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Fixed Income Basics

Fixed Income Basics. FIXED INCOME. AGENDA. BONDS GOVERNMENT BONDS CORPORATE BONDS PRICING CONVENTIONS HIGH YIELD BONDS REPO MARKETS BOND YIELDS. FIXED INCOME -- Financing. TWO WAYS FOR A FIRM TO RAISE MONEY: BORROW + Bank Loans - Cheap , covenants

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Fixed Income Basics

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  1. Fixed Income Basics

  2. FIXED INCOME AGENDA BONDS GOVERNMENT BONDS CORPORATE BONDS PRICING CONVENTIONS HIGH YIELD BONDS REPO MARKETS BOND YIELDS

  3. FIXED INCOME -- Financing • TWO WAYS FOR A FIRM TO RAISE MONEY: • BORROW • + Bank Loans • - Cheap , covenants • - Banks do not like funding growth through acquisitions • + Delay payment of accounting payables • + Issue notes and bonds • - Must pay interest and return principal at maturity • - Substantial acquisition flexibility • - Allows more senior debt • - No amortization requirements • - Higher transaction and registration costs

  4. FIXED INCOME -- Financing • TWO WAYS FOR A FIRM TO RAISE MONEY: • SELL STOCKS • + May pay dividends • + Stocks don’t mature and have limited liability • + Dilute to existing equity holders • + Public registration

  5. FIXED INCOME – Size of Market Source: US Federal Reserve, report Z.1/D.3.

  6. FIXED INCOME -- Financing • DEFINITION OF BOND: • Debt instrument requiring the issuer (also known as debtor or borrower) to repay to the lender/ investor the amount borrowed (par value) plus interest over some specified period of time. A typical plain vanilla bond specifies: • (1) A fixed date when the amount borrowed is due • (2) The contractual amount of interest which is typically paid every six or twelve months (coupon) • Assuming the issuer does not default or redeem the issue prior to the maturity date, an investor holding this bond until maturity is assured of a known cash flow pattern • Some bonds do not pay interest, but all bonds require a repayment of principal. • When an investor buys a bond, he/she becomes a creditor of the issuer.

  7. FIXED INCOME -- Bonds

  8. FIXED INCOME – Types of Bonds ZERO COUPON CORPORATE MUNICIPAL TREASURY AGENCY HIGH YIELD FLOATING FIX RATE CALLABLE ABS PUTABLE MBA COMMERCIAL PAPER STEP UP BONDS CERTIFICATE OF DEPOSIT

  9. FIXED INCOME – Bond Markets • Domestic bonds • Borrowers country and currency • Sovereign debt • Debt guaranteed by a government • Clear through likes of DTC • Foreign bonds • Issued in another country • Issued in that currency • Yankees, Bulldogs, Dragons, etc. • Euro bonds • Currencies: Eurodollar, Euroyen, etc. • Governments, large corporations • Supranational Agencies like IMF/ World Bank • Formed by two or more central governments through int. treaties • Outside regulatory jurisdiction of any one currency • Clear through Euroclear and Clearstream T+3 • Trade over a specific benchmark , often Libor • Global bonds • Big issuers that need worldwide investors, could be both Yankee and Eurobond • Can also settle in both international and domestic custody houses

  10. FIXED INCOME – Bond Markets • Issuer • + The borrower • Investor • + The lender • Coupon • + Rate of interest the borrower pays to the investors • + Can be fixed or floating • Maturity • + Date when borrower repays investor the principal • + Can sometimes be over more than one date • Par • + Bond trading at 100% of face value • + Discount means trading at a price less than par say 98.50 • + Premium means trading at a price higher than par say 102.50 • + Refers to the unchangeable face value of the bond • + Coupon is calculated on the par value/face of the bond • Zero Coupon • + No regular coupons just a heavily discounted bond

  11. FIXED INCOME – Bond Characteristics • Issued with maturity of 1 year + • Interest paid periodically (coupon) • Large amount of issue (par value) • Underwritten and distributed by a syndicate of banks • Tradable in secondary market • Issued in any major currency • Acquired by investors in most currencies • Market conditions and needs • Bearer/book entry securities

  12. FIXED INCOME – Bond Yields • Fixed rate coupon • Floating rate coupon • Zero coupon • Stripped coupon • Equity linked – convertibles • Index linked • Deferred interest • Multiple step up or single step up • High yield / junk bonds • Accrual bond

  13. FIXED INCOME – US Government Bonds • T BILLS = Short term debt obligations with less than one year maturity. Maturity cycles are 4, 13, and 26 weeks. By auction weekly. Issued on discount basis. • T NOTES = Debt security with fixed interest rate and maturity between one and ten years. Mostly quarterly issued. No tax deducted from domestic investor. • T BONDS = Fixed interest government debt with 10+ years maturity. Semi annual interest, auctioned quarterly or semi annually. Only taxed at federal level. US TREASURIES

  14. FIXED INCOME – US Government Bonds • STRIPS = Created by splitting interest from principal to create different cash flows to suit investor requirements. Created from T Bonds and traded on YTM basis. • SECONDARY = Usually free of commission as the traders use a buy/sell spread technique. • TIPS = Treasury security that is indexed to inflation. The coupon rate is fixed but the principal amount adjusts according to the CPI-U. • + Example: suppose a TIP purchased on July 1st with a coupon rate of 3%. You buy one bond ($1000 par value). The annualized rate of inflation is 4% over the next 6 months. • - Inflation adjusted principal  1000 * (1+0.04/2) = $1,020 • - Semi-annual coupon  0.03/2 * $1,020 = $15.30

  15. FIXED INCOME – US Government Bonds SOURCE: Bloomberg

  16. FIXED INCOME – UK Government Bonds • DEFINITION = debt securities issued by the • Bank of England. • STRATIGHTS = Normal bullet bonds with fixed interest coupons, issued by auction in the primary market and traded in exactly the same way as other fixed income securities. • CONVERTIBLES = Different from the corporate bond market this convertible bonds are current Gilts held by the investor that can be converted into a longer dated Gilt security at some point in the future. • INDEX LINKED = Similar to the US TIPS issues where the coupon is very low but the principal is linked to the Retail Price Index (RPI). They give the holder the coupon return over the inflation rate of the UK so the coupon indicates the real rate of return. • PERPETUALS = They do not have any maturity date and only pay coupon. They were started during WWII as a funding conduit for the government and are called names like “War Loans”. GILTS

  17. FIXED INCOME – UK Government Bonds SOURCE: Bloomberg

  18. FIXED INCOME – German Government Bonds • BOBLS = Bundesobligationem are the same as funds except that their maturities are for 5 years. There are many issues auctioned on a regular basis creating a very liquid market for this particular bond and maturity. • U-SCHATZE = Like Treasury bills with maturities up to 2 years. They are priced on a discount basis unlike Bunds and Bobls that are priced as coupon securities in the same way as US Treasury notes and bonds. • BUNDS = Bundesanleihen are Federal government bonds with maturities from 6 to 30 years. Most of the issues nowadays are for the benchmark 10-year maturity although the German government does try to issue one, 30 year bond, every year. They are government-backed instruments of the highest quality.

  19. FIXED INCOME – German Government Bonds SOURCE: Bloomberg

  20. FIXED INCOME – Treasury Auction • To finance the public debt, the U.S. Treasury sells bills, notes, bonds, and Treasury Inflation-Protected Securities (TIPS) to institutional and individual investors through public auctions. • Treasury auctions occur regularly and have a set schedule. There are three steps to an auction: announcement of the auction, bidding, and issuance of the purchased securities. • (1) Announcement • The auctions are announced in advance in most major newspapers and through press releases. The auction announcement details: • Amount of the security being offered • Auction date • Issue date • Maturity date • Terms and conditions of the offering • Noncompetitive and competitive bidding close times • Other pertinent information

  21. FIXED INCOME – Treasury Auction • (2) Bidding • When participating in an auction, there are two bidding options - competitive and noncompetitive. • Competitive bidding is limited to 35% of the issue amount for each bidder, and a bidder specifies the rate or yield that is acceptable. • Noncompetitive bidding is limited to purchases of $5 million for U.S. Treasury bills, notes, bonds, and TIPS. With a noncompetitive bid, a bidder agrees to accept the rate or yield determined at auction. • Bidding limits apply cumulatively to all methods that are used for bidding in a single auction. • All auctions are open to the public. • (3) Issuance • On issue day, the Treasury delivers securities to bidders who were successfully awarded securities in a particular auction. In exchange, Treasury charges the accounts of those bidders for payment of the securities. • Treasury bills are issued at a discount from face value and are paid at their par (face amount) at maturity. The purchase price is listed on the auction results press release and is expressed as a price per hundred dollars.

  22. FIXED INCOME – Corporate Bonds • DEFINITION: • Bonds issued by private and public corporations to raise funds for building facilities, purchasing equipment, or expanding their businesses. • When you buy a bond, you are lending money to the corporation that issued it. The corporation promises to return your money on a specified maturity date. Until that time, it also pays you a stated rate of interest, usually semiannually. • Fixed or floating coupons. • Any major currency is used and then companies use derivatives to hedge FX risk. • In general, any coupon, currency or maturity in tranches at different times. • Can be underwritten by a bank in the public market. • Can be private placements.

  23. FIXED INCOME – US Government Bonds • PRICING CONVENTIONS: • Bonds are priced as % of face value in 1/32nds • + Example: a price of 101-16 = 101.5% • “+” sign is used to represent 1/64th increment • + Example: a price of 101.16+ = 101.515625% • Instead of a “+” sign you may see that 97.302… • + Is = 97 30/32 + half a 32nd (64nd) real price 97 61/64 • + Extension digit 4 would represent a quarter of a 32nd (128nd) • Prices quoted are “clean” of accrued interest (invoice will include accrued)

  24. FIXED INCOME – Corporate Bonds • CHARACTERISTICS: • Essentially an IOU • Credit Rating of the company is very important • Unsecured senior debt • Sometimes called DEVENTURES because there is no physical collateral and are backed by the creditworthiness of the issuer • Issued in blocks of $1000 in par value • Maturity on averages is 10 years but could be more • Coupon in general is semi-annual on a 30/360 basis • The level of coupons depend on • Individual Corporation • Industry within which it operates

  25. FIXED INCOME – Corporate Bonds • CUSIP Number (US and Canada) • Stands for Committee on Uniform Securities Identification Procedures. • Identifies most securities, including: stocks of all registered U.S. and Canadian companies, and U.S. government and municipal bonds. • The CUSIP system, owned by the American Bankers Association and operated by Standard & Poor’s, facilitates the clearing and settlement process of securities. • A unique 9 character alpha/numeric code for each security • First six characters identify issuer • Next two characters identify issue type • Final digit is a check digit

  26. FIXED INCOME – Corporate Bonds • ISIN - (International) • Stands for Committee on Uniform Securities Identification Procedures. • All internationally traded securities issuers are urged to use this numbering scheme, which is now the accepted standard by virtually all countries. • A unique international code • 2 digit country code • 9 digit securities code issued by national numbering agency • 1 digit check code • SEDOL • The Stock Exchange Daily Official List number, a code used by the London Stock Exchange to identify foreign stocks, especially those that aren't actively traded in the U.S. and don't have a CUSIP number.

  27. FIXED INCOME – High-Grade Bonds • Investment grade securities • Low probability of default • Investment bank arranges issuance, sales, distribution • Investors require different maturities, coupons and credit risk • Market typically split into sectors: • + Energy • + Telecoms and Media • + Retail • + Financial Institutions • Higher returns than treasuries and money markets • + Bigger risk though • The lower the credit rating the greater the increase in default risk.

  28. FIXED INCOME – Pricing Pricing Conventions COUPON COUPON COUPON PRINCIPAL + INTEREST 1 YEAR 2 YEAR 4 YEAR 3 YEAR PRINCIPAL TODAY Cash-Flow of a 4y Bond

  29. FIXED INCOME – Bond Pricing P= Bond price = coupon for period = yield for period N= # of compounding periods per year T= total COUPON 10% COUPON 10% COUPON 10% PRINCIPAL $1,000 + INTEREST 10% PRINCIPAL TODAY $1,066.24 Example: Cash-Flow of a 4y Bond

  30. FIXED INCOME – Yield to Maturity • The yield to maturity is the yield that makes the present value of the cash-flows equal to the price. • + explicit formula, excel solver • + Also called the Internal Rate of Return (IRR) • Price/Yield relationship. • + It is the same to quote a price or a yield • A bond trading at par will have a coupon rate that is below the YTM. • A bond trading at a premium will have a coupon that is above the YTM. • Interest Rate Risk.

  31. FIXED INCOME – Clean / Dirty Price • Bonds are not always traded exactly on their coupon dates • + between dates there is accrued interest • + the buyer of the bond owes the seller the • portion of the next coupon which was earned from the last coupon to the selling date. • The buyer of a bond pays the seller the “clean price” of the bond plus the accrued interest. • Clean Price + Accrued Interest = Dirty Price.

  32. FIXED INCOME – Clean / Dirty Price EXAMPLE: Coupon = 5% semi annual , Yield = 6.7438% Clean price = 97.32 Settlement date = June 2nd 2010 Maturity date = January 20th 2010 Day count = 122 days Current Coupon Period = 182 days

  33. FIXED INCOME – Day Count Convention The bond market have day count conventions: ACTUAL/ACTUAL Where interest is calculated by dividing the number of days since the last coupon by the actual number of days in the year. Bond markets following this convention are US treasuries and recent Eurobond issues. 30/360 Every month is assumed to have 30 days even Feb so every year has 360 days. Used for US corporate bonds and older Eurobonds. Actual/365 Used in Japanese bond market.

  34. FIXED INCOME • CAUSES OF CHANGE IN BOND PRICES: • Change in interest rate • + Absolute and yield curve changes • Credit Quality • + Changes in credit spread • Proximity to maturity date • + Bond prices converge to par as maturity approaches • Inflation • Liquidity • Exchange Rates

  35. FIXED INCOME – High Yield Bonds • A high paying bond with a lower credit rating than investment-grade corporate bonds, Treasury bonds and municipal bonds. Because of the higher risk of default, these bonds pay a higher yield than investment grade bonds. • High-yield bonds are issued by organizations that do not qualify for “investment-grade” ratings by one of the leading credit rating agencies: Moody’s Investors Service, Standard & Poor’s Ratings Services and Fitch Ratings. • They have the potential for capital appreciation in the event of a rating upgrade, an economic upturn or improved performance at the issuing company. • Provide portfolio diversification because the high yield sector generally has a low correlation to other sectors of the fixed income market along with less sensitivity to interest rate risk.

  36. FIXED INCOME – High Yield Bonds • Rating reflects issuer ability to make interest and principal repayments • The weaker the company the higher the interest rate it must pay to borrow money

  37. FIXED INCOME – High Yield Bonds • Fallen Anger/Crossover: Bonds that were investment grade when issued but have fallen in quality below investment grade • Rule 144A: In the US allows qualified buyers to conduct a private placement without disclosure. These securities must be held for a specified period of time before they can be traded in the secondary market • CBOs: Collateralized Bond Obligations backed by a pool of high yield bonds. They are tiered investments that allow investors to diversify risk • Mezzanine: Debt that is usually high yield that lies between “Balcony” or senior debt and “Basement” or near equity debt • Leveraged Buyout (LBO): A takeover where the buyer borrows money to buy a controlling interest in a company. This is usually done by using the company’s assets as security for the loans taken out by the acquiring party and repaying the loans from the company’s cash flow • Total Return: Net price change of an investment during a given time period, which can be positive or negative, plus any income generated during that period, which is always positive • Yield to Worst: This is the bond’s worst yield for its current price and maturity call schedules. It is the conventional yield in the High Yield Bond Market

  38. FIXED INCOME – Repo Market • DEFINITION: Repurchase agreements are contracts for the sale and future repurchase of a financial asset, most often Treasury securities. At maturity, the seller repurchases the asset at the same price at which he sold it, and pays interest for the use of the funds.  Although legally a sequential pair of sales, in effect a repo is a short-term interest-bearing loan against collateral. • The annualized rate of interest paid on the loan is known as the repo rate.  Repos can be of any duration but are most commonly overnight loans.  • The seller of securities does a repo and the lender of funds does a reverse.  Because money is the more liquid asset, the lender normally receives a margin on the collateral, meaning it is priced below market value. • The overnight repo rate normally runs slightly below the Fed funds rate for two reasons:  • + A repo transaction is a secured loan, whereas the sale of Fed funds is an unsecured loan. • + Many who can invest in repos cannot sell Fed funds.  Even though the return is modest, overnight lending in the repo market offers several advantages to investors.  By rolling overnight repos, they can keep surplus funds invested without losing liquidity or incurring price risk.  They also incur very little credit risk because the collateral is always high grade paper.

  39. FIXED INCOME – Repo Market REPO MARKET Clients with cash borrowing needs Clients with cash invest Securities Securities • Central Banks • Mutual Funds • Bank Trust Departments • State and Local Govs • Insurance Companies • Private Clients • Commercial Banks • Hedge Funds • Wealthy Individuals • Insurance Companies Dealers borrow and lend cash and securities Cash Cash Cash Securities Cash Securities Securities Cash Clients that lend securities in order to leverage reinvest in other products Clients with security borrowing needs Interdealer Repo Brokers These participants do not take any principal positions but merely act as a non risk broker • Central Banks • Bank Security Lending Dept. • Life insurance Companies • Hedge Funds • Commercial Banks • Private Clients • Commercial Banks • Hedge Funds • US Gov’t Agencies

  40. FIXED INCOME – Repo Market • REP / REVERSE REPO • + The repo market talks about transactions from a securities perspective • + Therefore the “lender” is the person lending securities or the party doing a repo. The “borrower” is the person taking the securities and actually lending cash • DVP (Delivery versus Payment) • + Simultaneous exchange of cash for securities • Example trade price: 5.45% - 5.40% • BID = Dealer bids for collateral and charges 5.45% for lending cash • OFFER = Dealer offers collateral and pays 5.40% for cash borrowed

  41. FIXED INCOME – Repo Market • Borrower of Securities only entitled to earn the repo interest • All economic behavior of the bond must be passed back to the securities lender • This includes coupons • Paid to seller on day it is received (Classic repo) • Paid at maturity to seller (Buy/ Sell back repo)

  42. FIXED INCOME – Repo Market • USE: • Traders • + Finance long bond positions • + Enable dealers with no internal money market sources to take bond positions • + Enable to create short positions • + Cover failed transactions • + Repo trader acts as middle man pricing repos and reverse repos • + Collateral • Portfolio managers and bondholders • + Allows leverage of positions at low cost • + Cover cash shortages with term repos • + Enables efficient short borrowings without the need to liquidate securities • + Highly secure and flexible for investors • + Collateral delivered against payment (DVP) • Central Bank

  43. FIXED INCOME – Repo Market TRADER SECURITY CASH REPO COUNTERPARTY REPO COUNTERPARTY CASH = DIRTY PRICE SECURITY SELL SECURITY CASH SECURITY CASH BOND MARKET BOND MARKET FINANCING A LONG POSITION FINANCING A SHORT BOND SALE TRADER

  44. FIXED INCOME – Repo Market • TYPES: • Classical Repo / All in RepoMostly used in the US, UK, France, Switzerland and International Germany. • Buy / Sell • Mostly used in Italy, Spain, Emerging Markets, Domestic Germany and Japan. Is the spot sale and a forward repurchase of a security. It is two distinct outright cash market trades, one for forward settlement. The basic motivation of sell/buy backs is generally the same as for a classic repo • Out of Currency / Cross Currency Repo • A repo in which the securities are de nominated in a different currency to the collateral. • Tri-Party repo • The distinguishing feature of a tri-party repo is that a custodian bank or international clearing organization, the tri-party agent, acts as an intermediary between the two parties to the repo. The tri-party agent is responsible for the administration of the transaction including collateral allocation, marking to market, and substitution of collateral. • Open repo • An overnight repo which keeps rolling over until one of the parties gives notice of cancellation. Amount of cash lent changes with repo rate and securities price each day • Securities Lending • Mainly used in the UK. It is not a true repo as there is no sale and purchase

  45. FIXED INCOME • BOND CALLAllows the issuer to repay early at a specific price on dates agreed at issue. • Issuer will call or repay the bond if it is better for them • + If interest rates fall • + Repay bond and borrow at cheaper rate • Call Schedule • + Details call prices and dates n when the issuer can exercise the call • Deferred Call • + Issuer cannot initially call the bond for a period • First call date • Date when bond may be called first • Pro –Rata basis • All bondholders have same percentage of principal redeemed • Random Redemption • Computer program selects the serial numbers of the bonds to be called

  46. FIXED INCOME – Price Yields At low yields, prices rise at an increasing rate as yields fall Price A’ Price-yield function of an option-free bond B’ At high yields, prices fall at a decreasing rate as yields rise C’ Yield C A B

  47. 7. FIXED INCOME • THREE BONDS INITIALLY PRICED TO YIELD 9%: • 9% COUPON, 25 YEARS MATURITY PRICE= 100.00 • 6% COUPON, 25 YEARS MATURITY PRICE= 70.357 • 0% COUPON, 25 YEARS MATURITY PRICE= 11.071

  48. FIXED INCOME – Par Yield Curve • Normal approach to bond pricing is to use Yield to maturity • + YTM assumes a flat yield curve • + This is an unrealistic assumption • Bond should be treated as series of zero coupon cash flows • There should be no arbitrage between the YTM and Zero Coupon approaches • Very few zero coupon securities • + Especially risk free rate Treasuries • Par yield Curve • + Create par rates from current Treasury yield curve • + Par security is one that is trading at 100% • + Use on-the-run Treasuries and adjust yields to equal coupons converting them to par • + For gaps between 10 and 30 years – use off-the-run Treasuries

  49. FIXED INCOME – Par Yield Curve List of semi-annual Treasuries for the next 10 years where yields have been adjusted to coupon rates to create par Treasuries for each tenor.

  50. FIXED INCOME – Par Yield Curve DISCOUNT FACTOR:

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