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eBook 8
Fixed Income
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Bond price < Par value - Trading at discount
Bond price > Par value - Trading at premium
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Coupon payments Coupon is always calculated on Par value
Payments could be annual, semi-annual, quarterly or
monthly
Zero coupon bonds - Make no interest payments.
Bonds are issued at discount and redeemed at par
A legal contract between the issuer (borrower) and investor (lenders) is called bond indenture
Fi
Domestic bonds - They are issued in issuer’s home country and currency
Foreign bonds - Issued by foreign issuers but denominated in the currency
of the country where they trade
Eurobonds - Issued outside a country and denominated in a currency
other than that of the countries in which they trade
Global bonds - Eurobonds that trade in a country other than the country
that issues the currency the bond is denominated in and
in Eurobond market
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Unsecured bonds (debentures) - Represent a claim to
overall assets and cash flows of the issuer
Secured bonds - Backed by a claim to specific assets.
Reduces default risk. They are senior to unsecured bonds
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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
nT
Floating-rate notes Their interest rate is dependant on market rate (reference rate)
FRN coupon = Reference rate (LIBOR) + margin
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Index-linked bond - 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
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Principal protected bonds - Indexed bonds that do not pay
less than their original par value at maturity
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
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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
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It is a rate at which one bank lends another bank
For short term
Currency is USD
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Characteristics of US LIBOR
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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
Eg. If a bond’s interest rate is reset twice a year, appropriate reference rate is 6-month LIBOR
Sovereign governments may issue the bonds denominated in their own currency or
foreign currency
Bank debt
Commercial
paper
e Corporate
bonds
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Term maturity
Bilateral loan - Loan It is a short term structure - All bonds
given by only one unsecured debt issued mature on the same
bank by creditworthy date
nT
companies
Syndicated loan - Loan Serial maturity
given by a group of It is used to fund structure - Bonds
banks working capital mature on different
dates
Repo rate - Annualized percentage difference between selling and buying price
Repo margin (haircut) - Difference between the market value and the amount loaned
Repo margin will be lower if, Repo rate will be lower if,
e
93
= 3.22%
Repo margin = 97 − 93 = 4
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nT
Fi
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Maturity = 4 Yrs Coupon rate = 10% YTM = 12% Face value = 1000
LOS b Relationship b/w bond price, coupon rate, maturity and YTM
Eg.
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Spot rates - 1-Yr - 4% 2-Yr - 5% 3-Yr - 6% 4-Yr - 7%
Face value - 1000 Calculate price of the bond
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60 60 60 1060
Price = + + +
(1 + 0.04)1 (1 + 0.05)2 (1 + 0.06)3 (1 + 0.07)4
= 971.14
LOS d
nT
(Corp. bonds)
0 5 5.7 6 10
Street convention - Yield calculated using the stated coupon payment dates
True yield - Yield calculated after considering weekends and holidays
nT
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 Required margin (discount margin) - Margin that brings FRN to its par value
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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
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LOS g
Yields Spot rates
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Maturities Maturities
Yield curve Spot curve
Displays yields for different maturities Yield curve for single payments in the future
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Maturities Maturities
Par curve Forward curve
Constructed from the spot curve Displays yields for same maturities
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LOS h Calculating forward rates using spot rates
Eg. Spot5 = 15% Spot7 = 20% Calculate 2-yr forward rate, 5 years from now
0 5 7 0 5 7
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Z - spread eg. Risky bond, Face value = 1000 Coupon rate = 10% Maturity = 4 yrs Market value = 860
Spot rates (treasury) - Year 1 - 10%, Year 2 - 11%, Year 3 - 12%, Year 4 - 15%
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100 100 100 1100
860 = + + +
(1 + 10% + z-spread)1 (1 + 11% + z-spread)2 (1 + 12% + z-spread)3 (1 + 15% + z-spread)4
Bond - A Bond - B
(With call option) YTM = 16.48%
Primary benefits:
Œ Reduction in funding costs
Increase in the liquidity of financial assets
Other benefits:
Bank
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Receives cash
Special purpose
entity (SPE)
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Servicer
Mortgages and loans Known as ‘trust’ and is set
(assets) are removed from up specifically for buying
the B/S these loans and selling ABS
to investors
May use cash proceeds to
nT
SPE is a separate legal entity and buyers of ABS do not have claim on other assets of the bank
Loan amount
Loan-to-value ratio (LTV) - x 100
Value of collateral real estate
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
Prime loans - Mortgages with high LTV ratios, made to borrowers of high credit quality
Subprime loans - Mortgages to borrowers of lower credit quality
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ª Agency RMBS - Issued by GNMA, FNMA and Freddie Mac. Agency RMBS are
mortgage pass-through securities. Generally high quality.
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ª Non-agency RMBS - Issued by private companies. Non-agency RMBS typically
include credit enhancement
ª In sequential-pay CMO -
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ª Prepayment risk - Uncertainty about timing of the principal CFs from the ABS
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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)
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LOS g Commercial mortgage backed securities (CMBS)
ª There is a two level call protection (loan level and structural level)
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 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
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Reinvestment of coupons
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
Increase in YTM decreases the bond price but increases reinvestment income
LOS b
Macaulay Modified Effective
duration duration duration
Macaulay duration - V− − V+ V− − V+
∑ Weights x Maturities 2 × V0 × %∆ in yield 2 × V0 × ∆ yield curve
Eg #1 Macaulay duration
+ 6.4% − 5.9%
1064 1000 941
6.4 + 5.9
Modified duration =
2
= 6.15
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Embedded options have uncertain future CFs, because of which PV calculations for
bond value based on YTM cannot be used
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LOS d Key rate duration (partial duration)
Parallel shift in yield curve Nonparallel shift in yield curve
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Variable Effect
Maturity Ç Duration Ç
Coupon Ç Duration È
= 6 × 1050
= $6300
+ 6.4% − 5.9%
1064 1000 941
Due to convexity(+ve), bond price increases more for a given change in yield as
compared to decrease(%) for same change in yield
LOS i
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Calculating % ∆ in the full price of a bond
% ∆ full price of bond = −Duration(∆Y) + 1/2 × Convexity(∆Y)2
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LOS j Term structure of yield volatility and duration
Term structure of yield volatility - Relationship between maturity and yield volatility
−1583 1000
Fi
0 3 7 10
Macaulay duration
−1583 1000
0 3 7 10
Macaulay duration
Duration gap =
Zero
Given change in any of these components will have direct impact on YTM
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re
nT
Fi
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Downgrade risk Possibility that spreads will increase because the issuer has
(Credit migration risk) become less creditworthy
Spread risk Possibility that bond’s spread will widen due to downgrade
risk or liquidity risk or both
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General seniority rankings
First lien
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Senior secured debt
Junior secured debt
Senior unsecured debt
Senior subordinated debt
Subordinated debt
Junior subordinated debt
nT
All debt within the same category is said to rank pari passu. They have same
priority of claims
Since bankruptcies are costly and take a long time to settle, strict priority of
claims may not be followed
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EBITDA Debt/capital
ª Credit cycle - Credit spreads narrow as credit cycle improves. Credit spreads widen
as credit cycle deteriorates
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