Fixed Income Securities Lecture Notes Professor Doron Avramov Hebrew University of Jerusalem Chinese University of Hong Kong Syllabus: Course Description This course explores key concepts in understanding fixed income instruments. It especially develops tools for valuing and modeling risk exposures of fixed income securities and their derivatives. To make the material broadly accessible, concepts are, whenever possible, explained through hands-on applications and examples rather than through advanced mathematics. Never-the-less, the course is quantitative and it requires good background in finance and statistical analysis as well as adequate analytical skills. 2 Professor Doron Avramov, Fixed Income Securities Syllabus: Topics We will comprehensively cover topics related to fixed income instruments, including nominal yields, effective yields, yield to maturity, yield to call/put, spot rates, forward rates, present value, future value, mortgage payments, term structure of interest rates, bond price sensitivity to interest rate changes (duration and convexity), hedging, horizon analysis, credit risk, default probability, recovery rates, floaters, inverse floaters, swaps, forward rate agreements, Eurodollars, convertible bonds, callable bonds, interest rate models, risk neutral pricing, and fixed income arbitrage. 3 Professor Doron Avramov, Fixed Income Securities Syllabus: Motivation Fixed income is important and relevant in the financial economic domain. For one, much of the most successful and unsuccessful investment strategies implemented by highly qualified managed funds have involved fixed income instruments. Domestically and internationally, pension and mutual funds, among others, have largely been specializing in bond investing. Moreover, effective risk management is essential in the uncertain business environment in which interest rate and credit quality fluctuate often abruptly. Such uncertainties invoke the use of fixed income derivatives. 4 Professor Doron Avramov, Fixed Income Securities Syllabus: Motivation Fixed income derivatives are standard instruments for managing financial risk. More than 90% of the world's largest 500 companies use fixed income derivatives to manage interest rate and credit risk exposures. Further, financial engineers keep inventing new fixed income derivatives to help firms transfer risk more effectively and selectively. It is therefore critical for anyone involved in corporate finance or financial risk management to have deep-rooted understanding of interest rate risk and fixed income securities. 5 Professor Doron Avramov, Fixed Income Securities Syllabus: Resources Instructor I welcome students to see me whenever possible to discuss any aspect of the course. Teaching Assistant Recommended text: Handbook of Fixed Income Securities by Pietro Veronesi 6 Professor Doron Avramov, Fixed Income Securities Syllabus: Assessment Home Assignments (20%) – Problem sets will be assigned periodically. You have to submit all problem sets on time to be eligible for taking the final exam. Final Exam (70%) - The final exam will be based on the material and examples covered in class, problem sets, and assigned reading. The exam is closed books and closed notes. However, you will be allowed to bring in one piece of paper with handwritten or typed notes (double-sided, A4 size). You are not allowed to use any other notes. I will allow the use of non-programmable calculators during the exam. 7 Professor Doron Avramov, Fixed Income Securities Syllabus: Assessment Class Participation (10%) - It is mandatory to attend all sessions. If you happen to miss a session, make sure to catch up, as you are fully responsible for class lectures, announcements, handouts, and discussions. If you miss more than three sessions without proper documentations - you will be unable to take this course for credit. 8 Professor Doron Avramov, Fixed Income Securities Overview, Risk Profile, and Trading Strategies 9 Professor Doron Avramov, Fixed Income Securities Classifying Securities Basic Types Major Subtypes Money market instruments Interest-bearing Fixed-income securities Equities Ordinary and Preffered Stocks Options, Futures, Swaptions Derivatives Interest rate derivatives 10 Professor Doron Avramov, Fixed Income Securities Recent Statistics In July 2017, the total US national debt was about $19.9 Trillion (source: http://www.usdebtclock.org/) As of 2017, there was $20.9 trillion of U.S. corporate (Financial and Non Financial) debt outstanding, and from 1996 to 2015 corporate bond issuance grew from $343 billion to $1.49 trillion (source: Securities Industry and Financial Markets Association). As of the end of 2016, there was $267 billions of Hong Kong corporate (Financial and Non Financial) debt outstanding. As of the end of 2016, there was $6.1 trillion of China corporate (Financial and Non Financial) debt outstanding. By recent estimates, the worldwide bond market’s total value amounts to $94.5 trillion, considerably exceeding the worldwide stock market value, which is about $66.5 trillion. http://www.bis.org/statistics/secstats.htm?m=6%7C33%7C615 Why? Because bonds are issued by governments, agencies, states and municipalities (taxable and tax-exempt), mortgage-related and asset-backed, and corporations, while stocks are exclusively issued by corporations. 11 Professor Doron Avramov, Fixed Income Securities Bond vs. Stock Performance Stocks are perceived to be more risky than bonds and are thus expected to deliver higher average returns over an extended time period. Indeed, as you can observe from the next figures, stocks have overwhelmingly outperformed bonds over the 1925-2009 period, and much more so over the 1801 through 2001 period. But stocks are subject to massive short-term fluctuations. 12 Professor Doron Avramov, Fixed Income Securities A $1 Investment in Different Types of Portfolios, 1926—2009 Source: Global Financial Data (www.globalfinancialdata.com) and Professor Kenneth R. French, Dartmouth College. 13 Professor Doron Avramov, Fixed Income Securities The Very Long Run Perspective 14 Professor Doron Avramov, Fixed Income Securities Asset Allocation VS. Stock and Bond Picking Various studies show that asset allocation accounts for more than 90% from the yield of the investment portfolio, while less than 10% originates from individual choice of a stock or a bond. Dalbar research company compared Senior Investment Managers versus benchmarks. The comparison was done between the years 1993 and 2012, and it was found that even sophisticated investors were far below benchmarks. 15 Professor Doron Avramov, Fixed Income Securities Asset Allocation VS. Stocks and Bond Picking In fact, the Investment Managers dedicated great efforts to detect stocks and bonds that, in their opinion, were cheap and dedicated little effort in managing the allocation of the assets. The following graph makes the case: 16 Professor Doron Avramov, Fixed Income Securities What is Risk Premium? Risk premium (RP) is the average return of an investment over and above the risk free rate (proxied by T-bill rate). Investment Average Return (%) Risk Premium (%) Large stocks 11.7 7.9 Small stocks 17.7 13.9 Long-term corporate bonds 6.5 2.7 Long-term government bonds 5.9 2.1 U.S treasury bills 3.8 0.0 17 Professor Doron Avramov, Fixed Income Securities What is the Sharpe Ratio? The Sharpe Ratio – a common investment performance measure – divides the Risk Premium by the investment’s volatility. Series RP (%) Vol (%) SR Large-company stocks 7.9 20.5 0.39 Small-company stocks 13.9 37.1 0.38 Long-term corporate bonds 2.7 7.0 0.39 Long-term government bonds 2.1 11.9 0.18 18 Professor Doron Avramov, Fixed Income Securities Bond Yields: Japan China and Hong Kong Over recent years bond yields have been historically low. Period Japan Gov Bonds China Gov Bonds Yields Hong Kong Gov Bonds Yields Yields July 14, July14, July 14, July14, July14, July 14, 2016 2017 2016 2017 2016 2017 1 year -0.35% -0.11% 2.32% 3.46% 0.33% 0.52% 2 years -0.34% -0.12% 2.51% 3.49% 0.52% 0.83% 5 years -0.32% -0.06% 2.70% 3.53% 0.72% 1.24% 10 years -0.24% 0.07% 2.87% 3.59% 0.98% 1.45% 30 years 0.18% 0.86% 3.52% 3.99% -- -- Sources: https://www.bloomberg.com/markets/rates-bonds/government-bonds/japan https://www.investing.com/rates-bonds/world-government-bonds 19 Professor Doron Avramov, Fixed Income Securities Bond Yileds: US and Israel Over recent years bond yields have been historically low. Period US Treasury Yields Israeli Gov Bonds Yields July 14, 2016 July14, 2017 July 16, 2016 July16, 2017 1 year 0.49% 1.20% 0.11% 0.13% 2 years 0.67% 1.36% 0.19% 0.27% 5 years 1.11% 1.87% 0.81% 1.01% 10 years 1.55% 2.33% 1.82% 2.14% 30 years 2.27% 2.92% --- 3.35% Sources: http://www.bloomberg.com/markets/rates-bonds/government-bonds/us/ http://www.boi.org.il/he/DataAndStatistics/Pages/MainPage.aspx?Level=3&Sid=42&Subj ectType=2 20 Professor Doron Avramov, Fixed Income Securities Bond Funds Typically, households do not directly trade debt instruments. Rather, they invest through specialized funds, such as mutual funds and ETFs. For instance, in the US only 10% of bonds outstanding are directly traded by households. The fraction of equities directly held by households is considerably larger in the US and elsewhere. Depending on its investment objectives, a bond fund may concentrate its investments in a particular type of debt security or some mix. 21 Professor Doron Avramov, Fixed Income Securities Bond Funds The securities that funds hold vary in terms of: credit risk/rating duration type of issuer (government, corporation) indexation (foreign currency, CPI) embedded options (convertible, puttable, and callable) floating versus fixed rates 22 Professor Doron Avramov, Fixed Income Securities The Vanguard Group Get familiar with one of the largest worldwide bond mutual fund of The Vanguard Group ticker VBTLX http://finance.yahoo.com/q?s=VBTLX VBTLX manages around $ 178 billion, as of April 19, 2017, invested in hundreds of various positions. The Vanguard Group overall manages approximately 3 trillion dollar.