Introduction

FINC 6014 Fixed Income Securities

FACULTY OF
ECONOMICS & BUSINESS
 Lecture outline

› UoS outline
- Schedule
- Assessments
› Introduction to fixed income securities
- Classification of debt
- Participants
- Risks of investing in fixed income
- Risk-return history
- Primary and secondary markets
 Overview

› Why are you here?

- Importance for degree?
- Employment opportunities?
- You’re worried about your superannuation?

› What is Fixed Income Securities about?

 Contact details

› Lecturers
- Andrew Ainsworth (Course Co-ordinator)
- Phone: 9036 7992
- Email: andrew.ainsworth@sydney.edu.au
- Office: Room 408, Level 4, Economics & Business Building
- Consultation Times: Wednesday 10-11

- Abhishek Das
- Phone: 9114 0830
- Email: abhishek.das@sydney.edu.au
- Office: Room 456, Level 4, Merewether Building
- Consultation Times: Monday 10-11
 Textbooks

› Prescribed text
- Fabozzi, F.J. (2010) Bond Markets, Analysis and Strategies, 7th Edition, Pearson
Education

› The following useful texts are on library reserve:

- Sundaresan, S. (2009) Fixed Income Markets and Their Derivatives, 3rd edition,
Academic Press
- Martellini, L., P. Priaulet and S. Priaulet (2003) Fixed Income Securities:
Valuation, Risk Management, and Portfolio Strategies, John Wiley [available
online via the library catalogue]
- Hull, J. (2009) Options, Futures and Other Derivatives, 7th Edition, Pearson
Prentice Hall
 Assessments

Assessment task Weighting Due date Length

Mid-semester exam 25% Week 7 1 hour

Group assignment 25% Fri 22 October 12 pages

Final exam 50% Exam period 3 hours

 Mid-semester exam

› The objective of the mid-semester exam is to motivate you to regularly

revise the course material and to complete the tutorial questions
› The exam will provide you with feedback on your performance over the
first 6 weeks of the course
› The exam will be 1 hour in duration and will be held in Week 7
› It will examine all material covered in Weeks 1 to 6
 Group assignment

› Information about the structure of the group assignment will be provided

on Blackboard by the end of Week 3
› The project is to be completed in groups of 3-4 students in the same
stream
› Students are to begin forming groups from Week 1 and must have
completed the group formation process by Week 3
› Each group will be required to submit a group formation form in the lecture
in Week 3
› There will be a Blackboard discussion forum for group formation to
facilitate the process for students to set up groups
› The group assignment is due strictly by 4:00 p.m. on Friday 22 October
› Assignments must be submitted both electronically via Blackboard and in
hard copy using an assignment box.
 Final examination

› This will be a closed-book examination of three hours duration held during

the Examination Period
› The questions will cover the entire 13 weeks of the course
› Further details on the final exam will be provided in Week 13
 Penalties for late assessments

› Students will be penalised at a rate of 10 percent of the available mark per

day for assignments received after the due time and date
› For example, the awarded grade will be reduced to zero if the assessment
is handed in 9 days after the due date
 Feedback

› All results for assessment during the semester will be posted on

Blackboard no later than two weeks after the assessment is completed
› The solutions to the mid-semester exam and the assignment will be
discussed during the lecture after the marks have been released

› Collection of feedback from you

- There will be an informal questionnaire in the middle of semester for you to let
the teaching staff know what they are doing well and what needs to be improved
 Topic schedule
Week Week beginning Topic Reading

1 26 Jul Introduction Ch 1, 2

2 2 Aug Bond Prices and Yields Ch 2, 3

3 9 Aug Duration and Convexity Ch 4

4 16 Aug The Yield Curve and the Term Structure Ch 5, 17

5 23 Aug Bonds with Embedded Options Ch 18

6 30 Aug Corporate Debt and Credit Risk Modelling Ch 7, 22

7 6 Sep No lecture - EXAM

8 13 Sep Active and Passive Portfolio Management Ch 23, 24

9 20 Sep Liability-Driven Strategies and Bond Fund Performance Ch 25, 26

27 Sep AVCC Common Week

10 4 Oct Securitisation Ch 10, 11, 13

11 11 Oct Interest Rate Derivatives I Ch 27, 28

12 18 Oct Interest Rate Derivatives II Ch 28, 29

13 25 Oct Credit Default Swaps and Review Ch 30

 Lecture outline

› Introduction to fixed income securities

- Classification of debt
- Participants
- Risks of investing in fixed income
- Risk-return history
- Primary and secondary markets
 Introduction to fixed income securities

› A debt security, or a bond, is a financial claim by which the issuer, or the

borrower, is committed to paying back the bondholder the cash amount
borrowed, called principal, plus periodic interests calculated on this
amount during a given period of time
- Martellini, Priaulet and Priaulet (2003)

› “Plain vanilla” bond specifies

- Fixed date when amount borrowed (principal) is due
- The contractual amount of interest – frequency and size of interest payment

› Debt securities are

- Issued by borrowers to obtain capital
- These cash flows can be secured or unsecured
 Overview of debt contracts

› Issuer
- U.S Treasury, BHP
› Coupon rate
- 5.7%, annual, semi-annual
› Maturity date
- 4 March 2040
› Issue date
- 4 March 2010
› Issued amount
- Billions
› Outstanding amount
 Overview of debt contracts

› Market price
- Currently trading in the bond market
› Market yield
- Internal rate of return that forces price of security to equal PV of future CFs
› Contractual features
- Callable, convertible, puttable, sinking fund provisions
› Credit-rating category
- Investment vs. non-investment grade
 Cash-flow rights

› Debt contracts typically have precedence over residual claim such as

equity
› Bond covenants rank the seniority of different debt securities
› Secured vs. unsecured debt
› Debt contracts specify
- Bankruptcy events, and
- How bondholders will be compensated
 Participants in debt markets

› Three broad categories of players in debt markets

› Issuers
- Issue debt securities to raise capital
› Investors
- Invest savings by purchasing debt securities
› Intermediaries
- Assist buyers and sellers by making markets
 Issuers

› Governments, corporations, banks, special-purpose vehicles (SPVs),

foreign institutions
- Maximise capital raised
- Liquid secondary market for repurchasing and refinancing
- Alter issuance decisions if market of issuer-specific conditions change
- Minimise funding costs
 Intermediaries (sell-side)

› Investment banks, commercial banks, dealers, credit-rating agencies

- Assist in auctions, tenders and underwriting in primary markets
- Earn the bid-ask spread by making a secondary market
- Prop desk trading
- Provide risk management services and earn fees
 Investors (buy-side)

› Sovereign wealth funds, pension funds, insurance companies, managed

funds, commercial banks, asset management companies, households
- Obtain diversification
- To buy securities at a fair market price
- To alter previous investment decision at low cost
- To receive capital market expertise
 Participants

› Governments
- Issue and invest in debt securities
- e.g. financing a budget deficit
› Central banks
- Set monetary policy, conduct open market operations and provide discretionary
liquidity
› Federal agencies (US)
- e.g. Federal National Mortgage Association (Fannie Mae)
- Helps direct credit to the housing sector
 Participants

› Corporations and banks

- Issue both ST and LT securities
- Invest in debt securities
- Banks lend and borrow in the interbank market
› Financial institutions and dealers
- Intermediate, invest, issue and arbitrage in debt markets
- Assist in securitisation of mortgages, etc...
 Participants

› Buy-side institutions
- Pension funds, university endowments, etc
- Invest in debt markets on behalf of households
- Trade fixed income securities to maximise returns given a certain mandate
- Actual investments depend on mandate
› Households
- Obtain debt from banks and financial institutions (e.g. housing, cars, credit cards)
- Invest through superannuation/pension funds or managed investments
 Types of U.S. debt securities

› Treasury
- Debt obligation of the U.S. govt
› Municipal bonds
- Issued by state and local govts (e.g. Illinois, San Francisco)
› Agency
- Issued by federally related institutions and government sponsored enterprises
(e.g. Fannie Mae)
 Types of U.S. debt securities

› Corporate
- Issued by both U.S. and foreign corporations
› Money market
- Short-term debt (<13 months)
› Mortgage related
- Securities backed by mortgage loans
› Asset backed
- Securities backed by a pool of assets
 U.S. debt outstanding
10000

9000

8000

7000
Municipal
6000 Treasury
$US biillion

Mortgage-Related
5000
Corporate Debt
4000 Federal Agency
Money Markets
3000
Asset-Backed
2000

1000

0
1996 1998 2000 2002 2004 2006 2008
 U.S. debt issuance

3500

3000

2500
Municipal
$US billion

2000 Treasury
Mortgage-Related
1500 Corporate Debt
Federal Agency
1000 Asset-Backed

500

0
1996 1998 2000 2002 2004 2006 2008
 U.S. corporate issuance

3500

3000

2500
Non-Agency MBS
$US billion

2000 Straight Corporate Debt

Asset-Backed Debt
1500 Convertible Debt
Common Stock
1000 Preferred Stock

500

0
1990 1992 1994 1996 1998 2000 2002 2004 2006 2008
 U.S. trading volume by sector

600

500

400
Municipal
$US billion

Treasury
300 Agency MBS
Corporate Debt
Federal Agency
200
Equity

100

0
1996 1998 2000 2002 2004 2006 2008
Australian bond issuance
Australian non-govt bond issuance - Domestic
Australian non-govt bond issuance -Offshore
 Risks of investing in bonds

› Interest rate risk (including reinvestment)

› Credit risk
› Liquidity risk
› Contractual risk
› Inflation risk
› Event risk
› Tax risk
› Foreign exchange risk
 Risks of investing in bonds

› Interest rate risk

- Inverse relationship between prices and interest rates
- If interest rates ↑ → bond prices ↓ so investors make a capital loss
- Problem if investor has to sell bond prior to maturity
- Reinvestment of coupons also affected
- Most important source of risk
 Risks of investing in bonds

› Credit risk
- Risk that issuer may not be able make contractual payments to bondholders
- Treasury securities do not carry credit risk
- Why?
- What about Greek government debt securities?
- Credit ratings agencies assess credit risk
 Risks of investing in bonds

› Liquidity risk
- The ability to trade large size quickly, at low cost, when you want to trade (Harris
(2003, p.394))
- Why is this a risk?
 Risks of investing in bonds

› Contractual risk (call risk)

- Issuers may be able to “call” a bond
- If interest rates decline then an issuer is more likely to call a bond as they can
refinance at a cheaper rate
- Callable bonds should have a lower price, and higher yield than similar
instruments without a call feature
 Risks of investing in bonds

› Inflation risk
- Inflation affects the real purchasing power of coupon payments
- Fixed coupon securities incorporate compensation for expected inflation at
issuance
- Can invest in inflation indexed bonds or floating rate bonds
 Risks of investing in bonds

› Event risk
- The risk of adverse price changes if a company restructures or mergers with
another company
› Foreign exchange risk
- An Australian fund manager invests in Japanese government bonds
› Model risk
- Pricing models can be incorrect
- More relevant for interest rate derivatives than plain vanilla bonds
 Risk-return history

› Would you invest in bonds or equities?

› Why?

› And in the last 2 years?

 Risk-return history

1200

1000
Australian Equities

800

Australian Bonds
600
Global Equities
400

200
Global Bonds

0
1991 1993 1995 1997 1999 2001 2003 2005 2007 2009
 Risk-return history

50%
Australian Equities

40%
Australian Bonds
30%

20%

10%

0%

-10%

-20%

-30%

-40%
1991 1993 1995 1997 1999 2001 2003 2005 2007 2009
 Risk-return history

50%
Global Equities
40%
Global Bonds
30%

20%

10%

0%

-10%

-20%

-30%

-40%
1991 1993 1995 1997 1999 2001 2003 2005 2007 2009
 Risk-return history

50%

40%
Global Bonds
30%
Australian Bonds

20%

10%

0%

-10%

-20%

-30%

-40%
1991 1993 1995 1997 1999 2001 2003 2005 2007 2009
 Risk-return history

› Annual returns from 1991 to 2009

Aust Aust Global Global

Bonds Equities Bonds Equities
Geo. Mean 8.0% 10.9% 5.8% 5.9%
Std. Dev. 7.2% 18.8% 14.6% 17.6%
 Organisation of fixed income markets

› Primary markets
- Market where borrowers issue debt securities
- Investors provide capital to borrowers
- Debt securities are obtained by dealers using auctions, underwriting procedures
or tenders
- Dealers need to
- Assess demand for the issue
- Price the issue
- Hedge their positions
- Distribute the securities to investors
- Dealers include Barclays Capital, Deutsche Bank, J.P. Morgan, UBS and others
 Organisation of fixed income markets

› Secondary markets
- Market where previously issued securities are traded
- Generally over the counter (OTC) structure
- Dealers provide bid-ask quotes
- Investors buy and sell in the secondary market
- Differs to trading of stocks on exchanges
 Conclusion

› This lecture has provided an overview of

- The types of fixed income securities
- Participants in fixed income markets
- The historical performance of the fixed income asset class
- Fixed income market structures

› Next week
- Bond prices and yields