Download - 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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Fixed Income:Basic Concepts
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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Fixed Income:Basic Concepts
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
78
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%