UP CFA 2013 I Fixed Income

7/29/2019 UP CFA 2013 I Fixed Income

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*Elaboracion basada en las Kaplan Schweser Notes CFA Level 1

Fixed Income:Basic Concepts


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Fixed Income:

Basic Concepts

52. Features of Debt Securities


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Bond Indentures

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A bond indenture specifies all the obligations of the issuerof a fixed income security

Negative covenants - prohibitions on the borrower Restrictions on asset sales Negative pledge of collateral Restrictions on additional borrowings

Affirmative covenants - promises by the borrower Maintain financial ratios Timely payment of principal and interest


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Bond Features

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Face value, par value, maturity value

Coupon rate: Annual % of par value

Currency denomination

Redemption: At maturity vs. amortizing


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Coupon Structures

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Zero-coupon bonds

Pure discount bonds which pay no coupon

Step-up notes

Coupon rate increases over time

Deferred coupon

Bond's coupons compound


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Floating-Rate Securities

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Coupon formula

Reference rate + margin

For example, LIBOR + 1.5%, annualizedrates

Cap: Maximum on formula rate

Floor: Minimum on formula rate


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Accrued Interest

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Paid to a bond seller

Portion of the next coupon interest paymentalready earned by the seller

Full price = clean price + accrued interest

=


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Amortizing and Nonamortizing Bonds

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Nonamortizing securities pay only interest untilmaturity, then the par value is repaid

Coupon Treasury bonds Most corporate bonds

The bond terms may include a sinking fund orcall feature that can accelerate principal

repayment

Amortizing securities typically make equalpayments over the life of the bond, each consistsof interest and principal


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Call Provisions

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Issuer can repay principal prior to maturity

Call protection for some period

Call prices typically decrease over time(e.g., 15-year bond: callable after 5 years102 and callable after 10 years @ par)


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Refunding

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Refunding is calling (redeeming) a bonusing the proceeds of a lower-cost issue

Bond can be callable but not refundable


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Prepayment Option

On an amortizing security, such as amortgage

Prepayments are repayment of principal inexcess of scheduled principal payments


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Sinking Fund

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Sinking fund redemptions are calls of aportion of an outstanding bond issue, typically at par

Premium bonds: Cash paid to trustee,bonds to be retired chosen by lottery

Discount bonds: Bonds can be purchased

and delivered to trustee to be retired


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Redemption Prices

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Cali prices are regular redemption prices

Sinking fund redemptions andredemptions under other provisions arespecial redemption prices

(e.g., redemptions due to forced asset

sales)


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Embedded Options

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Options that benefit the issuer/borrower

decrease bond values/increase yields

Options that benefit the holder/lenderincrease bond values/decrease yields


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Embedded Options

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Option Type Benefits the.

Call Provision Issuer/Borrower

Prepayment Option Issuer/Borrower

Put Provision Buyer

Conversion Option Buyer

Caps Issuer/Borrower

Floors Buyer


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Margin Buying and Repurchase Agreements

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Margin buying: Borrowing funds to purchase securities.The securities are the collateral for the margin loan

Repurchase agreement: An institution sells a security witha commitment to buy it back at a specified higher price

Repo rate: The interest rate implied by the two prices Overnight repo: Repurchase agreement for one day Term repo: Agreement covering a longer period

Most bond dealer financing is achieved through repurchaseagreements rather than margin loan


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53. Risks Associated WithInvesting in Bonds

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Bond Risks

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1. Interest rate risk

2. Call/prepayment risk

3. Yield curve risk

4. Reinvestment risk

5. Credit risk

6. Liquidity risk

7. Exchange-rate risk

8. Volatility risk

9. Inflation risk

10.Event risk


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Bond Discounts and Premiums

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Yield = coupon rate bond price at par

Yield < coupon rate

bond price over parbond priced at a premium

Yield > coupon rate bond price under parbond priced at a discount


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Price/Yield for an 8% Bond

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Bond Value

Market Yield


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Factors Affecting Interest Rate Risk

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Callable Bond Value

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Callable bond = option free bond call option


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Floating-Rate Securities

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Coupon is periodically reset based on areference rate (plus a fixed margin)

Has interest rate risk between reset dates

Price may differ from par at reset if:

Credit quality of issuer changes after issuance

Margin over reference rate no longer appropriate


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Floating-Rate Securities - Problem

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Which of the following regarding floating-ratenotes is false?

A. The coupon rate is based on a short-termreference rate plus a margin.

B. A cap benefits the issuer (borrower) of a

floating rate note.

C. A floating rate note will be valued at par atevery coupon (reset) date.


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Measure Interest Rate Risk With

Duration

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Duration is the approximate percentage pricechange for a 1% change in yield

If market yield goes up 0.5%, bond price goesfrom 980 to 960; if yield goes down by 0.5%,price goes to 1,002:


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Price Impact of Yield Changes

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Based on the duration of 4.29:

If the yield goes up 0.25%, price goes down by4.29(0.25%) = 1.0725%

For a bond valued at $2.5 million, a yield changeof 0.25% leads to an approximate change invalue of 1.0725% (2.5 mil) = $28,812.50

Dollar duration of a bond is approximatechange in value for a 1% change in yield:0.0429 (2.5 mil)= $107,250


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Duration and Yield Curve Risk

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Portfolio duration is an approximation of theprice sensitivity of a portfolio to a parallel shiftof the yield curve (yields on all the bonds change

by the same percent)

For a non-parallel shift in the yield curve, theyields on different bonds in a portfolio canchange by different amounts

Yield curve risk: The interest rate risk of aportfolio of bonds that is not captured by theduration measure


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Duration and Yield Curve Risk

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Callable and Prepayable Securities

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Callable securities are likely to be calledwhen interest rates are low

Principal repayment on prepayablesecurities is faster when interest rates arelow

Investors must reinvest principal when ratesare low


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Factors Affecting Reinvestment Risk

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Reinvestment risk is higherwhen:

1. Coupon is higher

2. Bond has a call feature

3. A security is amortizing

4. A security contains a prepayment option


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Forms of Credit Risk

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Bond ratings indicate relative probability ofdefault

Downgrade risk: Probability of ratings decrease

Default risk: Probability of default

Credit spread risk: Risk of increase in spread

to Treasuries to compensate for given defaultrisk (bond rating)

The higher the rating (e.g., AA vs. A),the lower the market yield


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Liquidity Risk

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The bid-ask spread indicates the liquidity ofthe market for a security

A decrease in liquidity will increase the bid-ask spread, lead to a lower sale price,and decrease the returns on the position

Even if an investor plans to hold the security

until maturity, marking the security prices tomarket will result in lower returns whenliquidity decreases (bids fall)


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Exchange Rate Risk

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If an investor buys a security denominated in aforeign (to the investor) currency

Depreciation of the foreign currency reducesthe returns to a dollar-based investor

Exchange rate risk: Actual cash flows from the

investment may be worth more or less than wasexpected when the bond was purchased


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Inflation Risk

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Inflation (purchasing power) risk: Prices ofgoods and services increase more than expected

An increasing price level decreases theamount of real goods and services that bondpayments will purchase

When expected inflation increases, nominalyields rise, values of debt securities fall


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Effects of Yield Volatility

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Increase in yield volatility increases optionvalues

Increases value of putable bond =

(option-free bond value + put value )

Decreases value of callable bond =

(option-free bond value - call value )


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Event Risk

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Disasters (e.g., hurricanes, earthquakes, orindustrial accidents) can impair the ability of acorporation to meet its debt obligations

Corporate restructurings may result in bond ratingdowngrades

Regulatory issues may cause large cash

expenditures to meet new regulations

New regulations prohibiting financial institutions fromholding a certain type of security can lead to avolume of sales that decreases prices for the whole sector


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Sovereign Risk

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Sovereign bond credit spread may increase

Foreign government's credit rating may decline

Foreign government may default on or repudiate debts

Origins of sovereign risk are most often loweconomic growth/tax revenues, high government

spending


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Interest Rate Risk - Problem

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A bonds interest rate risk will increas with:

A. A put optionB. Shorter maturityC. Lower coupon.


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Volatility Risk- Problem

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An Increase in yield volatility will most likely:

A. Decrease the value of a callable bond.B. Decrease the value of a putable bond.C. Decrease the values of all option-free bonds.

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54. Overview of Bond

Sectors and Instruments

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Government Securities

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Sovereign debt: Bonds issued by centralgovernments; domestic, foreign, or Eurobond

U.S. Treasury securities consideredessentially free of default risk

Sovereign debt of other countries

considered to have varying degrees ofcredit risk

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Sovereign Debt Issuance Methods

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1. Regular cycle auctionsingle price: Highest price(lowest yield) at which the entire issue can be soldawarded to all bidders (e.g., U.S. Treasury debt)

2. Regular cycle auctionmultiple price: Winningbidders receive the bonds at the prices they bid

3. Ad hoc auction system: Government auctions new

securities when market conditions are advantageous

4. Tap system:Auction of bonds identical to previouslyissued bonds, periodically, no regular cycle

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U.S. Treasury Securities

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T-Bills: Pure discount securities, nocoupon, no interest payments, less than

one year maturity

Notes and bonds: Semi-annual couponinterest, face (par) value at maturity, 2 to30 years maturity

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U.S. Treasury Securities

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Treasury Inflation Protected Securities(TIPS)

Coupon rate is fixed

Real rate of return

Par value is adjusted for inflation

1/2 coupon rate x inflation adjusted par value= semiannual payment

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On- and Off-the-Run Treasuries

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On-the-run issues

Most recent auction issues, most liquid,

actively traded

Off-the-run issues

Older issues (replaced by more recentissues)

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Stripped Treasury Securities

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A type of zero-coupon bond created fromTreasury notes and bonds; the pieces (couponpayments and the principal payment) areseparated

Coupon strips are denoted = ci

Principal strips are denoted = pi

STRIPS (zeros) are taxed on implicit interest

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Securities Issued by Federal Agencies

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Federally related institutions (e.g., GNMA,TVA)

Government-sponsored enterprises (SallieMae, Freddie Mac, Fannie Mae)

Agency securities, very little credit risk

Debentures: Securities not backed bycollateral; unsecured bonds

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TIPS - Problem

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U.S. Treasury Inflation Protected Securities(TIPS):

A. have inflation-adjusted coupon rates.

B. have a par value that changes over time.

C. can be worth less than par at maturity.

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$100,00 30-Year 5.75% MortgageMonthly Payment = $583.57

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Payment Beginning Principal PrincipalPortion Interest Portion Remaining Principal

1 100,000.00 104.41 479.16 99,895.59

2 99,895.59 104.90 478.67 99,790.69

359 1,158.81 578.02 5.55 580.79

360 580.79 580.79 2.78 0.00

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Mortgage-Backed SecurIties

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Mortgage Passthrough Securities

Backed by pools of mortgages

Interest, principal payments, prepayments

Collateralized Mortgage Obligations (CMOs)

Created from mortgage passthroughs

More complex cash flow claimstranches

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Mortgage-Backed Securities

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CMO Tranche example: Sequential Tranches

Tranche I receives interest on its outstanding principaland all principal payments until the tranche iscompletely paid off

Tranche II receives interest on its outstanding principaland begins receiving all principal payments when

Tranche I is paid off

Tranche III receives only interest until Tranches I and IIare paid off, then receives alL remaining principalpayments

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Prepayment Risk

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Risk of receiving principal repayment in excessof scheduled principal payments

May lead to more funds to be reinvested whenrates for reinvestment are lowreinvestment risk

When rates increase, prepayments slow

Rapid prepayment results in gains for PO strips

Rapid prepayment decreases cash flows from IOstrips

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Motivation for Creating a cMO

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Alter maturity range and redistribute prepaymentrisk to make securities attractive to differentinstitutional investors

Creating a CMO does not alter the overall risk ofprepayment

Tranche with less prepayment risk [planned

amortization class (PAC)] coupled with tranchewith more prepayment risk (support tranche)

Goal is lower overall cost of funds (always!)

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State and Local Government Issues

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Municipal securities, a.k.a. munis, tax-free bondsInterest exempt from U.S. income tax and income taxin state of issue, often issued in serial form

Tax-backed (general obligation) bondsIssued by state, counties, cities, and other politicalsubdivisions; supported by taxes

Revenue bondsDebt serviced only with specific project'srevenues. Issued for transportation/airports,housing, port facilities, health care facilities, etc.

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Special Types of Munis

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Insured bonds

Backed by insurance policies in the event of

defaults, insured for life of issue, lowers yield,increases liquidity

Prerefunded bonds

Collateralized with escrow of Treasurysecurities which will support bond payments

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Corporate Bonds

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Secured bonds: First claim against specificcollateral (mortgage debt, collateral trustbonds) Debenture bonds: Unsecured bonds, nospecific collateral (debentures) Subordinated debenture bonds: Lowerpriority claim

Bonds have a priority of claims over bothpreferred and common stockholders in theevent of bankruptcy

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Corporate Debt Securities

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Commercial paper 2 to 270 days Pure discount Not liquid

Sold through dealers or by the company itself

Medium-Terni Notes (MTN) Continuously offered by agent Buyers can customize

9 months to 30+ years Fixed, floating, or structured

Structured Notes MTN combined with derivative, "rule busters"

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Debt Securities Issued by Banks

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Negotiable CDs Days to 5 years Secondary market Domestic (U.S.) and Eurodollar

Issued primarily in LondonLIBOR

Bankers acceptances Created to guarantee payment for shipped goods Short term Pure discount Few dealers, liquidity risk

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Asset-Backed Securities (ABS)

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Debt securities backed by financial assets(e.g., mortgages, auto loans, credit card

receivables)

Firm sells assets to Special Purpose VehicleSeparate entity, bankruptcy remote

SPV issues securitiesCan have better rating (lower yield) than firm'sdebt Reduce funding costs

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Asset-Backed Securities (ABS)

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External Credit Enhancements

Corporate guarantees

Bank letters of credit

Bond insurance (insurance wrap)

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Collateralized Debt Obligations

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Balance Sheet CDOsTo reduce loans on balance sheet (banks)

Arbitrage CDOs

Profit from cash flow spread

TranchesCreated based on seniority of claims to cash flows fromcollateral

Collateral is a pool of other debt obligations (e.g., businessloans, mortgages, asset-backed securities, other CDOs,etc.)

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Primary and Secondary Markets

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Primary market: Newly created debt securities

Firm commitment: Investment bankerpurchases the entire issue and resells it Best efforts basis: Investment banker agreesto sell all of the issue that they can Private placement (Rule 144A offering): Sold to asmall number of investors, issue is not registered

for sale to the public

Secondary market: Sales of existing securitiesthrough exchanges, OTC (dealer) markets, orelectronic trading networks

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Fixed Income:

Basic Concepts

55. Understanding Yield Spreads

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Interest Rate Policy Tools

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Discount rate

Open market operations

Bank reserve requirements

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Yield Curve Shapes

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Term Structure Theories

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1. Pure Expectations TheoryYield curve shape determined by expectationsabout future short-term rates

2. Liquidity Preference (Premium) TheoryGreater premium (yield) required for longermaturities; upward sloping

3. Market Segmentation TheorySupply and demand for specific maturityranges determines interest rates; any shape

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Treasury Spot Rates

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Treasury spot rates: Appropriatediscount rate forsingle payments of

various maturities from Treasury securities

Conceptually like zero-coupon bond rates

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Yield Spread Measures

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Absolute spread = Higher yield - Lower yield

Relative spread =

Relative spread preferred because absolute spreadis not sensitive to yield levels, only differences

Yield Ratio =

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Yield Spread Calculations

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5-year Treasury yields 5%

5-year A-rated corporate yields 6.25%

Absolute spread =

Relative spread =

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Credit Spreads

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Difference between yields of bonds thatdiffer only in credit rating

Often quoted as a spread to Treasuries

Credit spreads narrow during expansionsand widen during contractions/recessions

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Embedded Options and Spreads

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Including a put, conversion, or exchangeoption with a corporate bond reduces required

yield and decreases yield spread relative to Treasuries

Including a call option increases required yieldand increases yield spread relative to Treasuries

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Liquidity and Yield

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Investors prefer more liquidity so lessliquid issues have greater required

yields and greater yield spreads relativeto Treasuries, which are very liquid

Larger issues typically have more liquidityand therefore, lower yields and lower yield

spreads than otherwise identical smaller issues

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After-Tax and Taxable Equivalent

Yields

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After-tax yield = Taxable x ( 1 Marginal tax rate)

Taxable equivalent yield =

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After-Tax Yield - Problem

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Tax-free bond yields 4% Taxable bond yields 7%

Investor marginal tax rate is 30%

Which bond will the investor prefer?

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LIBOR and Funded Investors

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London Interbank Offer Rate (LIBOR)

Most important reference rate for floating-rate

securities

A funded investorborrows short term(typically at LIBOR) to finance aninvestment position

Profits depend on funding costs

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Floating-Rate Securities - Solution

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Which of the following regarding floating-ratenotes is false?

C. A floating rate note will be valued at parat every coupon (reset) date.

Credit rating can change, spread canchange, or cap or floor in effect.

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Interest Rate Risk-Solution

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A bond's interest rate risk will increase with:

C. lower coupon.

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Volatility Risk - Solution

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An increase in yield volatility will most likely:

A. decrease the value of a callable bond.

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TIPS - Solution

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U.S. Treasury Inflation Protected Securities(TIPS):

B. have a par value that changes over time

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After-Tax Yield - Solution

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Tax-free bond yields 4% Taxable bond yields 7%Investor marginal tax rate is 30%Which bond will the investor prefer?

After-tax yield = 7% * (1 - 0.30) = 4.9%

Tax - equivalent yield =

Either way, we see the taxable is preferred4.9% > 4% and 5.71% < 7%

Documents

UP CFA 2013 I Fixed Income