fixed fixed notional amountnotional amount..

Things to remember:Things to remember:

•Buying (going long) a swap = paying fixed Buying (going long) a swap = paying fixed rate, receiving floatingrate, receiving floating

•Selling (going short) a swap = paying Selling (going short) a swap = paying floating, receiving fixedfloating, receiving fixed

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IV. IV. SwapsSwaps


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SecuritizationSecuritization•Securitization was one of the biggest financial Securitization was one of the biggest financial innovations of the last 40 years.innovations of the last 40 years.

•Definition: transforming illiquid/non-financial Definition: transforming illiquid/non-financial products into tradable financial securities.products into tradable financial securities.

•Two most common methods:Two most common methods:

•Pooling: using large pools of securities to Pooling: using large pools of securities to diminish the illiquidity/risk of a single one.diminish the illiquidity/risk of a single one.

•Tranching: dividing cash flows into Tranching: dividing cash flows into separate “tranches” that have different risk separate “tranches” that have different risk levels, in order to target differing investor levels, in order to target differing investor appetites for risk.appetites for risk.

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Mortgage Backed SecuritiesMortgage Backed Securities•The history of MBS is an excellent example of both The history of MBS is an excellent example of both processes.processes.

•Problems with investing in individual mortgages: Problems with investing in individual mortgages: small size (to an institutional investor) and small size (to an institutional investor) and prepayment risk (at the “whim” of the homeowner).prepayment risk (at the “whim” of the homeowner).

•In the late 70s and early 80s, Mortgage Pass-Thrus In the late 70s and early 80s, Mortgage Pass-Thrus were popularized: securities whose coupons were were popularized: securities whose coupons were supported by pools of [numerous] mortgage supported by pools of [numerous] mortgage securities.securities.

IndividuIndividual al

MortgagMortgagee


MortgaMortgagege


MortgaMortgagege


MortgaMortgagegeIndividuIndividu

al al MortgaMortga

gege


MortgaMortgagege


MortgaMortgagege


MortgaMortgagege


MortgaMortgagege


MortgaMortgagege


MortgaMortgagege


MortgaMortgagege


MortgaMortgagege


MortgaMortgagege


MortgaMortgagege

IndividuaIndividual l

MortgagMortgagee



al al MortgaMortga

gege


MortgaMortgagege


MortgagMortgageeIndividuIndividual al

MortgaMortgagege

MBS Pass-MBS Pass-ThruThru

IssuerIssuer(Fannie Mae, Freddie (Fannie Mae, Freddie

Mac, I-Banks)Mac, I-Banks)

Pass-Pass-Thru Thru

InvestorInvestorss

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CMOsCMOs•The next step in securitization was tranching.The next step in securitization was tranching.

•CMOs = Collateralized Mortgage Obligations.CMOs = Collateralized Mortgage Obligations.

•Rather than divide all the pooled mortgage cash flows Rather than divide all the pooled mortgage cash flows equally among investors, CMOs divide them into separate equally among investors, CMOs divide them into separate “tranches” of securities with different payment profiles.“tranches” of securities with different payment profiles.

•Commonly, the different tranches receive different Commonly, the different tranches receive different timing of payments.timing of payments.


MortgagMortgagee


MortgaMortgagege


MortgaMortgagege



al al MortgaMortga

gege


MortgaMortgagege


MortgaMortgagege


MortgaMortgagege


MortgaMortgagege


MortgaMortgagege


MortgaMortgagege


MortgaMortgagege


MortgaMortgagege


MortgaMortgagege


MortgaMortgagege


MortgagMortgagee


MortgaMortgagege

Pass-Pass-ThruThru


MortgaMortgagege

Pass-Pass-ThruThru


MortgaMortgagege

CMOCMO

IssuerIssuer(I-Banks)(I-Banks)

First 18mos

First 18mos

payments

payments

Tranche Tranche A A

InvestorInvestorss

18mos-18mos-36mos36mos

Tranche Tranche B B

InvestorInvestorss36mos+

36mos+Tranche Tranche

C C InvestorInvestor

ss

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IV. IV. SwapsSwaps


~ Fin ~~ Fin ~

Documents

1 Welcome to the Jungle: Fixed Income Topics November 21, 2004 Zachary Emig MBA Class of 2005 Ross School of Business Finance Club