OVERVIEW

of
FIXED INCOME INSTRUMENTS
and

FUNDAMENTAL CONCEPTS

© 2000, 02, 04, 06 Steven Dym

revised 2007, 08, 10, 11
2014, 18 for Rutgers Business School

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 FIXED INCOME SECURITIES

Fixed income securities are “debt instruments.” They are also known simply as “bonds,”
even though, as listed below, bonds are technically just one type of debt instrument. Like
the market, we will use these terms inter-changeably.

Fixed income instruments are issued by:

- governments, federal and municipal
- government agencies
- corporations, non-financial and financial
- special purpose vehicles (trusts)

I Government Securities

 Background

Governments borrow in order to fund deficits – any excess of expenditures

over revenue. Expenditures include both current and capital spending, and
transfer payments. Revenue (in nature economies) consists mostly of taxes.
Governments also borrow in order to refinance maturing (and “called” – see
Callable Bonds below) debt. They issue combinations of bills, notes and
bonds, plus inflation-indexed securities. (A number of governments issue
floating rate instruments – see below).

Governments typically adhere to a regular schedule of security issuance. In

some countries, the sale is managed by the central bank. Because they are
“risk-free” (in the narrow sense of no default), the bonds serve as the
benchmark for all other fixed income securities. To achieve benchmark
status, the highest degree of liquidity is required as well (as manifested in a
tight “bid-asked spread”). Benchmark bonds are used for quoting other bonds
as a spread, or yield differential, and for hedging other fixed-income
instruments.

The most recently auctioned bond within each maturity sector serves as the
benchmark for that sector, and is known in the U.S. as “on-the-run.” All
others are “off-the-run.”

 T-bills

U.S. Treasury bills are simple IOU-like instruments, with only one cash flow
at maturity – the “face value” – within a year. The interest rate is implicit in
the difference between the price and the payment at maturity. They are used

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by investors strategically – i.e., as part of a portfolio allocation – or as a

temporary parking place for funds. Unlike longer term, coupon paying
Treasury instruments, bills are sold weekly by the U.S. Treasury, with
maturities of one month (4 weeks), three months (13 weeks) and six months
(26 weeks). Year bills (52 weeks) are auctioned every four weeks.

 Notes and Bonds

Treasury notes, bonds and inflation protected securities make regular coupon
payments plus principal at maturity. Unlike corporate and other bonds,
Treasuries do not amortize (portions of principal paid prior to stated
maturity). Hence, their cash flows are completely described by their coupon
rate and maturity. However, the frequency of coupon payments varies,
depending on the country. Regardless, coupons are quoted on annual basis.
(A 5% quoted coupon, for example, may pay 2.5% semi-annually.) Note as
well that fractional period, weekends and holidays are treated in various
ways, known as “day-count conventions.” The U.S. Treasury currently
issues notes and bonds with original maturities of 2,3,5,7,10 and 30 years
(only the last is officially termed “bond”).

Among Treasury securities, only bonds may be callable. But the U.S. halted
their issuance some years ago (see below for a brief analysis).

The U.S. Treasury only recently began issuing a Floating Rate Note (FRN).
Their structure is described in the “Corporates” section below, as they are
more prevalent there.

 Inflation and “Real” Interest Rates.

Interest rates on all bonds must include an extra amount - a “premium” – to

compensate for expected inflation. The investor, therefore, receives a “real”
rate of interest plus the expected inflation premium. The sum of the two is
known as the “nominal” (or stated) interest rate.

 Treasury Inflation Protected Securities.

These bonds are “indexed” to the inflation rate. That is, they pay (in the UK,
for example) a fixed interest rate plus an amount which reflects the most
recent inflation rate. In the U.S., this is done by adjusting the principal
according to the inflation rate, and paying the stated coupon on the varying

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principal amount. A higher inflation rate produces a larger coupon and vice-
versa. Thus, unlike ordinary bonds, the total coupon payment of TIPS is not
known in advance.

Ordinary bonds, on the other hand, contain an inflation premium fixed at the
issue date. Hence, their “real return” (stated interest rate less actual inflation)
varies inversely with inflation. Because the inflation premium in TIPS is
paid according to the actual inflation rate, their real return is fixed.

 Price Risk

Government securities are riskless only in the narrow sense of being credit
risk-free. Except in quite restrictive instances, investment in Treasury issues
does entail interest rate risk (as well as call risk, if applicable). Since the
bond’s coupon is fixed, as market interest rates change, the bond becomes
more or less attractive as it competes with bonds carrying current market
coupons. Therefore, lower or higher price are caused by increases or
decreases in market interest rates. When yields rise above the bond’s
coupon, its price will drop below par, and trade at a “discount.” When yields
fall below the coupon, the price jumps above par, or “premium.”

Interest rate sensitivity generally increases with maturity. This is strictly true
for zero coupon bonds. In the presence of coupon payments, the relationship
is more complicated, as coupons somewhat mute price reaction to interest
rate changes. Market participants employ a measure termed “duration,”
which quantifies the price responsiveness of a bond to interest rate changes
and incorporates all the bond’s parameters, not just maturity. Longer
duration bonds are more price responsive than shorter duration notes to equal
changes in interest rates and, in fact, the degree of price responsiveness is
proportional to the bond’s duration. Price responsiveness, in turn, is the key
ingredient in interest rate risk.

Because the coupon on a floating rate note changes with the market, the
investor is never “stuck” with an outdated coupon; i.e., it is always “up to
date.” Hence, an increase in market interest rates won’t force an FRN’s price
to drop. Conversely, a decline in rates will not result in a price increase.

 Callable Bonds

Securities which are callable allow the issuer to repay principal on or after the
call date. This is an attractive option, allowing the borrower to refinance at

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possibly lower interest rates, yet lock in the bond’s coupon if rates rise.
Because it is a negative for the investor – who must re-invest at lower rates if
called, yet accept the bond’s coupon when market rates have risen – callable
bonds must pay a higher rate than non-callable, known as the call spread, or
premium. The call premium moves in opposite direction of the level of
interest rates, since a decline in rates makes calling more likely, and vice-
versa. This “cushions” somewhat the impact of changing rates on callable
bond prices relative to non-callable.

At the same time, this embedded option in the callable bond rises in value if
interest rate volatility increases, and falls if volatility declines. This inserts an
additional risk parameter into callable bonds.

 Yield Curve

The relationship between the interest rate of bonds and their remaining
maturity is summarized in a “yield curve.” By plotting yield against maturity,
it presents a summary picture of the state of fixed income markets. In some
cases, only “on-the-run: bonds are employed, requiring interpolation for the
other points on the curve. Alternatively, all the government bonds can be
used and a curve is “fitted” to the points.

Yield curves can have various slopes, shapes and positions. The primary
determinants of the yield curve at any moment in time are expectations of
market participants as to the future course of interest rates, in turn determined
by the stage of the business cycle, the level of economic activity and inflation.
As such, yield curves produce “forward rates,” crucial inputs to portfolio
management decisions, as well as for pricing fixed income derivatives.

Yield curves differ by currency (i.e., the country’s economy) and by sector
(e.g., government bond yield curve, corporate bond curve, interest rate swap
curve).

II Government-Related Securities

 Strips (“Zeros”)

Zero coupon bonds result from separating the periodic cash flows of
government bonds and selling each individually; i.e., “stripping.” As the U.S.
Treasury does not issue zeros directly, stripping is left to dealers (who also do

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the reverse – reconstitute strips into whole bonds). Other governments do
issue zeros. There are also some agency and corporate zero coupon bonds.

The zero coupon bonds so created are single cash flow securities. These
structures appeal to a class of investors with long term horizons, particularly
to pension funds looking to match liabilities. Dealers also use zeros to create
(“synthesize”) customized bonds of nearly any coupon (and amortization
schedule). Among bonds of equal maturity, strips display the highest degree
of price sensitivity.

 Government Guaranteed Debt

In many countries, the central government (as well as local government

entities) guarantees the debt of private borrowers. They may do so directly
(e.g., student loans) or through a specially formed agency (e.g., residential
mortgages – see below).

 Mortgage instruments

Securities issued by individuals to finance home purchases, with the home

serving as collateral for the loan, are “residential mortgages. They usually
carry a fixed interest rate, with an original maturity of 25 to 30 years.

Floating rate and hybrid structures are popular as well. The instruments differ
from government/corporate bonds in that (besides the collateral): coupons are
paid monthly; a servicing charge is added; amortization of principal begins
immediately; and borrowers have the right to prepay outstanding principal.
The last feature introduces pre-payment risk into mortgages (and into
securities backed by such mortgages), the distinguishing feature of this asset
class.

In the U.S., the most actively traded residential mortgage products are groups
of individual mortgages “pooled” together. If specific parameters are
satisfied, they are backed by the U.S. Treasury – so called “pass-thrus” –
which, therefore, have no credit risk. US agencies also guarantee pass-thrus.
Adding another layer, dealers use mortgage collateral to create CMOs –
collateralized mortgage obligations. Non-agency, non-government backed
mortgages are purchased as “whole loans” or packaged as “private label”
mortgage-backed securities. Mortgages backed by commercial property are
issued and trade in the capital markets as well.

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It is important to distinguish between residential mortgage instruments
guaranteed by government agencies (which trade in the mortgage market) and
the bonds issued by the agencies themselves (which are debentures, not
mortgage instruments).

 Agency issues

Agencies, also known as “government sponsored enterprises,” are government

created entities with mandates to support particular sectors of the economy
(e.g., housing, students). They are among the largest borrowers in the capital
markets (and are active derivatives participants), using these funds to make
loans and/or purchase securities in their mandated sectors. The relationships
between agencies and the government are vague and not consistent across
agencies (some are stockholder-owned corporations). Their credit-worthiness
is below Treasuries, but normally above corporates.

Besides issuing debentures, a number of agencies purchase loans and

securities in their sectors, pool them, and sell securities representing interest in
the pools, with the agency providing some credit guarantee

III Money Markets

 Open market paper

Money market instruments are those with an original maturity within one
year. They are employed by investors as a “parking place” for funds until
their allocation to their ultimate asset classes, or as an independent investment
with close to zero interest rate sensitivity. Because of their short maturities,
their price responsiveness to market interest rate changes are normally
minimal. Alternatively, these instruments can be combined with derivatives
to substitute for longer term securities.

Money market securities are issued by:

- government, known as T-bills, and its agencies, as discount notes

- banks, mostly in the form of deposits of various types
- firms, in the form of commercial paper, an unregistered borrowing
- special purpose entities financing of securities, known as asset-
backed commercial paper

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Money market mutual funds are open-end funds which purchase these
securities. (Because of the muted price volatility of the assets, the fund’s “net
asset value” can be maintained at one.)

 LIBOR

Banks borrow and lend among themselves in the money markets. This “inter-
bank” market is twenty-four hours, and exists for the world’s major
currencies, for various maturities. The impact of central bank monetary
policy changes and the economy's dynamics on financial markets are initially
felt in the money market.

LIBOR – the London Inter-Bank Offered Rate - reflects the interest rate
participating banks charge other banks during London’s morning hours in the
EuroDollar (a type of offshore market). LIBOR is used as a pricing index for
many bank loans to corporations, floating rate notes, forward rate agreements
and interest rate swaps (see later).

 Dealer financing

Securities dealers finance their inventory with short term borrowing. The
preferred vehicle is a “repurchase agreement,” wherein the bond being
financed serves as collateral for the borrowing. (Other market participants use
repos for leverage as well.) Unlike ordinary collateralized lending, the bond
underlying the repo transaction may be sold by the lender (to be returned, of
course, upon maturity of the repo). In this way, repos are used to create short
positions (“reverse repo”), by dealers as well as speculators.

IV Corporate Securities

 Investment grade bonds

Debt instruments issued by private sector firms to fund capital expenditures,

expansion, acquisitions and other corporate purposes. In the investment grade
class, payment of promised cash flows will likely be made in a timely fashion,
but credit risk – the possibility of default and the ensuing inability to meet
promised cash flows – does exist. This results in an extra yield – a “credit
spread” – that corporate bonds must pay above Treasury bonds of similar
maturity in order to attract investors. The primary determinants of a bond’s

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credit risk are the issuer’s leverage, its volatility of earnings, and the particular
bond’s position in the firm’s capital structure (e.g., senior vs. junior). Because
the credit risk is want distinguishes a corporate from a Treasury, corporate
bonds are typically quoted according to their spread above similar maturity
government bonds

Rating agencies (Moody’s, S&P, Fitch) analyze company fundamentals from

the perspective of default risk. They summarize their findings with a letter
grade. The lower the rating, the greater the perceived credit risk, hence the
wider the spread.

The corporate bond market comprises a diverse set of issuers, such as

industrials, utilities, financials and foreign. They are referred to as sectors.
Liquidity varies greatly, as issuance sizes can range from under $100 million
to over $1 billion. Smaller sized deals are often done as a “private
placement,” which may not require official registration.

Bonds are either secured with collateral, or are simply debentures. In the
event of default, payments made from available funds (“recovery value”) are
tiered according to seniority, and spreads in the marketplace generally reflect
this tiering.

In some cases, principal is repaid prior to the final maturity. These are known
as amortizing bonds, and they follow a pre-set amortization schedule. When
the amortization period begins, coupons equal the coupon rate applied to the
remaining principal. (Corporate bonds may also “capitalize, that is, interest is
added to principal rather than paid in cash.) Bonds with zero amortization
(and not callable) are known as “bullets.”

Coupons are paid on a floating or fixed basis. Fixed-coupon corporate bonds

must pay the Treasury interest rate (hence are priced along the government
bond yield curve) plus an extra amount to compensate for credit risk.
Changes in either the Treasury rate or the issuer’s credit condition impart
price volatility to the bond. Corporate floating-rate notes (FRNs) issues
typically pay a coupon equal to LIBOR, which adjusts periodically, plus a
spread, reflecting the degree of credit risk. Because the base rate follows
LIBOR, these issues are largely immune from the effects of movements in
interest rates overall (i.e., Treasury rates). However, their prices do react to
shifts in the issuer’s credit worthiness; i.e. to changes in credit spread. The
interest rate on FRNS may be “capped;” such notes require a greater spread to
compensate the investor (but, as an embedded option, they also respond to
interest rate volatility).

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Many corporate securities are callable, providing the issuer with the option to
pre-pay prior to maturity (unlike amortizing bonds which require early
repayment). Then call option is typically exercised when interest rates are
substantially lower than the bond’s stated coupon. Callable bonds must pay
the investor a higher yield than otherwise similar bonds to compensation the
investor for bearing the risk of call – if called, the investor must reinvest at the
then lower rates.

Bonds may be secured (with real estate, for example). These bonds will pay
an interest rate below that of a comparable unsecured instrument of the same
issuer. In the latter category, bonds are further differentiated by senior or
junior (subordinated). Senior bond holders stand ahead of subordinated as
claimants to a company’s cash flow (and assets in event of bankruptcy.
Hence, their yield is lower.

 Speculative grade bonds

Corporates rated below investment grade by the rating agencies. Within this
class, payments of promised cash flows are at significant risk. In general,
leverage ratios in this sector are substantially greater than in the investment
grade sector. Further, recovery in event of default is normally below that for
investment grade (again largely due to greater leverage). Their yield,
therefore, is higher, hence their alternative name, “High Yield Bonds.”

Speculative grade bonds are often structured to preserve cash up front, such as
deep discount or “two-step” coupons. They also commonly contain
“covenants” – restrictions on the company’s behavior (e.g., minimum
coverage ratio) to reduce risk to the bondholders. Sizes of high yield issues
are typically smaller than investment grade; as a result, liquidity is poorer.
Unlike investment grade issues, speculative grade credit spreads, hence bond
prices, are quite sensitive to overall level of economic activity.

“Leveraged loans” are a related market. These are loans to highly leveraged
borrowers. Loans differ from bonds in their legal and institutional structure.
There is more negotiation between borrower and lender, and the paper is not
as easily transferable in secondary market transactions as are bonds.

A recent addition to this market is Distressed Debt, the trading of loans and
bonds of issuers in or near default. Their prices depend on market
participants’ expectations of asset values post liquidation or reorganization,
known as “recovery value.”

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V Asset Backed Securities

 Home mortgages

The earliest and still predominant form of collateral for asset-backed securities
is residential mortgages. Mortgage loans are purchased from the originator,
pooled together, and sold to investors (“securitization”). If the mortgages
qualify for specific programs, their payments are guaranteed either by the
government or its agencies, and known as “pass-thrus.” Non-qualifying
mortgages may be guaranteed by private insurance companies or other
financial institutions.

Mortgages present pre-payment risk to investors (which is not addressed by

the above guarantee). In order to make pre-payment risk more acceptable to
investors, a large portion of mortgages are today repackaged into
“collateralized mortgage obligations.” The CMO technology, which
essentially redistributes the pre-payment risk, allows for a host of structures
and derivatives.

 Other asset-backed structures

Asset-backed securities (ABS) were originally created to relieve bank balance

sheets. A Special Purpose Vehicle is created to purchase loan assets from a
bank (the “originator”), which then issues bonds backed by these loans. In
this way, unlike the traditional framework, with bank loans being financed by
deposits, the assets are now being financed by capital markets investors.
Besides capital relief from banks, arbitrage driven deals exist, where income
from the underlying assets exceeds debt service costs of the bonds.
Automobile and credit card loans were the early forms of, and remain very
popular, collateral; home equity and other consumer loans were more recently
introduced. “Sub-prime” mortgages, which do not qualify for agency
purchase and securitization, present significant credit risk, are a recent form of
collateral for this market. Other deals include manufactured housing and
student loans. Securities backed by corporate loans and bonds, plus
commercial mortgages, are structured similarly and trade in their own
markets (covered later in CDOs.)

The underlying collateral in an ABS is generally not government or agency

guaranteed. To deal with this – and this is the basic innovation - the SPV
issues bonds (“tranches”) of various degrees of credit risk. Any defaults that
occur in the collateral are allocated to the bond holders in a sequence. This

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sequential credit risk exposure produces a hierarchy of credit risk for the
tranches, much like a senior/subordination structure found in corporate bonds.
In addition, the structure embeds various forms of credit enhancements into
the senior tranches.

VI Local Government / Municipal Securities

In many countries, state and local governments and other political divisions, as
well as “agencies” and “authorities created by them, issue debt securities in the
capital markets. They are known as municipal bonds. Like corporate bonds,
municipal securities are subject to default risk, and are rated by the rating
agencies.

In some countries, most notably the United States, municipal are free of federal
income tax. In the U.S., they are also free of state tax if held by citizens of that
domicile. Because of this feature, yields of municipal bonds are below those of
comparable taxable entities. Suppose an investor is in a 20% tax bracket. A
corporate bond paying 5% would yield 4% to the investor after 20% of the 5% is
subtracted and paid as tax. A tax-free municipal bond paying 5%, by contrast,
would yield the investor the full coupon. Hence, for this investor, a 4% municipal
yield is “equivalent” to a 5% corporate. Note that the relative attractiveness of
tax-free vs. taxable bonds – and this measure of equivalence – is a function of the
investor’s marginal tax bracket.

The U.S., the municipal bond market includes General Obligation bonds, which
are backed by the overall revenue raising ability of the municipal government –
taxes, tolls, etc. When a particular project is supported by the government,
Industrial Revenue bonds are issued, whose debt service is funded by earnings
from that project. “Build America Bonds” are not tax-exempt. However, the US
government pays qualifying municipal issuers a subsidy. The “BABs” program is
being phased out.

Municipalities often issue bonds over a series of maturities, rather than one large
bullet issue. These are termed “serial” bonds. Variable Demand Obligations have
long term maturities, but their interest rates adjust regularly to current market
conditions.

Smaller municipalities with relatively minor presence in investor portfolios, as

well as issuers with otherwise lower credit ratings often purchase insurance on all

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or a portion of their bonds in order to raise the rating and thereby reduce interest
costs. These insured bonds had until recently accounted for a large portion of the
muni market. Problems at insurers have reduced their presence.

Individuals are large investors in the muni market. They purchase bonds directly
or via tax-free mutual funds. Funds are open or closed-end, the latter often using
leverage to increase yield.

Although municipal obligations are generally tax-free, depending on the investor

their income can be subject to the “alternative minimum tax.” Furthermore, only
interest income is free of tax; capital gains are taxed (at the capital gains rate), net
of losses, of course. The accrual to par of original issue discount (OID) bonds is
not taxed, as it is effectively a payment by the issuer.

VII Fixed Income Mutual Funds

Technically investment companies (hence governed by investment company

regulations). Investor can buy bonds via mutual funds rather than directly. The
funds, or investment companies, sell shares and use the proceeds to purchase
bonds, etc. Open-end funds are purchased by investors directly from (and sold
directly to) the investment company. Their Net Asset Values, therefore, do not
diverge from the value of the portfolio of securities owned by the fund. Closed-
end funds, on the other hand, are traded in the secondary market, hence they may
be priced at a discount or premium to their NAV. Exchange-traded funds (ETFs)
are a relatively new vehicle. The majority are “passively” managed. Importantly,
unlike their open-end counterpart, they are priced intra-day, yet do not deviate, to
any significant extent, from their NAV.

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