FI NN 6211

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Lecture1
Introductionto
Fixed Income Securities FixedIncomeSecurities
FINN6211
OutlineofLecture
Thispurposeofthislectureistoprovide
youwithanintroductiontofixedincome
markets.Inparticularwediscuss:
Whystudyfixedincomesecurities
Whatismeantbyfixedincome
FixedIncomeTerminology
Whatarethemajorfixedincomemarketsand
theuniquefeaturesofinstrumentsineach
market
RisksinFixedIncomeSecurities
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WhyStudyFixedIncomeSecurities?
Twothirds ofthemarketvalueofallsecuritiesthat
areoutstandingintheworldareclassifiedasfixed
incomesecurities.
Mostparticipantsincorporateandfinancialsectors
ti i t i th fi d i iti k t t participateinthefixedincomesecuritiesmarketto
varyingdegrees.Forexample:
Corporationsissuecommercialpaper.
CorporationsinvestinTreasurybonds.
Governmentandmunicipalsissuedebt.
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DebtSecuritiesMarket
Issuers
FinancialIntermediaries
Investors
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IssuersofDebtSecurities
Governmentsandagencies
Corporations
CommercialBanks
StatesandMunicipals
SpecialpurposeVehicles
ForeignInstitutions
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ObjectivesofIssuers
Tosellsecuritiesatafairvalue
Toissuedebtsecuritiesthatbestsuittheir
needs
h li id d k i h i Tohaveliquidsecondarymarketsintheir
securities
Tohaveflexibilityinmodifyingtheirsecurities
afterissuance
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FinancialIntermediaries
Primarydealers
Investmentbanks
Creditratingagencies
Creditandliquidityenhancers
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ObjectivesofFinancialIntermediaries
Marketmakingactivitiesintheprimary
market:auction,underwriting,and
distribution
Liquid secondary market Liquidsecondarymarket
Riskmanagementandassetliability
management
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Investors
Governments
Pensionfunds
Insurancecompanies
Mutualfunds
Commercialbanks
Foreigninstitutions
Retailinvestors
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ObjectivesofInvestors
Diversification
Buysecuritieswithariskreturnprofilethat
bestfitstheirneeds
G i f i di i Getinformationoncreditrating
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11
Source: Fixed Income Securities: Tools for Todays Markets, Tuckman 3e, 2011, Wiley.
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Source: Fixed Income Securities: Tools for Todays Markets, Tuckman 3e, 2011, Wiley.
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WhatisaFixedIncome Security?
Whenwesayfixed income,wemeanthemarket
fordebt,anddebtrelatedinstruments.
Duetofinancialinnovation,itisnotalwaysclearif
agivensecurityshouldbeclassifiedasafixed
incomesecurity.
Thedefiningcharacteristicoftheseinstrumentsis
thattherearewelldefinedrulesfortheschedule
ofpayouttotheholderandthesepayoutsare
contractual(i.e.,legallybinding)obligationsofthe
issuer.
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WhatisaFixedIncome Security?
Inparticular,adebtinstrumentrequiringtheissuer(debtoror
borrower)torepaythelender(investororholder)theamount
borrowedandinterestoveraspecifiedperiodoftime.
Inthecorporatecontext,holdersoffixedincomeobligations
takepriorityoverequityholderswithrespecttoafirmscash
flows flows.
Ifafirmdefaultsonabond,thebondholdersgenerallyhave
therighttotakeoverthefirm,gainingownershipfromthe
equityholders.
Agencyconflictsarisewhenequityholderstakeactionsthat
reducethevalueofabond,withouttriggeringdefault,suchas
takingonadditionalriskafterissuingabond.
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WhatisaFixedIncome Security?
Abulletsecurityisgenerallyanyinstrument
thathasafixedcoupon,fixedmaturity,andno
callprovisionsorotheroptions.
Mostfixedincomesecuritiestradeindealers
marketviaanOTC(overthecounter)system,
whichisessentiallyaseriesofcomputerand
phonenetworksamongdealersandbrokers.
FewaretradedonexchangessuchastheNYSE.
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FixedIncomeTerminology
Mainelementsonadebtinstrument:
Maturity(short,intermediate,andlong)
Principalorfacevalueorparvalue
Issuer
coupon and coupon payment dates couponandcouponpaymentdates
zeros
floatersandinversefloaters
deferredcouponbonds(LBOandrecapitalization):
deferredinterest;stepup,paymentinkind,coupon
reset.
Amortizingversusnonamortizinginstruments
frequencyofcouponpayments
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FixedIncomeTerminology
Mainelementsofabond(continued)
Covenants(e.g.,dividendrestriction)
Provisions(e.g.,sinkingfund)
Options Options
Call
Put
Conversion
Exchangeableoption
couponsandprincipalpaidindifferentcurrencies
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FixedIncomeTerminology
Mostbonds(althoughnotall)haveaspecified
maturity date,ortimetomaturity.
Theparamount istheface valueofthebond i.e.
theprincipalamountofthebond.
The coupon rate on a fixed income security is used Thecouponrate onafixedincomesecurityisused
solelytodeterminetheperiodiccashflows(coupon
payments)madetothebondholder.
Mostbondspayinterestonanannual,semiannual
orquarterlybasis.Manymortgagerelatedbonds,
however,payinterestonamonthlybasis.
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TypicalCashFlowPattern TypicalCashFlowPattern
couponrate2.125%,facevalue$1,000,000 couponrate2.125%,facevalue$1,000,000
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Source: Fixed Income Securities: Tools for Todays Markets, Tuckman 3e, 2011, Wiley.
FixedIncomeTerminology
Theyield onafixedincomesecurityistherateof
returnonabondgiventheperiodiccashflowsand
thecurrentprice.
Bondsusuallytradeatapricethatisdifferentfrom
the par amount (at a premium if higher than par; at theparamount(atapremium ifhigherthanpar;at
adiscount iflowerthanpar).Theyieldandthe
couponratearethesameonlyifthebondis
purchasedatpar.
Onebasispoint is1/100
th
ofapercentagepoint,i.e.
1basispoint(1bp)=.0001.
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SelectedTreasuryBondPrices SelectedTreasuryBondPrices
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Source: Bloomberg, May 19, 2012
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SelectedTreasuryBondPrices SelectedTreasuryBondPrices
Pricesarepresentedasapercentoffacevalue; Pricesarepresentedasapercentoffacevalue;
numberafterhyphenisin32nd,orcalled numberafterhyphenisin32nd,orcalledticks ticks..
Forexample: Forexample:
1.75%coupon,5/15/22maturitybond,priceis 1.75%coupon,5/15/22maturitybond,priceis
3.00%coupon,5/15/42maturitybond,priceis(+means 3.00%coupon,5/15/42maturitybond,priceis(+means
halfatick) halfatick)
% 25 . 100 %
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8
100 08 100 =
(

+
22
% 890625 . 103 %
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5 . 28
103 28 103 =
(

+ +
FixedIncomeTerminology
Theindenture isthecontract(awritten
agreementbetweentheissuerand
bondholder)thatsetforththepromisesofa
corporatebondissuerandtherightsofthe
investors,usuallyspecifyingthecouponrate,
maturity date options covenants provisions maturitydate,options,covenants,provisions,
andotherterms.
Thebondcovenants specifytheexact
contractualrulesandrestrictions.
Oftenathirdparttrusteewillhavethe
responsibilityforinterpretingandapplyingthe
bondcovenants.
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FixedIncomeTerminology
Absolutepriorityrules(APR) thecontractual
rulesunderwhichthebondholdersarepaidin
theeventofabankruptcy.
Incaseofreorganization/bankruptcy,itisvery
common for the bondholders to agree to commonforthebondholderstoagreeto
deviationsfromthisinordertonegotiatea
betterdealwiththemanagers/equityowners
ofthefirmortoabidebythecourtsdecisions.
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FixedIncomeTerminology
Manycorporatebondswillhaveasinkingfund
provision.Thisisanagreementwhichrequires
thatthebondissuerperiodicallyretirea
specifiedportionofthebondissuance.
Somebonds,especiallythoseoflowercredit , p y
qualityissuers,willrequireareservefund,
whichrequiresthatthefirmbegingradually
placingfundsintoanaccounttoguaranteethe
ultimaterepaymentoftheprincipal.
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FixedIncomeTerminology
Somebondswillcomewiththirdparty
guarantees thatinsurethatthebondholders
willreceivetheprincipalsum.
Acalloption enablestheissuertoredeemthe
b d i i Th i i bondspriortomaturity.Theprovision
specifiesthecallschedule(astepdown
schedule)containingthepricesandtimesof
theredemptioniftheissuerchooseto
exercisethecall.
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FixedIncomeTerminology
Aputable bondisoneinwhichtheholderhas
therighttosellthebondbacktotheissuer
usuallyatpar.
Aconvertible bondisoneinwhichthe
bondholdercancoverttheirdebttoafixed
numberofcommonequityshares.
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FixedIncomeTerminology
Aexchangeable bondisoneinwhichthe
bondholdercancoverttheirdebttoafixed
numberofcommonequitysharesofthe
companyotherthantheissuer.
The coupon and principal payments may be Thecouponandprincipalpaymentsmaybe
structuredtobepaidindifferentcurrencies
(dualcurrencybonds).Forexample,coupon
paymentsarepaidinJapaneseyenand
principalinU.S.dollars.
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FixedIncomeTerminology
Municipalbondshaveanumberofinteresting
features.Therearetwobasictypesof
municipalbonds:
GeneralObligationBonds(GOBs) The
governments taxation authority supports the government staxationauthoritysupportsthe
bond.
Revenuebonds revenuefromaspecificproject
isusedtopaythebondsdown.Itisverycommon
forhighways,bridges,hospitals,industrialparksto
bepaidforthisway.
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MajorFixedIncomeMarketSectors
SovereignDebt Debtissuedbyanationalgovernment.
USTreasury,U.K.Gilts,etc.
AgencySecurities Debtissuedbyquasigovernmental
entities.
CorporateSecurities Debtissuedbycorporations. p y p
Municipals debtissuedbycities,localgovernments.
MortgagebackedSecurities(MBS) Debtbackedsolely
byapoolofunderlyingmortgages.
AssetbackedSecurities Debtthatisbackedbyassets,
suchascreditcards,carloans,studentloans,etc.
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TreasuryMarket
Securitiesarebackedbythefullfaithandcreditof
USgovernment.
Securitiesareoftenviewedastheworldbenchmark
forliquidityandquality(defaultfree!)
M t tl i d T iti ll d MostrecentlyissuedTreasurysecuritiesarecalled
ontherun securities,whicharethemostliquid.
Ontherun issuesbecomeofftherun oncethe
Treasuryannouncesanewissue.Offtherun
issuesarestillliquid,buttheymaynotactuallytrade
eachday.
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TreasuryMarket TreasuryMarket
Source: The Bureau of the Public Debt, April 30, 2012
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TreasuryMarket
TreasuryBillsandNotespayinterestona
semiannualbasis.
Theflatprice (orthecleanprice)isthe
quotedprice,anddoesnotincludethe q p ,
accruedinterest.
Theinvoiceprice (orthecashpriceorthe
dirtyprice)isthesumoftheflatpriceandthe
accruedinterest.
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Treasury Yield Curve Treasury Yield Curve
*Bloomberg, as of January 9, 2012
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Source: Bloomberg, May 19, 2012
OtherSovereignMarkets
Canada
Typicallybulletloans,230years.
Britain
StandardGilts:bulletloans.
Indexlinked:inflationlinkedbonds.
Irredeemablegilts:perpetualbonds(thatmaybecalled
atpar.)
Japan
Largemarket,quotedonsimpleyieldbasis,typically
issuesbulletbonds.Callableatanytime.
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36
Source: Fixed Income Securities: Tools for Todays Markets, Tuckman 3e, 2011, Wiley.
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AgencyMarket
GovernmentSponsoredEnterprises(GSEs)are
privatecompaniesthattheFederal
governmentimplicitlyguarantees.
MostwellknownareFannieMaeandFreddie
Mac.
Theseagenciesissueregulardebtaswellas
securitiesbackedbymortgages(orassets).
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AgencyMarket
MajorAgencies
FederalHomeLoanBank(FHLB)
FederalNationalMortgageAssociation(FNMA)
FederalHomeLoanMortgageCorporation
(FHLMC)
TennesseeValleyAuthority(TVA)
StudentLoanMarketingAssociation(SLMA)
FarmCreditSystem(FCS)
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CorporateMarket
Corporatedebtismuchmorecomplexin
structureanddesignthanTreasuryand
agencysecurities.
Individualissuestendtobesmaller,liquidity , q y
anddefaultareseriousconcerns.
Bidaskspreadsarewideranddepthnarrower
duetoliquidityconcerns.
Defaultriskisnontrivial,thereforetheroleof
ratingagenciesareimportant.
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CorporateMarket
Threeprimarycategoriesofdebt:
Moneymarketinstruments lessthan1year
maturity,suchascommercialpapers.
Medium Term notes maturity ranging from 1 MediumTermnotes maturityrangingfrom1
yearto30years,flexibleissuancescheduleasthey
areshelfregistered.
Corporatebonds/notes usuallylongerthan5
yearsmaturity.
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CorporateMarket
Somekeyterms:
CommercialPaper Shorttermdiscountnotes,
thatifunder270daystermrequirenoSEC
registration.
Shelfregistration SEC allows a firm to file a Shelf registration SECallowsafirmtofilea
singleregistrationthatisgoodfor3years,
allowingthemtothenissuemultiplebondsunder
thatregistration.
Highyieldbonds Thesocalledjunkbonds,quite
popularinthebuyoutactivities.
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MortgageBackedMarket
ThebasicstepsforFannie/Freddietocreatea
MBS:
1. Banks/Brokers/MortgageCompaniesoriginate
mortgages.
2. OriginatorssellloanstoFannie/Freddie.
3 Fannie/Freddie pay originators to service loans on 3. Fannie/Freddiepayoriginatorsto service loanson
theirbehalf.
4. Fannie/Freddiepoolsloanstoformamortgagepool.
5. Fannie/Freddiesellsbondsbackedbythispool.
6. Allcashflowsgeneratedbypoolofloansispassed
through proportionatelytotheownersoftheMBS.
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MortgageBackedMarket
FannieMaeandFreddieMacguaranteethatif
theborrowersdefault,theMBSinvestorswill
receiveallinterestandprincipal.
FannieMaeandFreddieMachaveminimum
underwriting standards for loans they will underwritingstandardsforloanstheywill
purchaseandputintopools.
MBSaretradedinanactivesecondarymarket.
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AssetBackedMarket
ThesuccessoftheMBSmarkethasspurred
therapiddevelopmentofothersecuritized
markets,including:
Carloans
Creditcardsreceivables
Homeequityloans
Studentloans
Equipmentleases
Hospitalbillreceivables
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RisksinBonds
Interestraterisk
Reinvestmentrisk
Defaultrisk
Inflationrisk
Exchangeraterisk g
Liquidityrisk
Volatilityrisk
Callrisk
Yieldcurverisk
Eventrisk
RiskRisk
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