MFE8812 Seminar Slide 01 (2pg) PDF

Global Capital Market
Fixed Income Securities and Markets

Risks Associated with Fixed-Income Investments
MFE8812 Bond Portfolio Management
William C. H. Leon
Nanyang Business School
January 16, 2018
1 / 126 William C. H. Leon MFE8812 Bond Portfolio Management

1 Global Capital Market

Overview
Some Facts
2 Fixed Income Securities and Markets

Overview
Bonds
General Characteristics of Bond
Non-Standard Bonds
Bonds by Issuers
Money-Market Securities
Central Bank
Some Money-Market Instruments
3 Risks Associated with Fixed-Income Investments

Overview
Key Interest Rate Related Risk
Other Risk

Fixed Income Securities and Markets Some Facts
Overview
The capital market is composed of the debt market, in which debt
securities are issued and traded, and the stock market, in which shares of
ownership in companies are issued and traded.
In the United States as well as worldwide, the debt market is much larger
than its stock market counterpart.

Global Market Capitalization of Debt & Stock

Reasons for Differences in Market Capitalization

Debts still accounted for 75 percent of corporate financing even though
stocks may be a cheaper source of capital for corporations as they do not
require fixed interest payments and the stock market was enjoying record
highs in the two decades before the 2008 global financial crisis.
The debt market is larger than the stock market for various reasons:
1 Both governments and corporations issue debt securities, whereas
only corporations issue stocks.
The U.S. Treasury is the largest issuer of debt securities worldwide.
Because U.S. Treasury securities are backed by the full faith and
credit of the government, investors perceive them as risk-free and
highly liquid.
2 Most investors are older and risk-averse, and they may prefer the
regular income of debt securities.


Global Financial Stock

The worlds stock of equity and debt rose by $11 trillion in 2010, reaching a
total of $212 trillion. This surpassed the previous peak of $202 trillion in 2007.
Nearly half of this growth came from an $6 trillion increase in the market
capitalization of global stock.
The total value of all debt reached $158 trillion, an increase of $5.5
trillion from the previous year.
Government debt grew by 12 percent and accounted for nearly 80
percent of net new borrowing, or $4.4 trillion. This reflected large
budget deficits in many mature economies, amplified by a slow
economic recovery.
Bond issues by non-financial businesses remained high in 2010 at
$1.3 trillion – thats more than 50 percent above the level prior to the
2008 crisis. This reflected very low interest rates and possibly tighter
access to bank credit. Corporate bond issuance was widespread
across regions.
Bank lending grew in 2010 as well, with the global stock of loans held
on the balance sheets of financial institutions rising by $2.6 trillion.


Growth in Global Debt

Global debt outstanding has more than doubled over the past ten years,
increasing from $78 trillion in 2000 to $158 trillion in 2010.
Debt grew faster than GDP over this period, with the ratio of global debt
to world GDP increasing from 218 percent in 2000 to 266 percent in 2010.
Most of this growth ($48 trillion) has been in the debt of governments
and financial institutions.
Although government debt has been the fastest-growing category, it
is notable that bonds issued by financial institutions to fund their
balance sheets have actually been a larger class of debt over the past
ten years.
Bonds issued by financial institutions around the world has increased
by $23 trillion over the past decade. In 2010, this shrank by $1.4
trillion as banks moved to more stable funding sources.
Non-securitized lending is still the largest component of all debt and
continued to grow in 2010.


Growth of Total Public Debt

Government debt has increased significantly.
There was some growth between 2000 and 2008, but the amount of
government debt has jumped in 2009 and 2010.
Public debt outstanding stood at $41.1 trillion at the end of 2010, an
increase of nearly $25 trillion since 2000. This was the equivalent of
69 percent of global GDP, 23 percentage points higher than in 2000.
In just two years (2009 and 2010), public debt has grown by $9.4
trillion or 13 percentage points of GDP.
In 2010, 80 percent of the growth in total debt outstanding came from
government debt.
While stimulus packages and lost revenue due to anemic growth have
widened budget deficits since the crisis, rising global public debt also
reflects long-term trends in many advanced economies. Pension and
health care costs are increasing as populations age, and unfunded
pension and health care liabilities are not reflected in current
government debt figures.
Without fiscal consolidation, government debt will continue to
increase in the years to come.


Growth of Public Debt Among Countries

Public debt in many developed economies have steadily increased over time.
In the 1970s, 1980s, and 1990s, there were numerous sovereign debt crises
in emerging markets that proved very costly in terms of lost output, lower
incomes, and years of slower economic growth. But today it is developed
country governments that must act to bring their growing public debt
back under control.
In most emerging markets, public debt has grown roughly at the same
pace as GDP since 2000 and the ratio of government debt to national
GDP remains rather small.
In contrast, Japan, the United States, and many Western European
governments have seen their debt rise significantly.
Japans government debt began rising after its financial crisis in 1990
and has now reached 220 percent of GDP.
In both the United States and Western Europe in 2010, the ratio of
public debt grew by 9 percentage points to stand at more than 70
percent of GDP by the end of the year.


Non-Financial Corporate Bond Issuance

Issuance of corporate bonds by non-financial issuers nearly doubled in
2009 compared with 2008 as bank lending standards tightened and
interest rates stayed at historic lows.
Historic high issuance totaled $1.5 trillion in 2009, with $548 billion
in Western Europe.
Corporate bond issuance remained high in 2010 at $1.3 trillion, more than
50 percent above 2008 levels.
Given the pressures on the banking system, those corporations that
could access the capital markets directly did so in order to secure
long-term financing.
Although the majority of growth occurred in developed countries,
corporate bond issuance has also grown rapidly in recent years in
emerging economies.
In total, emerging markets accounted for 23 percent of global
corporate issuance in 2010, up from just 15 percent three years
earlier.

Non-Financial Corporate Bond Issuance

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There is still significant room for further growth in corporate bond

markets in virtually all countries outside the United States.
The United States is the only country where corporations rely on debt
capital markets to provide a sizable share of their external financing.
Bonds account for 53 percent of corporate debt financing in the
United States compared with 24 percent in Western Europe and only
16 percent in emerging economies.
Given the higher cost of bank financing, especially in light of new capital
requirements, there may be more rapid expansion of debt capital markets
in Europe and in emerging markets.


Growth of On-Balance-Sheet Loans

Loans held by banks, credit agencies, and other financial institutions account
for the largest share of global debt outstanding (at 31 percent).
On-balance-sheet loans grew from $31 trillion in 2000 to $49 trillion in
2010, an increase of 4.8 percent per annum.
However, this global total hides key differences between regions.
Since 2007, outstanding loan volumes in both Western Europe and
the United States have been broadly flat with a decline in 2009
followed by a modest increase in 2010.
In Japan, the stock of loans outstanding has been declining since
2000, reflecting de-leveraging by the corporate sector.
Lending in emerging markets has grown at 16 percent annually since
2000, and by 17.5 percent a year in China.
In 2010, loan balances increased worldwide by $2.6 trillion.
Emerging markets accounted for three-quarters of this growth.
Chinas net lending grew by $1.2 trillion, partly reflecting government
stimulus efforts, while lending in other emerging markets rose by
$800 billion.

Issuance of Securitized Assets

Securitized lending was the fastest-growing segment of global debt from
2000 to 2008 with outstanding volumes increasing from $6 trillion to $16
trillion (average growth of 13 percent per year).
Roughly 80 percent of securitization issuance over this period
occurred in the United States.
The issuance of mortgage-backed securities by government-sponsored
enterprises more than doubled between 2000 and 2007 and hit a
peak in 2002 that was nearly four times as large as in 2000.
The creation of asset-backed securities by US banks and other
non-government issuers tripled over this period, as did securitization
in the rest of the world albeit from much lower levels.
Since 2008, securitization by the US private sector and in other parts of
the world has fallen dramatically.
Only US government-supported mortgage issuers have sustained activity
in the market over the past few years – and new issuance in 2009 surged
and roughly matched the peak level of 2002.

Issuance of Securitized Assets

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Future prospects in the securitization market are unclear.

Regulators are seeking to curtail the shadow banking system.
Financial institutions argue that securitization facilitates lending to
those in need of credit.

Bonds
Overview
Fixed-income markets are populated with a vast range of instruments. We
will discuss some of these instruments, namely, bonds and money-market
instruments, and describe their general characteristics.
A bond is a financial claim by which the issuer, or the borrower, is
committed to paying back to the bondholder, or the lender, the cash
amount borrowed (called the principal), plus periodic interests calculated
on this amount during a given period of time.
A money-market instrument is a short-term debt instrument with a
maturity typically less than or equal to 1 year.

Bonds
Definition of a Bond
A bond is a financial claim by which the issuer (or the borrower) is
committed to paying back to the bondholder (or the lender) the cash
amount borrowed, called principal, plus periodic interests, called coupon,
calculated on this amount during a given period of time.
A bond can have either a standard or a non-standard structure. A
standard bond is a fixed-coupon bond without any embedded option,
delivering its coupons on periodic dates and principal on the maturity date.
The purpose of a bond issuer is to finance its budget or investment
projects at an interest rate that is expected to be lower than the return
rate of investment (at least in the private sector). Through the issuance
of bonds, it has a direct access to the market, and so it avoids borrowing
from investment banks at higher interest rates.
A bondholder has the status of a creditor, unlike the equity holder who
has the status of an owner of the issuing corporation. This is generally
why a bond is less risky than an equity.

Bonds
Example of a Bond

Bonds
Terminology & Convention: Forms of Bond

Bearer form. This means the bond is traded without any record of
ownership, so physical possession of the bond is the sole evidence of
ownership.
Registered form. This means the bond issuer keeps records of bond
owners and mails out payments to those bond owners. Most bonds issued
today are in registered form.
Book-entry form. This means the bond ownership is recorded
electronically. Book-entry bonds eliminate the need to issue paper
certificates of ownership. When such bonds are traded, accounting entries
are changed in the books of the institutions where traders maintain
accounts.

Bonds
Terminology & Convention: Bond Issuers

The issuers name. For example, Bundesrepublik Deutschland for a
Treasury bond issued in Germany.
The issuers type. This is mainly the sector the issuer belongs to: for
example, the oil sector, if Total S.A., a French multinational integrated oil
and gas company, is the bond issuer.
The issuers domicile.

Bonds
Terminology & Convention: Bond Issues

The bonds currency denomination. An example is the U.S. Dollar (USD)
for a US Treasury bond.
The market in which the bond is issued. It can be the domestic market of
any country; the eurodollar market, which corresponds to bonds
denominated in USD and issued in any other country than the US.
The announcement date. This is the date on which the bond is
announced and offered to the public.
The total issued amount.
The maturity date. This is the date on which the principal amount is due.
The minimum amount and minimum increment that can be purchased.
The minimum increment is the smallest additional amount of a bond that
can be bought above the minimum amount.

Bonds

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The interest accrual date. This is the date when interest begins to accrue.
The first coupon date. This is the date of the first interest payment.
The settlement date. This is the date on which payment is due in
exchange for the bond. It is generally equal to the trade date plus a
number of working days.
The type of guarantee. This is the type of underlying guarantee for the
bondholder. The guarantee type can be a mortgage, an automobile loan,
a government guarantee, etc.
The seniority of claim. This refers to the order of repayment in the event
of a sale or bankruptcy of the issuer.
The rating. The task of rating agencies consists in assessing the default
probability of corporations through what is known as rating. A rating is a
ranking of a bonds quality, based on criteria such as the issuers reputation,
management, balance sheet, and its record in paying interest and principal.

Bonds

Bonds

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The issuance price. This is the percentage price paid at issuance.

The spread at issuance. This is the spread in basis points to the
benchmark Treasury bond.
The outstanding amount. This is the amount of the issue still outstanding.
The identifying code. The most popular ones are the ISIN (International
Securities Identification Number) and the CUSIP (Committee on Uniform
Securities Identification Procedures) numbers.

Bonds
Terminology & Convention: Bond Coupons

The coupon type. It can be fixed, floating, a multi-coupon (a mix of fixed
and floating or different fixed). For example, a step-up coupon bond is a
kind of multi-coupon bond with a coupon rate that increases at
predetermined intervals.
The coupon frequency. The coupon frequency for Treasury bonds is
semiannual in the United States, the United Kingdom and Japan, and
annual in the Euro zone, except for Italy where it is semiannual.
The coupon rate. It is expressed in percentage of the principal amount.
The nominal amount (or par amount or principal amount). This is the
face value of the bond. Note that this amount is used to calculate the
coupon bond. For example, consider a bond with a fixed 5% coupon rate
and a $1,000 nominal amount. The coupon is 5% × $1, 000 = $50.

Bonds
Terminology & Convention: Bond Coupons

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The day-count type. The most common types are Actual/Actual,

Actual/365, Actual/360 and 30/360.
Actual/Actual (respectively Actual/365, Actual/360) means that the
accrued interest between two given dates is calculated using the exact
number of calendar days between the two dates divided by the exact
number of calendar days of the ongoing year (respectively 365, 360).
30/360 means that the number of calendar days between the two
dates is computed assuming that each month counts as 30 days.

Bonds
Terminology & Convention: Bond Redemptions

The redemption value. This is expressed in percentage of the nominal
amount, it is the price at which the bond is redeemed on the maturity
date. In most cases, the redemption value is equal to 100% of the bond
nominal amount.
The redemption feature. Non-standard bonds may have callable, puttable
and convertible features.
Call feature grants issuer the right to retire a bond, fully or partially,
before maturity.
Put feature grants bondholder the right to sell a bond back to the
issuer at some fixed value on designated dates.
Convertible feature usually grants bondholder the right to convert a
bond into a predetermined amount of the issuer’s equity at
designated dates.

Bonds
Example: A US Treasury Bond

Consider the US Treasury bond, with coupon rate 3.5% and maturity date
11/15/2006 (Month/Day/Year), that bears a semiannual coupon with an
Actual/Actual day-count basis. The issued amount is equal to $18.8 billion; so
is the outstanding amount. The minimum amount that can be purchased is
equal to $1,000. The T-bond was issued on 11/15/01 on the US market, and
interests began to accrue from this date on. The price at issuance was 99.469.
The first coupon date is 05/15/02, that is, 6 months after the interest accrual
date (semiannual coupon). This bond has a AAA rating.

Bonds

Bonds
Market Quotes: Bond Quoted Price

Bonds are usually quoted in price, yield or spread over an underlying
benchmark bond. Bond price is always expressed in percentage of the bond
nominal amount.
The quoted or market price of a bond is usually its clean price, i.e., its
invoice price minus the accrued interest.
When an investor purchases a bond, he is entitled to receive all the future
cash flows of this bond, until he no longer owns it.
If he buys the bond between two coupon payment dates, he logically
must pay for it at a price reflecting the fraction of the next coupon
that the seller of the bond is entitled to receive for having held it
until the sale.

Bonds
Market Quotes: Bond Quoted Price

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The price an investor has to pay when he purchases a bond is called the
dirty price (or full price or gross price or invoice price).
Dirty price is computed as the sum of the clean price and the portion
of the coupon that is due to the seller of the bond. This portion is
called the accrued interest. Note that the accrued interest is
computed from the last coupon payment date to the settlement date.

Bonds
Clean Price, Dirty Price & Accrued Interest

Quoted price of bond is a clean price.
Settlement price of a bond is dirty price.
Clean price of a bond is equal to the dirty price on each coupon payment
date.
Dirty Price = CleanPrice + AccruedInterest

Market Quote n
PV (CFs) ×Coupon
N
Accrued Interest
Period (n)
Coupon Period (N)
Last Coupon Settlement Next Coupon

Date Date Date

Bonds
Example
On 10 Dec 2xx1, an investor buys the 5-year US Treasury bond with coupon
3.5% and maturity 15 Nov 2xx6. The current clean price is 96.15625. Hence
the market value of $1 million face value of this bond is equal to
96.15625% × $1, 000, 000 = $961, 562.50.
There are 26 calendar days between the last coupon payment date (15 Nov
2xx1) and the settlement date (11 Dec 2xx1), and there are 181 calendar days
between the last coupon payment date (15 Nov 2xx1) and the next coupon
payment date (15 May 2xx2). Hence, because the coupon frequency is
semiannual, the accrued interest is
3.5% 26
× = 0.251381%.
2 181
To buy this bond, the investor will pay
(96.15625% + 0.251381%) × $1, 000, 000 = $964, 076.31.

Bonds
Exercise
Consider a bond that pays coupon on the first of January and July every year.
Suppose you sold the bond and settled the transaction on 3 Mar 2xx6. Suppose
there are
181 days between 1 Jan 2xx6 and 1 Jul 2xx6, and
61 days between 1 Jan 2xx6 and 3 Mar 2xx6.
What are the accrued interest you are entitled to based on the
1 actual/actual day-count basis, and
2 30/360 day-count basis?

Bonds
Answer

Bonds
EXCEL Functions
Last Coupon Settlement Next Coupon

Date Date Date
COUPDAYBS COUPDAYSNC
COUPDAYS
COUPDAYS(Settlement, Maturity, Frequency, Basis).

Returns the number of days in the coupon period that contains the
settlement date.
COUPDAYBS(Settlement, Maturity, Frequency, Basis).
Returns the number of days from the beginning of the coupon period
to the settlement date.
COUPDAYSNC(Settlement, Maturity, Frequency, Basis).
Returns the number of days from the settlement date to the next
coupon date.
Bonds
EXCEL Functions
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Options.
Frequency.
1 = Annual coupon payments.
2 = Semiannual coupon payments.
Basis.
0 or omitted = US (NASD) 30/360.
1 = Actual/actual.
2 = Actual/360.
3 = Actual/365.
4 = European 30/360.

Bonds
US (NASD) 30/360 Day-Count Basis

The US (NASD) 30/360 day-count basis assumes that each month has 30 days
and the total number of days in the year is 360. There are adjustments for
February and months with 31 days.
1 Given Date 1 = D1 /M1 /Y1 and Date 2 = D2 /M2 /Y2 (in the form of
Day/Month/Year) where Date 2 is later than Date 1.
2 If D1 = 31, change D1 to 30.
3 If D2 = 31 and D1 = 30, change D2 to 30.
4 The number of days between Date 1 and Date 2 is
(Y2 − Y1 ) × 360 + (M2 − M1 ) × 30 + (D2 − D1 ).

Bonds
30/360 Day-Count Basis

The 30/360 day-count basis is different outside the United States, where the
calculation in step 3 was further simplified.
1 Given Date 1 = D1 /M1 /Y1 and Date 2 = D2 /M2 /Y2 (in the form of
Day/Month/Year) where Date 2 is later than Date 1.
4 The number of days between Date 1 and Date 2 is
(Y2 − Y1 ) × 360 + (M2 − M1 ) × 30 + (D2 − D1 ).

Bonds
Exercise
Suppose you sold a corporate bond with a nominal value of $1,000. The bond
matures on 29 Nov 2xx8 and it pays 8% coupon semi-annually on 29 May and
29 Nov during its lifetime.
If the settlement date is on 31 January 2xx3, what is the interest accrued on

the bond?
1 Assume the US 30/360 day-count basis.
2 Assume the 30/360 day-count basis.

Bonds
Answer

Bonds
Market Quotes: Bond Quoted Yield

The quoted yield of a bond is the discount yield that equalizes its dirty price
times its nominal amount to the sum of its discounted cash flow.
Consider the previous example where, on 10 Dec 2xx1, an investor buys
the 5-year US Treasury bond with coupon 3.5% and maturity 15 Nov
2xx6; the bond has the clean price of 96.15625 and the dirty price of
96.407631. The cash flow schedule of the bond with $1 million face value
is as follows:
Date Cash Flow Date Cash Flow
15/05/x2 17,500 15/11/x4 17,500
15/11/x2 17,500 15/05/x5 17,500
15/05/x3 17,500 15/11/x5 17,500
15/11/x3 17,500 15/05/x6 17,500
15/05/x4 17,500 15/11/x6 1,017,500
The quoted yield of the bond is 4.375% (see next slide street convention).
The equivalent 1-year compounded yield of the bond is 4.423%.

Bonds

Bonds
Market Quotes: Bond Quoted Spread

Corporate bonds are usually quoted in price and in spread over a given
benchmark bond rather than in yield. So as to recover the corresponding yield,
you simply have to add this spread to the yield of the underlying benchmark
bond
Consider the Ford Motor Credit bond with coupon 6.75% and maturity 15
Aug 2xx8 (see next slide). The bond has a spread of 156.4 basis points
(see Interpolated Spread (ISPRD) function) over the interpolated USD
swap yield, a spread of 234 basis points over the interpolated US Treasury
benchmark bond yield; a spread of 259 basis points (Spread (SPRD)
function) over the US Treasury benchmark bond with the nearest
maturity; and a spread of 191 and 144 basis points over the 10-year
Treasury benchmark bond and the 30-year Treasury benchmark bond,
respectively.
Quoting spreads over treasury bonds is fairly common on bond markets.
Note that using an interpolation on the treasury bond curve may lead to
different results depending on the two bonds and the interpolation
method.

Bonds

Bonds
Bid vs. Ask Quoted Price & Yield

Note that every traded bond has a bid as well as an ask quoted price.
The bid price is the price at which an investor can sell a bond.
The ask price is the price at which he can buy it.
The ask price is of course higher than the bid price, which means that the
ask yield is lower than the bid yield. The difference between two yields is
known as the bid-ask spread. It is a kind of transaction cost.
It is very small for liquid bonds such as US or Euro Treasury bonds.
It is large for fairly illiquid bonds.
The bonds mid price is simply the average of its bid and ask prices. The
same holds for the mid yield.

Bonds

Bonds
Non-Standard Bonds: Strips

Strips are zero-coupon bonds mainly created by stripping government
bonds of the G7 countries.
In August 1982, Merrill Lynch and Salomon Brothers bought
long-term Treasury bonds and created synthetic zero-coupon
Treasury receipts collateralized by the payments on the underlying
Treasury bonds. Merrill Lynch marketed its Treasury receipts as
Treasury Income Growth Receipts and Salomon Brothers marketed
its receipts as Certificates of Accrual on Treasury Securities.
The U.S. Treasury announced its Separate Trading of Registered
Interest and Principal (STRIPS) program to facilitate the stripping
of designated Treasury securities in February 1985.
Although the trademark synthetic zeros were a success, but because
of the higher liquidity of strips, they were dominated by strips.

Bonds

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The investors who buy strips are usually long-term investors like pension
funds and insurance companies.
One of their aims is to secure a return over their long-term
investment horizon.
Consider an investor who is supposed to guarantee 6% per annum
over 20 years on its liabilities. If he buys and holds a strip with a
maturity equal to its investment horizon, that is 20 years, and a
YTM of 6%, he perfectly meets his objective because he knows
today the return per annum on that bond, which is 6%. In contrast,
coupon-bearing bonds do not allow him to do so, because first they
bear an interest reinvestment risk and second their duration hardly
ever, if not never, reaches 20 years.

Bonds

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There exist two types of strips – coupon strips and principal strips.
Coupon strips and principal strips are built by stripping the coupons
and the principal of a coupon-bearing bond, respectively.
The main candidates for stripping are government bonds (Treasury
bonds and government agency bonds).
Strips are not as liquid as coupon-bearing bonds; hence, their bid-ask
spread is usually higher.

Bonds
Non-Standard Bonds: Floating-Rate Notes

Floating-Rate Notes (FRN) are bond securities that bear floating coupon
rates. This generic denomination encompasses two categories of bonds:
Floating-rate bonds.
These are bonds whose coupon rates are indexed on a short-term
reference with a maturity inferior to 1 year, like the 3-month Libor.
The coupons of floating-rate bonds are reset more than once a year.
Variable-rate bonds or adjustable-rate bonds.
These are bonds whose coupon rates are indexed on a longer-term
reference with a maturity superior to 1 year, like the 10-year Constant
Maturity Treasury (CMT) bond yield.
The coupons of variable-rate bonds may have a reset frequency
exceeding 1 year. Usually, the reset frequency is equal to the coupon
payment frequency.

Bonds

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FRNs differ from each other as regards the nature of the coupon rate
indexation. Coupon rates can be determined in three ways:
First, as the product of the last reference index value and a
multiplicative margin.
Second, as the sum of the last reference index value and an additive
margin.
Third, as a mix of the two previous methods.
Note that when the sign of the multiplicative margin is negative, the bond
is called an inverse floater. The coupon rate moves in the opposite
direction to the reference index; thus, to prevent it from becoming
negative, a floor is determined that is usually equal to zero. Such bonds
have become fairly popular under a context of decreasing interest rates.

Bonds
Example of Floating-Rate Bond

Consider an investor who buys a floating-rate bond whose coupon rate is equal
to 3-month Libor + 20bp.
He is entitled to receive, every period determined in the contract (usually
every 3 months), a coupon payment inversely proportional to its annual
frequency and principal payment on the maturity date.
The coupon rate will be reset every 3 months in order to reflect the new
level of the 3-month Libor.

Bonds
Example of Inverse Floater

Consider an investor who buys an inverse floater whose coupon rate is equal to
max(0, 16% − 2x), where x is the 2-year T-Bond yield.
He is entitled to receive, every period determined in the contract (usually
every year), a coupon payment inversely proportional to its annual
frequency and principal payment on the maturity date.
The coupon rate will be reset every 2 years in order to reflect the new
level of the 2-year bond yield.

Bonds
Example: French 10-Year CMT Bond

Consider the French 10-Year CMT Bond with maturity date 25/10/2xx6 that
bears a quarterly floating coupon that is indexed on TEC10 (see next slide).
TEC10 is a French 10-year Constant Maturity Treasury reference. It is
determined on a daily basis as the 10-year interpolated yield between two
active Treasury bond yields with very close maturity dates.
The bond coupon rate is equal to TEC10 − 100bp and entitles the
bondholder to receive every quarter on January 25th, April 25th, July 25th
and September 25th a coupon payment equal to
1
(1 + TEC10 − 100bp) 4 − 1, and principal payment on 25/10/2xx6.
Coupon rates are reset every quarter with an Actual/Actual day-count
basis. For example, the coupon paid on April 25th is determined using the
TEC10 index five working days before January 25th.

Bonds

Bonds

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An investor who buys a FRN typically hedge against parallel shifts of the
interest rate curve because the coupons of the bond reflect the new level
of market interest rates on each reset date.
FRNs usually outperform fixed-rate bonds with the same maturity
when interest rates shift upwards and under-perform them when
interest rates shift downwards.
For inverse floaters, the issue is more complex because of the way they are
structured.
A decrease in interest rates will not necessarily result in the price
appreciation of inverse floaters despite the increase in the coupon
rate.
Their performance depends actually on the evolution of the
interest-rate curve shape.

Bonds
Non-Standard Bonds: Inflation-Indexed Bonds

Inflation-indexed bonds deliver coupons and principal that are indexed on
the future inflation rates. They are structured so as to protect and
increase an investors purchasing power.
They are mainly issued by governments to make it clear that they are
willing to maintain a low inflation level. They are more developed in the
United Kingdom, followed by the United States.
An inflation-indexed bond can be used to hedge a portfolio, to diversify a
portfolio or to optimize assetliability management.
Investors can use inflation-indexed bond to hedge against a rise in
the inflation rate.
Inflation-indexed bond presents a weak correlation with other assets
such as stocks, fixed-coupon bonds and cash, which makes it an
efficient asset to diversify a portfolio.
Insurance companies and pension funds that guarantee performances
indexed on inflation to their clients can buy inflation-indexed bonds
to reduce the mismatch between assets and liabilities.

Bonds
Government & Municipal Bonds: The US Market

Government securities.
Government securities can be divided into two categories: Treasury
securities and Federal Agency securities.
Treasury securities.
Treasury securities are issued by the US Department of the Treasury
and backed by the full faith and credit of the US government.
The Treasury market is the most active market in the world, thanks
to the large volume of total debt and the large size of any single
issue. The amount of outstanding marketable US Treasury securities
is huge, with $18 trillion as of December 31, 2014.
The Treasury market is the most liquid debt market, that is, the one
where pricing and trading are most efficient. The bid–ask spread is
by far lower than in the rest of the bond market.

Bonds

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Treasury securities (continue).

On-the-run securities are recently issued Treasury securities, as
opposed to off-the-run securities, which are old issued securities.
Benchmark securities, which are recognized as market indicators. As
they are over-liquid, they trade richer than all their direct neighbors.
There typically exists one such security on each of the following curve
points: 2 years, 5 years, 10 years and 30 years.

Bonds
Example of Treasury Securities

Consider the following bonds on 07/12/2001:
The 5-year US Treasury benchmark bond had a coupon of 3.5%, a
maturity date 15/11/2006 and an issuance date 15/11/2001. Its yield is
4.45%.
The 5-year off-the-run US T-bond had a coupon of 7%, a maturity date
15/07/2006 and an issuance date 15/07/1996. Its yield is 4.48%.
The difference of coupon level between the two bonds is becasue:
The 5-year off-the-run T-bond was originally a 10-year T-bond. Its
coupon reflected the level of 10-year yields at that time.
The level of the US government yield curve on 15/07/1996 was at least
200 basis points over the level of the US government yield curve on
15/11/2001.
Furthermore, the yield of the off-the-run bond was higher than that for the
benchmark bond, which illustrates the relative richness of the latter.

Bonds

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Federal agency securities.

Agency securities are issued by different organizations, seven of
which dominate the market in terms of outstanding debt:
The Federal National Mortgage Association (Fannie Mae).
The Federal Home Loan Bank System (FHLBS).
The Federal Home Loan Mortgage Corporation (Freddie Mac).
The Farm Credit System (FCS).
The Student Loan Marketing Association (Sallie Mae).
The Resolution Funding Corporation (REFCO).
The Tennessee Valley Authority (TVA).

Bonds

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Federal agency securities (continue).

Agencies have two common features:
They were created to fulfill a public purpose. For example, Fannie
Mae and Freddie Mac aim to provide liquidity for the residential
mortgage market. The FCS aims at supporting agricultural and rural
lending. REFCO aims to provide financing to resolve thrift crises.
The debt of most agencies is not guaranteed by the US government.
Whereas federally sponsored agency securities (Fannie Mae, FHLBS,
Freddie Mac, FCS, Sallie Mae, REFCO) are generally not backed by
the full faith and credit of the US government, and so contain a
credit premium, federally related institution securities (GNMA:
Government National Mortgage Association) are generally backed by
the full faith and credit of the US government, but as they are
relatively small issues, they contain a liquidity premium.

Bonds

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Federal agency securities (continue).

Agencies are differently organized.
Fannie Mae, Freddie Mac and Sallie Mae are owned by private-sector
shareholders.
Farm Credit System and the Federal Home Loan Bank System are
cooperatives owned by the members and borrowers.
Tennessee Valley Authority is owned by the US government

Bonds

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Municipal securities.
Municipal bonds are issued by state and local governments, such as
counties, special districts, cities and towns, to raise funds in order to
finance projects for the public good such as schools, highways,
hospitals, bridges and airports.
Municipal bonds are exempt from federal income taxes, which makes
the municipal sector being referred to as the tax-exempt sector.
There are two generic types of municipal bonds: general obligation
bonds and revenue bonds.
General obligation bonds have principal and interest secured by the
full faith and credit of the issuer and are usually supported by either
the issuers unlimited or limited taxing power.
Revenue bonds have principal and interest secured by the revenues
generated by the operating projects financed with the proceeds of the
bond issue. Many of these bonds are issued by special authorities
created for the purpose.

Bonds
Government & Municipal Bonds: Credit Risk

Treasury securities are considered to have no credit risk.
Federal agencies’ debt are high-quality debt. All rated agency senior debt
issues are triple-A rated by Moodys and Standard & Poors. This rating
often reflects not only healthy financial fundamentals and sound
management, but also and above all, the agencies relationship to the US
government.
Municipal debt issues, when rated, carry ratings ranging from triple-A, for
the best ones, to C or D, for the worst ones.

Bonds
Government & Municipal Bonds: Other Characteristics

Government and municipal securities can be distinguished by their cash
flow type, their maturity level, their maturity type and their interest-rate
type.
Cash flow type.
There are discount securities, and fixed and floating coupon
securities.
Maturity level.
The 1-year maturity is the frontier separating money-market
instruments (with maturity below it) from bond instruments (with
maturity above it).
Treasury securities with original maturity equal or below 1 year are
called Treasury bills; they are discount securities. Treasury securities
with original maturity between 2 years and 10 years are called
Treasury notes, and Treasury securities with original maturity over 10
years are called Treasury bonds; both are coupon securities, and
some of them are stripped.

Bonds
Government & Municipal Bonds: Other Characteristics

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Maturity type.
A security with a single maturity is called a term security.
A security that can be retired prior to maturity is called a callable
security. Although the US government no longer issues callable
bonds, there are still outstanding issues with this provision.
Treasury bonds are bullet bonds, meaning that they have no
amortization payments.
Interest-rate type.
Agency securities, municipal securities and most Treasury securities
are nominal coupon-bearing securities.
Only a few Treasury securities are inflation-linked, that is, they bear
real coupons. They are called Treasury Inflation Protected Securities
(TIPS).

Bonds
Government & Municipal Bonds: Markets

Treasury securities are traded on four markets: the primary market, the
secondary market, the when-issued market and the repo market.
The primary market.
This is the market where newly issued securities are first sold through
an auction which is conducted on a competitive bid basis. The
auction process happens between the Treasury and dealers according
to regular cycles for securities with specific maturities.
Auction cycles are as follows: 2-year notes are auctioned every
month and settle on the 15th. Five-year notes are auctioned
quarterly (in Feb, May, Aug & Nov of each year), and settle at the
end of the month. Ten-year notes are auctioned quarterly (in Feb,
May, Aug & Nov of each year), and settle on the 15th of the month.
Thirty-year bonds are auctioned semiannually (in Feb & Aug of each
year), and settle on the 15th of the month.
Auction is announced by the Treasury one week in advance, the
issuance date being set one to five days after the auction.

Bonds

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The secondary market.

This is the market where previously issued securities are bought and
sold, a group of US government security dealers offering continuous
bid and ask prices on specific outstanding Treasury securities.
It is an over-the-counter market.
The when-issued market.
This is the market where Treasury securities are traded on a forward
basis before they are issued by the Treasury.

Bonds

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The repo market.

This is the market where securities are used as collateral for loans.
A distinction must be made between the general-collateral (GC) repo
rate and the special repo rate.
GC repo rate applies to the major part of Treasury securities.
Special repo rates are specific repo rates. They typically concern
on-the-run and cheapest-to-deliver securities, which are very
expensive.
Special repo rates are at a level below the GC repo rates. Indeed, as
these special securities are very much in demand, the borrowers of
these securities on the repo market receive a relatively lower repo rate
compared to normal Treasury securities.

Bonds
Government & Municipal Bonds: Main Issuers

The four major government bond (i.e., bond and note issued by the
Treasury of each country) issuers in the world are Euroland, Japan, the
United Kingdom and the United States.

Bonds
Corporate Bonds: Main Characteristics

Corporate bonds are issued by entities (firms, banks) belonging to the
private sector. They represent what market participants call the credit
market.
They are far less liquid than government bonds: they bear higher bid–ask
spreads.
Issuer of a corporate bond has the obligation to honor his commitments to
the bondholder. A failure to pay back interests or principal according to
the terms of the agreement constitutes what is known as default. There
are two sources of default:
The shareholders of a corporation can decide to break the debt
contract. This comes from their limited liability status: they are
liable of the corporations losses only up to their investment in it.
They do not have to pay back their creditors when it affects their
personal wealth.
Creditors can prompt bankruptcy when specific debt protective
clauses, known as covenants, are infringed.

Bonds
Corporate Bonds: Main Characteristics

(Continue)
Corporate bonds are affected by default or credit risk. Their yields contain
a default premium over Treasury bonds.
In case of default, there are typically three eventualities:
Default can lead to immediate bankruptcy. Depending on their debt
securities seniority and face value, creditors are fully, partially or not
paid back, thanks to the sale of the firms assets. The percentage of
the interests and principal they receive, according to seniority, is
called the recovery rate.
Default can result in a reorganization of the firm within a formal
legal framework that depends on the countrys legislation. e.g. under
Chapter 11 of the American law, corporations that are in default are
granted a deadline so as to overcome their financial difficulties.
Default can lead to an informal negotiation between shareholders
and creditors. This results in an exchange offer through which
shareholders propose to creditors the exchange of their old debt
securities for a package of cash and newly issued securities.

Bonds
Corporate Bonds: The Corporate Bond Market

Market size.
In the context of a historically low level of interest rates, the
corporate bond market is rapidly developing and growing.
Within the four major bond markets in the world, the the US Dollar
(USD) corporate market is the most mature, followed by the Sterling
(GBP) market and the Euro (EUR) market, the growth of the latter
being reinforced by the launching of the Euro. The Japanese Yen
(JPY) market differentiates itself from the others, because of the
credit crunch situation and economic difficulties it has been facing.
The USD corporate bond market is much bigger and also more
diversified than the others: it is, for instance, more than twice as big
as the Euro market, and low investment-grade ratings are much more
represented.

Bonds
Corporate Bonds: The Corporate Bond Market

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Sector breakdown.
The corporate bond market can be divided into three main sectors:
financial, industrial and utility.
Apart from the USD market, the financial sector is over-represented.
It is another proof of the maturity of the USD market, where the
industrial sector massively uses the market channel in order to
finance investment projects.

Bonds
Definition of Money-Market Instruments

Money-market instruments are short-term debt instruments with a maturity
typically less than or equal to 1 year.
Some of these instruments such as certificates of deposit may have a
maturity exceeding 1 year.
These instruments are very sensitive to the Central Bank monetary policy.
There are basically three categories of issuers on this market: government
(at both the federal and local levels), banks and corporations.

Bonds
Role of the Central Bank

The central bank, through its privileged triple status of governments
banker, banks banker and nations banker, steers the general level of
interest rates.
As the governments banker, it finances budget deficits.
As the banks banker, it supervises and regulates the banking system.
As the nations banker, it conducts the monetary policy of the nation.
All these tasks are guided by two objectives:
First, the stability of prices.
Second, the support of a sustainable economic growth.
In order to meet these targets, the Central Bank has the responsibility of
setting the official interest rate of the nation, through its open market
operations, i.e., the purchase and sale of government securities, which
allows it to control money supply. This key interest rate is basically an
interest rate at which banks can borrow.

Bonds
Role of the Central Bank: Setting Interest Rate

The Central Bank set the key interest rate at which banks can borrow at.
It is either the overnight (means for one trading day) interest rate at
which banks can borrow from the Central Bank (e.g. UK, Euro area)
in exchange for eligible securities such as Treasury Bills. In this case,
it is called a repo rate.
Or, it is the overnight interest rate set in the Central Bank funds
market, at which banks can borrow or lend Central Bank funds so as
to meet their reserve requirements (e.g. US, Japan) with the Central
Bank. It is called the Fed Funds rate in the United States and the
unsecured overnight call rate in Japan.
The two types of interest rates, which both exist in each of the
above-mentioned countries, are very close to one another. The repo rate
being lower owing to the fact that the corresponding loan is collateralized
by a security.

Bonds
Role of the Central Bank: Setting Interest Rate

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This key interest rate then affects the whole spectrum of interest rates
that commercial banks set for their customers (borrowers and savers),
which in turn affects supply and demand in the economy, and finally the
level of prices.
The shorter the debt instrument, the greater its sensitivity to monetary
policy action. Indeed, medium-term and long-term debt instruments are
more sensitive to the market expectations of future monetary policy
actions than to the current Central Bank action itself.

Bonds
Treasury Bills
Treasury Bills (T-Bills) are Treasury securities with a maturity below or
equal to 1 year. They entail no default risk because they are backed by
the full faith and creditworthiness of the government.
They bear no interest rate and are quoted using the yield on a discount
basis or on a money-market basis depending on the country considered.
The liquidity of T-Bills may be biased by the so-called squeeze effect,
which means that the supply for these instruments is much lower than the
demand, because investors buy and hold them until maturity.
This phenomenon is particularly observable in the Euro market.

Bonds
Treasury Bills
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Yield on a discount basis.

The yield on a discount basis denoted by yd is computed as
F −P N
yd = ×
F n
where F is the face value, P the price, N the year-basis (360 or 365) and
n the number of calendar days remaining to maturity.
It is the yield calculation used in the Euro zone, in the United States
and in the United Kingdom.
The year-basis is 360 in the United States, can be 360 or 365 in the
Euro zone depending on the country considered, 365 in the United
Kingdom.
The yield on a discount basis can retrieve the T-bill price as
n
P = F × 1 − yd × .
N

Bonds
Treasury Bills
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Yield on a money-market basis.

The yield on a money-market basis denoted by ym is computed as
n 1
1 − yd × =
N 1 + ym × n
N
yd × N
ym = .
N − yd × n
The yield on a money-market basis can retrieve the T-bill price as
F
P= .
1 + ym × n
N
It is the yield calculation used in Japan where the year-basis is 365.

Bonds
Exercise
1 Compute on a discount basis the yield on a 90-day US T-bill with price
$9,800, and face value $10,000.
2 Compute the price of a US T-bill with maturity 28/03/2xx2 and a

discount yield of 1.64% as of 17/12/2xx1.
3 Compute the yield on a money-market basis on a 62-day Japan T-bill with

price 99 yens and face value 100 yens.
4 Compute the price of a French T-bill with maturity 07/03/2xx2 and a

money-market yield of 3.172% as of 17/12/2xx1.

Bonds
Answer

Bonds
Certificates of Deposit
Certificates of deposit are debt instruments issued by banks in order to
finance their lending activity. They entail the credit risk of the issuing
bank.
They bear an interest rate that can be fixed or floating, and that is paid
either periodically or at maturity with principal. Their maturity typically
ranges from a few weeks to three months, but it can reach several years.
They trade on a money-market basis. The price is computed using the
following equation
1 + c × nNc
P=F×
1 + ym × nNm
where c the interest rate at issuance, nc is the number of days between
issue date and maturity date, and nm is the number of days between
settlement and maturity.

Bonds
Bankers Acceptances
Bankers acceptances are drafts that are drawn and accepted, and
therefore guaranteed by banks. These bills of exchange mainly guarantee
foreign trade transactions.
They bear no interest rate. So, the market price of a bankers acceptance
is calculated in the same manner as the price of a T-Bill.
They trade on a discount basis in the United States and on a
money-market basis in the Euro area.
Its discount or money-market yield accounts for the credit risk that
neither the importer nor the bank honor their commitment.

Bonds
Commercial Papers
Commercial papers are unsecured short-term debt securities issued by
corporations including industrial and financial companies. They entail the
credit risk of the issuing entity.
They are slightly riskier than bankers acceptances as the latter are
guaranteed by the accepting bank beside the guarantee of the issuing
company.
Corporations typically use them either as a way of raising short-term
funds or as interim loans to finance long-term projects while awaiting
more attractive long-term capital market conditions, which is called
bridge financing. Commercial papers are usually rolled over by the
issuing corporation until reaching its lending horizon.
They bear no interest rate. So, the market price of a commercial paper is
calculated in the same manner as the price of a T-Bill. Their maturity
ranges from 2 to 270 days.
They trade on a discount basis in the United States and on a
money-market basis in the Euro area.

Bonds
Repo & Reverse Repo Market Instruments

Repurchase (repo) and reverse repurchase (reverse repo) agreement
transactions are commonly used by traders and portfolio managers to
finance either long or short positions (usually in government securities).
A repo is a means for an investor to lend bonds in exchange for a
loan of money. More precisely, a repo agreement is a commitment by
the seller of a security to buy it back from the buyer at a specified
price and at a given future date. It can be viewed as a collateralized
loan, the collateral here being the security.
A reverse repo is a means for an investor to lend money in exchange
for a loan of securities. A reverse repo agreement is a repo
transaction viewed from the buyers perspective.
The repo rate is computed on an Actual/360 day-count basis.
When the maturity of the loan is 1 day, the repo is called an overnight
repo. When the maturity exceeds 1 day, the repo is called a term repo.

Bonds
Example of a Repo Transaction

Suppose an investor lends EUR 1 million of the 10-year Bund benchmark bond
(i.e., the Bund 5% 04/07/2x11 with a quoted price of 104.11, on 29/10/2x01)
over 1 month at a repo rate of 4%. There is 117 days accrued interest as of
the starting date of the transaction.
At the beginning of the transaction, the investor will receive an amount of
cash equal to the gross price of the bond times the nominal of the loan,
i.e.,
(104.11 + 5 × 117 ÷ 360)% × EUR 1, 000, 000 = EUR 1, 057, 350.00.
At the end of the transaction, in order to repurchase the securities he will

pay the amount of cash borrowed plus the repo interest due over the
period, i.e.,
EUR 1, 057, 350 × (1 + 4% × 30 ÷ 360) = EUR 1, 060, 874.50.

Bonds

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From an investment point of view, the repo market offers several opportunities:
The opportunity of contracting less expensive loans than traditional bank
loans (because repo loans are secured loans).
The opportunity of investing in a very liquid short-term market.
The opportunity of investing cash over tailor-made horizons, by rolling
over either several overnight transactions or different repo transactions
with various maturity horizons. This is particularly attractive for an
investor who has a short-term undefined horizon. It allows him to avoid
the price risk he would incur if he had chosen to invest in a money-market
security.
The opportunity for a buy-and-hold investor of putting idle money to
work. Indeed, by lending the securities he owns in his portfolio, he receives
some cash that he can invest in a money market instrument. His gain will
be the difference between the money-market income and the repo cost.

Bonds

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The opportunity to take short positions that enable portfolio managers to

construct alternative strategies by combining long and short positions.
For a short-term investor with an unknown investment horizon, the
strategy of buying a money-market security and the strategy of rolling
over cash on the repo market do not entail the same interest-rate risk.
The former bears the risk that the security may be sold before its maturity
date (price risk) at an unknown price, while the latter bears the risk that
the cash may be reinvested at an unknown repo rate (reinvestment risk).

Other Risk
Risks of Fixed-Income Securities

The risks associated with investing in fixed-income securities include:
Interest rate or market risk.
Yield curve risk.
Volatility risk.
Reinvestment risk.
Call risk.
Prepayment risk.
Credit risk.
Default risk, downgrade risk and credit spread risk.
Inflation or purchasing power risk.
Currency or exchange rate risk.
Liquidity or marketability risk.

Other Risk
Risks of Fixed-Income Securities

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Event risk.
Corporate takeovers, restructuring or regulatory changes.
Country or sovereign risk.
Risk risk.

Other Risk
Interest Rate or Market Risk

The price of a fixed-income security will change in the opposite direction
to the change in interest rates or yields.
Consider a 20-year bond with 6% semi-annual coupon. If the yield
investors require to buy this bond is 6%, the price of this bond would
be $100.
However, if the required yield increased to 6.5%, the price of this
bond would decline to $94.4479. Thus, for a 50 basis point increase
in yield, the bonds price declines by 5.55%.
If, instead, the yield declines from 6% to 5.5%, the bonds price will
rise by 6.02% to $106.0195.
The risk that an investor faces is that the price of a bond held in a
portfolio will decline if market interest rates rise.
This risk is referred to as interest rate risk or market risk, and is the major
risk faced by investors in the fixed-income market.

Other Risk
Relationship between Interest Rates & Price

The price of a bond changes in the opposite direction to the change in
interest rates. So, for an instantaneous change in interest rates the
following relationship holds:
if interest rates increase, price of a bond decreases;
if interest rates decrease, price of a bond increases.
A bond will trade at a price equal to par when the coupon rate is equal to
the yield required by market.
A bond will trade at a price below par (sell at a discount) or above par
(sell at a premium) if the coupon rate is different from the yield required
by the market.

Other Risk
Bond Features that Affect Interest Rate Risk

A bond’s price sensitivity to changes in market interest rates depends on various
features of the issue, such as maturity, coupon rate, and embedded options.
The longer a bond’s maturity, the greater the bond’s price sensitivity to
changes in interest rates.
The lower the coupon rate, the greater the bond’s price sensitivity to
As interest rates decline, the price of a callable bond may not increase as
much as an otherwise option-free bond.
The higher a bond’s yield, the lower the bond’s price sensitivity to

Other Risk
Measuring Interest Rate Risk

What we are interested in is a first approximation of how a bond’s price
will change when interest rates change.
We can look at the price change in terms of
the percentage price change from the initial price or;
the dollar price change from the initial price.
The duration of a bond refers to the estimate of the percentage price
change in the its price for a 100 basis points change in its yield.
It is important to note that the computed duration of a bond is only as
good as the valuation model used to get the prices when the yield is
shocked up and down. If the valuation model is unreliable, then the
duration is a poor measure of the bond’s price sensitivity to changes in
yield.

Other Risk
Yield Curve Risk

There is a structure of interest rates and not just one interest rate or yield
in the economy. One important structure is the relationship between yield
and maturity. The graphical depiction of this relationship is called the
yield curve.
When interest rates change, they typically do not change by an equal
number of basis points for all maturities. In other words, the changes in
the yield curve may not be confined to parallel shifts.

Other Risk
Parallel Shift in the Yield Curve

Other Risk
Non-Parallel Shift in the Yield Curve

Other Risk
Yield Curve Risk

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Fixed-income securities have different exposures to how the yield curve

shifts. This risk exposure is called yield curve risk.
The implication is that any measure of interest rate risk that assumes that
the interest rates changes by an equal number of basis points for all
maturities (referred to as a “parallel yield curve shift”) is only an
approximation.
The yield curve is a series of yields, one for each maturity. It is possible to
determine the percentage change in the value of a portfolio if only one
maturity’s yield changes while the yield for all other maturities is
unchanged. This is a form of duration called rate duration, where the
word ”rate” means the interest rate of a particular maturity.
Consequently, there is not one rate duration but a rate duration for each
maturity.

Other Risk
Yield Curve Risk

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In practice, a rate duration is not computed for all maturities. Instead, the
rate duration is computed for several key maturities on the yield curve and
this is referred to as key rate duration. Key rate duration is therefore
simply the rate duration with respect to a change in a “key” maturity
sector.
Vendors of analytical systems report key rate durations for the maturities
that in their view are the key maturity sectors.

Other Risk
Volatility Risk
Volatility risk is the risk of a change in the price of a bond as a result of
changes in the interest rate volatility.
For bonds with embedded options, changes in expected volatility have
effects on the values of their options.
For a callable bond, if expected yield volatility increases, the price of
the embedded call option will increase. As a result, the price of a
callable bond will decrease (because the former is subtracted from
the price of the option-free bond).
For a putable bond, if expected yield volatility decreases, the price of
the embedded put option will decrease. Therefore, the price of a
putable bond will decrease.

Other Risk
Reinvestment Risk
Reinvestment risk is the risk that the proceeds received from the payment
of interest and principal (i.e., scheduled payments and principal
prepayments) that are available for reinvestment must be invested at a
lower interest rate than the security that generated the proceeds.
Reinvestment risk is present when an investor purchases a callable
bond. When the issuer calls a bond, it is typically done to lower the
issuers interest expense because interest rates have declined after the
bond is issued. The investor faces the problem of having to reinvest
the called bond proceeds received from the issuer in a lower interest
rate environment.
Reinvestment risk also occurs when an investor purchases a bond
and relies on the yield of that bond as a measure of return. For the
yield computed at the time of the bond purchase to be realized, the
investor must be able to reinvest any coupon payments at the
computed yield.

Other Risk
Call Risk & Prepayment Risk

For an investor in callable bond, there are at least three disadvantages to
call provisions:
The cash flows of a callable bond is not known with certainty
because it is not known when the bond will be called.
Because the issuer is likely to call the bonds when interest rates have
declined below the bonds coupon rate, the investor is exposed to
reinvestment risk.
The price appreciation potential of the callable bond will be reduced
relative to an otherwise comparable option-free bond.
These disadvantages faced by the investor in a callable bond is said to
expose the investor to call risk.
The same disadvantages apply to mortgage-backed and asset-backed
securities where the borrower can prepay principal prior to scheduled
principal payment dates. This risk is referred to as prepayment risk.

Other Risk
Credit Risk
An investor who lends funds by purchasing a bond issue is exposed to credit
risk. There are three types of credit risk:
1 default risk,
2 credit spread risk, and
3 downgrade risk.

Other Risk
Default risk
Default risk is defined as the risk that the issuer will fail to satisfy the
terms of the obligation with respect to the timely payment of interest and
principal.
The percentage of a population of bonds that is expected to default is
called the default rate.
If a default occurs, this does not mean the investor loses the entire
amount invested. An investor can expect to recover a certain percentage
of the investment. This is called the recovery rate.
Given the default rate and the recovery rate, the estimated expected loss
due to a default can be computed.

Other Risk
Credit Spread Risk

The yield on a bond is made up of two components: (1) the yield on a
similar default-free bond issue and (2) a premium above the yield on a
default-free bond issue necessary to compensate for the risks associated
with the bond. The risk premium is referred to as a yield spread.
The part of the risk premium or yield spread attributable to default risk is
called the credit spread.
The price performance of a non-Treasury bond issue and the return over
some time period will depend on how the credit spread changes. If the
credit spread increases, investors say that the spread has “widened” and
the market price of the bond issue will decline (assuming U.S. Treasury
rates have not changed).
The risk that an issuer’s debt obligation will decline due to an increase in
the credit spread is called credit spread risk.

Other Risk
Downgrade Risk
Investors may gauge the default risk of an issue by its credit ratings
assigned to the issue by rating agencies.
A credit rating is an indicator of the potential default risk associated
with a particular bond issue or issuer. It represents in a simplistic
way the credit rating agencys assessment of an issuers ability to meet
the payment of principal and interest in accordance with the terms of
the indenture.
Once a credit rating is assigned to a debt obligation, a rating agency
monitors the credit quality of the issuer and can reassign a different credit
rating.
An improvement in the credit quality of an issue or issuer is rewarded
with a better credit rating, referred to as an upgrade.
A deterioration in the credit rating of an issue or issuer is penalized
by the assignment of an inferior credit rating, referred to as a
downgrade.

Other Risk
Downgrade Risk
(Continue)
An unanticipated downgrading of an issue or issuer increases the credit

spread and results in a decline in the price of the issue or the issuer’s
bonds. This risk is referred to as downgrade risk and is closely related to
credit spread risk.
A popular tool used by managers to gauge the prospects of an issue being
downgraded or upgraded is a rating transition matrix. This is simply a
table constructed by the rating agencies that shows the percentage of
issues that were downgraded or upgraded in a given time period.

Other Risk
One-Year Rating Transition Matrix

Other Risk
Inflation or Purchasing Power Risk

Inflation or purchasing power risk arises from the decline in the value of a
security’s cash flows due to inflation, which is measured in terms of
purchasing power.
Except for inflation protection bonds, a bond investor is exposed to
inflation risk because the interest rate the issuer promises to make is
fixed for the life of the issue.

Other Risk
Currency or Exchange Rate Risk

A bond whose payments are not in the domestic currency of the portfolio
manager has unknown cash flows in her domestic currency. The cash
flows in the manager’s domestic currency are dependent on the exchange
rate at the time the payments are received from the issuer.
The risk of receiving less of the domestic currency when investing in a
bond issue that makes payments in a currency other than the manager’s
domestic currency is called exchange rate risk or currency risk.

Other Risk
Liquidity or Marketability Risk

When an investor wants to sell a bond prior to the maturity date, she is
concerned with whether or not the bid price from broker/dealer is close to
the indicated value of the issue.
Liquidity or marketability risk is the risk that the investor will have to sell
a bond below its indicated value, where the indication is revealed by a
recent transaction.
The primary measure of liquidity is the size of the spread between the bid
price (the price at which a dealer is willing to buy a security) and the ask
price (the price at which a dealer is willing to sell a security).
The wider the bid-ask spread, the greater the liquidity risk.
A liquid market can generally be defined as one where there are small
bid-ask spreads which do not materially increase for large
transactions.
Bid-ask spreads, and therefore liquidity risk, change over time. Changing
market liquidity is a concern to portfolio managers who are contemplating
investing in new complex bond structures.

Other Risk
Liquidity or Marketability Risk

(Continue)
An institutional investor who plans to hold an issue to maturity but is

periodically marked-to-market is concerned with liquidity risk. By marking
a position to market, the security is revalued in the portfolio based on its
current market price.
Typically, a portfolio manager will solicit bids from several
broker/dealers and then use some process to determine the bid price
used to mark (i.e., value) the position. The less liquid the issue, the
greater the variation there will be in the bid prices obtained from
broker/dealers. With an issue that has little liquidity, the price may
have to be determined from a pricing service (i.e., a service company
that employs models to determine the fair value of a security) rather
than from dealer bid prices.
For investors who plan to hold a bond until maturity and need not
mark the position to market, liquidity risk is not a major concern.

Other Risk
Event Risk
The ability of an issuer to make interest and principal payments may
change dramatically and unexpectedly because of factors including the
following:
1 a natural disaster (such as an earthquake or hurricane) or an
industrial accident that impairs an issuer’s ability to meet its
obligations;
2 a take over or corporate restructuring that impairs an issuer’s ability
to meet its obligations; and
3 a regulatory change.
These factors are commonly referred to as event risk.
The first type of event risk results in a credit rating downgrade of an issuer
by rating agencies and is therefore a form of downgrade risk. However,
downgrade risk is typically confined to the particular issuer whereas event
risk from a natural disaster usually affects more than one issuer.
The second type of event risk also results in a downgrade and can also
impact other issuers.

Other Risk
Event Risk
(Continue)
The third type of risk listed above is regulatory risk. This risk comes in a
variety of forms.
1 Regulated entities include investment companies, depository
institutions, and insurance companies. Regulation of these entities is
in terms of the acceptable securities in which they may invest and/or
the treatment of the securities for regulatory accounting purposes.
2 Changes in regulations may require a regulated entity to divest itself
from certain types of investments. A flood of the divested securities
on the market will adversely impact the price of similar securities.

Other Risk
Country or Sovereign Risk

When an investor acquires a bond issued by a foreign entity, the investor
faces country or sovereign risk.
This is the risk that, as a result of actions of the foreign government,
there may be either a default or an adverse price change even in the
absence of a default.
This is analogous to the forms of credit risk.
Even if a foreign government does not default, actions by a foreign
government can increase the credit risk spread sought by investors or
increase the likelihood of a downgrade. Both of these will have an
adverse impact on a bond’s price.

Other Risk
Country or Sovereign Risk

(Continue)
Sovereign risk consists of two parts.

First is the unwillingness of a foreign government to pay. A foreign
government may simply repudiate its debt.
The second is the inability to pay due to unfavorable economic
conditions in the country.
Historically, most foreign government defaults have been due to a
government’s inability to pay rather than unwillingness to pay.

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Global Capital Market

Fixed Income Securities and Markets

MFE8812 Bond Portfolio Management

Nanyang Business School

January 16, 2018

1 / 126 William C. H. Leon MFE8812 Bond Portfolio Management

Global Capital Market

1 Global Capital Market

2 Fixed Income Securities and Markets

3 Risks Associated with Fixed-Income Investments

2 / 126 William C. H. Leon MFE8812 Bond Portfolio Management

3 / 126 William C. H. Leon MFE8812 Bond Portfolio Management

Global Capital Market

Global Market Capitalization of Debt & Stock

4 / 126 William C. H. Leon MFE8812 Bond Portfolio Management

Reasons for Diﬀerences in Market Capitalization

5 / 126 William C. H. Leon MFE8812 Bond Portfolio Management

Global Capital Market

6 / 126 William C. H. Leon MFE8812 Bond Portfolio Management

Global Financial Stock

7 / 126 William C. H. Leon MFE8812 Bond Portfolio Management

Global Capital Market

8 / 126 William C. H. Leon MFE8812 Bond Portfolio Management

Growth in Global Debt

9 / 126 William C. H. Leon MFE8812 Bond Portfolio Management

Global Capital Market

10 / 126 William C. H. Leon MFE8812 Bond Portfolio Management

Growth of Total Public Debt

Global Capital Market

12 / 126 William C. H. Leon MFE8812 Bond Portfolio Management

Growth of Public Debt Among Countries

13 / 126 William C. H. Leon MFE8812 Bond Portfolio Management

Global Capital Market

14 / 126 William C. H. Leon MFE8812 Bond Portfolio Management

Non-Financial Corporate Bond Issuance

15 / 126 William C. H. Leon MFE8812 Bond Portfolio Management

Global Capital Market

Non-Financial Corporate Bond Issuance

There is still signiﬁcant room for further growth in corporate bond

16 / 126 William C. H. Leon MFE8812 Bond Portfolio Management

17 / 126 William C. H. Leon MFE8812 Bond Portfolio Management

Global Capital Market

Growth of On-Balance-Sheet Loans

19 / 126 William C. H. Leon MFE8812 Bond Portfolio Management

Global Capital Market

Issuance of Securitized Assets

20 / 126 William C. H. Leon MFE8812 Bond Portfolio Management

Issuance of Securitized Assets

Future prospects in the securitization market are unclear.

21 / 126 William C. H. Leon MFE8812 Bond Portfolio Management

Global Capital Market

22 / 126 William C. H. Leon MFE8812 Bond Portfolio Management

23 / 126 William C. H. Leon MFE8812 Bond Portfolio Management

Global Capital Market

24 / 126 William C. H. Leon MFE8812 Bond Portfolio Management

Terminology & Convention: Forms of Bond

25 / 126 William C. H. Leon MFE8812 Bond Portfolio Management

Global Capital Market

Terminology & Convention: Bond Issuers

26 / 126 William C. H. Leon MFE8812 Bond Portfolio Management

Terminology & Convention: Bond Issues

27 / 126 William C. H. Leon MFE8812 Bond Portfolio Management

Global Capital Market

Dirty Price = CleanPrice + AccruedInterest