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Fixed Income FIXED INCOME Fixed Income: Basic Concepts 1 *Elaboracion basada en las Kaplan Schweser Notes CFA Level 1 JDS AR FIXED INCOME Fixed Income: Basic Concepts 52. Features of Debt Securities 2 JDS AR FIXED INCOME Bond Indentures A bond indenture specifies all the obligations of the issuer of 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 3 JDS AR FIXED INCOME Bond Features • Face value, par value, maturity value • Coupon rate: Annual % of par value • Currency denomination • Redemption: At maturity vs. amortizing 4 JDS AR FIXED INCOME Coupon Structures ■ Zero-coupon bonds ■ Pure discount bonds which pay no coupon ■ Step-up notes ■ Coupon rate increases over time ■ Deferred coupon ■ Bond's coupons compound 5 JDS AR FIXED INCOME Floating-Rate Securities Coupon formula ■ Reference rate + margin ■ For example, LIBOR + 1.5%, annualized rates Cap: Maximum on formula rate Floor: Minimum on formula rate 6 JDS AR FIXED INCOME Accrued Interest ■ Paid to a bond seller ■ Portion of the next coupon interest payment already earned by the seller ■ Full price = clean price + accrued interest 푑푎푦푠 푠푖푛푐푒 푙푎푠푡 푐푢푝표푛 퐴퐼 = 푥 푐푢푝표푛 푝푎푦푚푒푛푡 푑푎푦푠 푏푒푡푤푒푒푛 푐푢푝표푛푠 7 JDS AR FIXED INCOME Amortizing and Nonamortizing Bonds ■ Nonamortizing securities pay only interest until maturity, then the par value is repaid ■ Coupon Treasury bonds ■ Most corporate bonds ■ The bond terms may include a sinking fund or call feature that can accelerate principal repayment ■ Amortizing securities typically make equal payments over the life of the bond, each consists of interest and principal 8 JDS AR FIXED INCOME Call Provisions . 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 years 102 and callable after 10 years @ par) 9 JDS AR FIXED INCOME Refunding ■ Refunding is calling (redeeming) a bon using the proceeds of a lower-cost issue ■ Bond can be callable but not refundable 10 JDS AR FIXED INCOME Prepayment Option ■ On an amortizing security, such as a mortgage ■ Prepayments are repayment of principal in excess of scheduled principal payments 11 JDS AR FIXED INCOME Sinking Fund . Sinking fund redemptions are calls of a portion 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 12 JDS AR FIXED INCOME Redemption Prices . Cali prices are regular redemption prices . Sinking fund redemptions and redemptions under other provisions are special redemption prices (e.g., redemptions due to forced asset sales) 13 JDS AR FIXED INCOME Embedded Options • Options that benefit the issuer/borrower decrease bond values/increase yields • Options that benefit the holder/lender increase bond values/decrease yields 14 JDS AR FIXED INCOME Embedded Options Option Type Benefits the…. Call Provision Issuer/Borrower Prepayment Option Issuer/Borrower Put Provision Buyer Conversion Option Buyer Caps Issuer/Borrower Floors Buyer 15 JDS AR FIXED INCOME Margin Buying and Repurchase Agreements ■ Margin buying: Borrowing funds to purchase securities. The securities are the collateral for the margin loan ■ Repurchase agreement: An institution sells a security with a 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 repurchase agreements rather than margin loan 16 JDS AR FIXED INCOME Fixed Income: Basic Concepts 53. Risks Associated With Investing in Bonds 17 JDS AR FIXED INCOME Bond Risks 1. Interest rate risk 6. Liquidity risk 2. Call/prepayment risk 7. Exchange-rate risk 3. Yield curve risk 8. Volatility risk 4. Reinvestment risk 9. Inflation risk 5. Credit risk 10.Event risk 18 JDS AR FIXED INCOME Bond Discounts and Premiums • Yield = coupon rate → bond price at par • Yield < coupon rate → bond price over par bond priced at a premium • Yield > coupon rate → bond price under par bond priced at a discount 19 JDS AR FIXED INCOME Price/Yield for an 8% Bond Bond Value Market Yield 20 JDS AR FIXED INCOME Factors Affecting Interest Rate Risk 21 JDS AR FIXED INCOME Callable Bond Value Callable bond = option free bond – call option 22 JDS AR FIXED INCOME Floating-Rate Securities ■ Coupon is periodically reset based on a reference 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 23 JDS AR FIXED INCOME Floating-Rate Securities - Problem Which of the following regarding floating-rate notes is false? A. The coupon rate is based on a short-term reference 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 at every coupon (reset) date. 24 JDS AR FIXED INCOME Measure Interest Rate Risk With Duration Duration is the approximate percentage price change for a 1% change in yield If market yield goes up 0.5%, bond price goes from 980 to 960; if yield goes down by 0.5%, price goes to 1,002: 25 JDS AR FIXED INCOME Price Impact of Yield Changes Based on the duration of 4.29: ■ If the yield goes up 0.25%, price goes down by 4.29(0.25%) = 1.0725% ■ For a bond valued at $2.5 million, a yield change of 0.25% leads to an approximate change in value of 1.0725% (2.5 mil) = $28,812.50 ■ Dollar duration of a bond is approximate change in value for a 1% change in yield: 0.0429 (2.5 mil)= $107,250 26 JDS AR FIXED INCOME Duration and Yield Curve Risk • Portfolio duration is an approximation of the price sensitivity of a portfolio to a parallel shift of the yield curve (yields on all the bonds change by the same percent) • For a non-parallel shift in the yield curve, the yields on different bonds in a portfolio can change by different amounts • Yield curve risk: The interest rate risk of a portfolio of bonds that is not captured by the duration measure 27 JDS AR FIXED INCOME Duration and Yield Curve Risk 28 JDS AR FIXED INCOME Callable and Prepayable Securities ■ Callable securities are likely to be called when interest rates are low ■ Principal repayment on prepayable securities is faster when interest rates are low ■ Investors must reinvest principal when rates are low 29 JDS AR FIXED INCOME Factors Affecting Reinvestment Risk Reinvestment risk is higher when: 1. Coupon is higher 2. Bond has a call feature 3. A security is amortizing 4. A security contains a prepayment option 30 JDS AR FIXED INCOME Forms of Credit Risk Bond ratings indicate relative probability of default ■ 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 default risk (bond rating) The higher the rating (e.g., AA vs. A), the lower the market yield 31 JDS AR FIXED INCOME Liquidity Risk . The bid-ask spread indicates the liquidity of the 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 to market will result in lower returns when liquidity decreases (bids fall) 32 JDS AR FIXED INCOME Exchange Rate Risk If an investor buys a security denominated in a foreign (to the investor) currency ■ Depreciation of the foreign currency reduces the returns to a dollar-based investor ■ Exchange rate risk: Actual cash flows from the investment may be worth more or less than was expected when the bond was purchased 33 JDS AR FIXED INCOME Inflation Risk ■ Inflation (purchasing power) risk: Prices of goods and services increase more than expected ■ An increasing price level decreases the amount of real goods and services that bond payments will purchase ■ When expected inflation increases, nominal yields rise, values of debt securities fall 34 JDS AR FIXED INCOME Effects of Yield Volatility Increase in yield volatility increases option values Increases value of putable bond = (option-free bond value + put value ↑ ) Decreases value of callable bond = (option-free bond value - call value ↑ ) 35 JDS AR FIXED INCOME Event Risk ■ Disasters (e.g., hurricanes, earthquakes, or industrial accidents) can impair the ability of a corporation to meet its debt obligations ■ Corporate restructurings may result in bond rating downgrades ■ Regulatory issues may cause large cash expenditures to meet new regulations New regulations prohibiting financial institutions from holding a certain type of security can lead to a volume of sales that decreases prices for the whole sector 36 JDS AR FIXED INCOME Sovereign Risk . 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 low economic growth/tax revenues, high government spending 37 JDS AR FIXED INCOME Interest Rate Risk - Problem A bond’s interest rate risk will increas with: A. A put option B. Shorter maturity C. Lower coupon. 38 JDS AR FIXED INCOME Volatility Risk- Problem 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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