FIxed Income Presentation

Fixed Income : Valuation and Analysis
Christophe Dispas
Fundamentals
What is a bond?
Fundamentals  Debt of a borrower (issuer) towards a lender (bondholder)
 Financial obligation
Time Value of
Money
 Stream of future cash flows :
 Interest payments
 Principal repayment
 Principal : legal structure different from its coupons
Fixed Income
Portfolio  Bond indenture
Management
Strategies
 Any assets a prior claim of creditors?
 Garantees and commitments?
Fixed Income : Valuation and Analysis- 2

Fundamentals
Coupon and principal
 Name – Coupon – Maturity

Fundamentals
 Face value :
 Total amount repaid at maturity
 Used to determine coupon payments
Time Value of
Money  Time to maturity
 Maturity date
Fixed Income  Coupon payment : coupon rate x face value

Portfolio
Management  Annually, semi-annually, …
Strategies
 Legal differences : expected return pre tax and after
tax

Fundamentals
Fundamentals
Time Value of
Money
Fixed Income
Portfolio
Management
Strategies

Fundamentals
Price quotes
Fundamentals  Market value
 Percentage of the face value

 US : in 32nds of a percent
Time Value of  Size of minimum price change
Money
Fixed Income
Portfolio
Management
Strategies

Fundamentals
Fundamentals
Time Value of
Money
Fixed Income
Portfolio
Management
Strategies

Fundamentals
Fundamentals
Time Value of
Money
Fixed Income
Portfolio
Management
Strategies

Fundamentals
Accrued interest
 To compare bonds => Clean price

Fundamentals
 Clean price = net of interest
 Buy or Sell : pro-rata basis of the coupon added to the

Time Value of
Money
clean price
 Dirty price = clean price + accrued interest
Fixed Income  Accrued interest =

Portfolio
Management
Principal x (Coupon rate/Nr. Coupons per year) x fractional coupon period
Strategies

Fundamentals
Accrued interest : use the right conventions
Coupon Frequency Accrued Interest
Government Bonds
Fundamentals USA Semi-annual Actual/Actual
Japan Semi-annual Actual/365
UK Semi-annual Actual/Actual
France Annual Actual/Actual
Germany Annual Actual/Actual

Time Value of
Netherlands Annual Actual/Actual
Money
Canada Semi-annual Actual/365
Australia Semi-annual Actual/Actual
Italy Semi-annual Actual/Actual
Corporate Bonds
Fixed Income USA Annual or Semi-annual 30/360
Portfolio
Management UK Semi-annual Actual/365 or
Actual/Actual *
Strategies
Eurobonds
Issued Annual 30/360
before 1/1/99 (some Semi-annual)
Issued Annual Actual/Actual
after 31/12/99 (some Semi-annual)

Fundamentals
Types of fixed income securities
 Straight bond
 Interest payments periodically
Fundamentals
 Principal at maturity
 Sinking-fund provision
 Sinker percentage : retire a portion of the
Time Value of
Money outstanding debt (sinker percentage), each year
 Callable bonds
 Issuer has the right to repurchase the bond at
Fixed Income call price, at call date
Portfolio
Management
 Protect issuer if interest rate drop
Strategies

Fundamentals
 Putable bonds : bondholder has the right

Fundamentals
 Bullet bonds : bonds that cannot be redeemed prior to
maturity
Time Value of
 Perpetual bonds : principal never redeemed
Money
 Zero-coupon bonds :
 Do not pay any interest
 Generally issued at large discount to the face value
Fixed Income
Portfolio
Management
 Stripped bonds :
Strategies  Zero-coupon bonds
 Artificially created from default risk free
government bonds

Fundamentals
 Income bonds :
 Pays interest only if profits of the issuing firm are
Fundamentals
adequate enough to pay interest
 A missed coupon is not a default
 Cumulative / non-cumulative
Time Value of
Money  Floating rate notes :
 Coupon adjusted periodically
 Depend on a base or benchmark rate
Fixed Income  Dual currency bonds :

Portfolio
Management
 Interest paid in one currency, principal in another
Strategies  Foreign interest payment securities
 Multiple currency clause bonds

Fundamentals
 Convertible bond :
Fundamentals  The holder can exchange the security for shares of
the company
 Terms set in the bond indenture (number of
shares, …)
Time Value of
Money
Fixed Income
Portfolio
Management
Strategies

Fundamentals
4 types of bonds based on the issuer :
 Domestic bonds :
 Domestic issuer
Fundamentals
 Usually in local currency
 Foreign bonds :
Time Value of
 Foreign issuer
Money  Local market
 Usually local currency
 Eurobonds :
Fixed Income  Multinational syndicate
Portfolio
Management
 All countries other than the one in whose currency
Strategies the bond is denominated
 Trade in the international marketplace
 Global Bonds
Fundamentals
Money market instruments :
Fundamentals  Short term debt securities
 Maturities up to 12 months
Time Value of
Money
 Liquid
 Very large denominations
Fixed Income  Interest earned expressed on the bank discount basis

Portfolio
Management
Strategies

Fundamentals
Fundamentals  Treasury bills
 Discount with respect to the face value
Time Value of
Money
 Interest = face value – purchase price
 Competitive auction : bid is filled if price entered is

high enough (relative to other participants’ bid)
Fixed Income
Portfolio  Non-competitive auction : price is equal for all the
Management
Strategies
subscribers (marginal price or average price)
 Interest rate and credit risk very low

Fundamentals
 Commercial paper
Fundamentals
 Short term unsecured debt
 Issued by large and well-known companies

Time Value of
Money
 Usually guaranteed by a bank line of credit
 Rating
Fixed Income
Portfolio
Management
 Most frequent maturities : 1 or 2 months
Strategies
 Source of funds cheaper than the ordinary bank
borrowing

Fundamentals
 Bankers’ acceptance
Fundamentals
 Commercial bills of exchange whose credit risk

has been guaranteed by a bank
Time Value of
Money  Traded at a discount
 Accepting institution is obligated to pay
Fixed Income The bank receive a fee

Portfolio
Management
Strategies  Usually less risky than commercial paper

Fundamentals
 Certificate of deposit (CD)

Fundamentals
 Time deposit with a bank
 Usually a given period of time

Time Value of
Money
 Usually a fixed rate of interest, paid at maturity
 Cannot be withdrawn, but can be sold over the

Fixed Income secondary market
Portfolio
Management
Strategies

Fundamentals
Government bonds :
 Maturity higher than 1 year

Fundamentals
 US Government bonds :
 Treasury notes : up to 10 years

Time Value of
Money  Treasury bonds : 10 to 30 years
 Semi-annual coupon payments
 Government guaranteed : low credit risk
 Circulation is managed by Central Bank book-entry
Fixed Income form : no physical circulation
Portfolio
Management
Strategies

Fundamentals
Corporate securities
 Issued by private and public corporations

Fundamentals
 Usually, interest payments are semi-annual
 Bond indenture can be very specific and complex

Time Value of
Money
 Up to 10 years : notes; Over 10 years : bonds
 Classification based on the nature of the issuer :

Fixed Income traditional classification is sectorial
Portfolio
Management
Strategies

Fundamentals
Fundamentals
 Credit quality :
 Offer document
 Ratings
Time Value of
Money  Protection :
 Mortgage bonds
 Collateral trust bonds
 Senior claim
Fixed Income
Portfolio
Management
Strategies

Fundamentals
 Debenture bond : recovery rate is the same as general

creditors’ one (the claim is junior)
Fundamentals
 Subordinated debenture bonds :
 Rank after secured bonds in claim on corporate
earnings and assets
Time Value of
Money  Difference in protection = difference in yield
 Secured => ordinary => subordinated
Fixed Income
 Call provision
Portfolio
Management
Strategies  Sinking funds :
 Control the credit risk
 Balloon payment : amount remaining
 Accelerated sinking fund
Fundamentals
Indices
 General price performance of a group of bond issues

Fundamentals
 Broad-based market indices or sub-segments
Time Value of
 Brokers publish indices to sell tracking and
Money rebalancing services to investors
 Total return indices
Fixed Income  Non liquid bonds : fair price

Portfolio
Management
Strategies

Fundamentals
Indices
Fundamentals
Time Value of
Money
Fixed Income
Portfolio
Management
Strategies

Fundamentals
Indices
Fundamentals
Time Value of
Money
Fixed Income
Portfolio
Management
Strategies

Fundamentals
Indices
Fundamentals
Time Value of
Money
Fixed Income
Portfolio
Management
Strategies

Time value of money
 Present is certain, future not => to differ consumption

requires incentive : interest rate
Fundamentals
 Simple vs compound interest
 Simple interest = (initial value) . (interest rate) . (Nbr of years)

 Hypothesis : interest payments are not reinvested
Time Value of
Money
 Compound interest
 Interest is reinvested
Fixed Income  Compound interest =
Portfolio
Management
Strategies (initial amount) . [(1+ interest rate)nbr of years - 1]

Time value of money
 Simple interest
Fundamentals
Time Value of
Money
Fixed Income
Portfolio
Management
Strategies

Time value of money
 Simple interest
Fundamentals
Time Value of
1000 EUR . 0,07 . 10 = 700 EUR
Money
Fixed Income
Portfolio
Management
Strategies
1000 EUR . [(1+ 0,07)10 - 1] = 967,15 EUR

Time value of money
Present and future value
 Present value of future payment : discounting

Fundamentals
Time Value of
Money
Fixed Income
Portfolio
Management
Strategies

Time value of money
 Present value of future payment : discounting

Fundamentals
Time Value of
Money
Fixed Income
Portfolio
Management
Strategies

Time value of money
 Future value of a payment : compounding

Fundamentals
Time Value of
Money  Example :
100 000 EUR deposited in a bank account with 5%

Fixed Income
annual interest rate
Portfolio
Management End year 1 : 100 000 EUR . (1+ 0,05) = 105 000 EUR
Strategies
End year 2 : 105 000 EUR . (1 + 0,05) = 110 250 EUR
Equals : 100 000 EUR . (1+0,05)2

Time value of money
 High interest rate and long investment period lead to

Fundamentals
greater accumulation of compound interest
Example
Time Value of
Money
 1000 EUR, interest rate = 10,5%, 67 years
Fixed Income Simple interest : 1000 EUR + (1000 EUR . 0,105 . 67) = 8 035 EUR
Portfolio
Management
Strategies
Compound interest : 1000 EUR . (1+0,105)67 = 804 030,69 EUR

Time value of money
Annuities
 Fixed amount paid each year for a specified number of

years
Fundamentals
 Hypothesis :
Time Value of
First payment is received one year from now
Money
Fixed Income
Portfolio
Management
Strategies

Time value of money
Annuities
 Present value
Fundamentals
Time Value of
Money
 Future value
Fixed Income
Portfolio
Management
Strategies

Time value of money
Annuities
 Future value
Fundamentals
Time Value of
Money
Fixed Income
Portfolio
Management
Strategies

Time value of money
Continuous discounting and compounding
 Compounding can take place more than annually

Fundamentals
 Initial amount N invested at a rate R during n years :
Time Value of
Money
 When m tends to infinity :
Fixed Income
Portfolio
Management
Strategies

Time value of money
Fundamentals
Time Value of
Money
Fixed Income
Portfolio
Management
Strategies

Time value of money
Fundamentals
Time Value of
Money
Fixed Income
Portfolio
Management
Strategies

Time value of money
Bond yield measures
 Current yield
Fundamentals
Time Value of
Money
 The price is the clean price

 Bond’s current yield varies inversely with the
Fixed Income bond’s price
Portfolio
Management
Strategies

Time value of money
Bond yield measures
 Current yield
Fundamentals
 Not adequate to compare bonds
 Current yield of a zero-coupon bond is zero

Time Value of  Current yield of a bond under par decrease as
Money the bond approaches maturity
Fixed Income
Portfolio
Management
Strategies

Time value of money
Bond yield measures
 Yield to maturity
Fundamentals
 Discount rate that equals present value of future
cash flows and market price :
Time Value of
Money
Fixed Income
 Internal rate of return (IRR) of the investment in the
Portfolio bond
Management
Strategies

Time value of money
Bond yield measures
Fundamentals
Time Value of
Money
Fixed Income  Assumes bond is held to maturity

Portfolio
Management
 Cash flows are received as scheduled
Strategies  YTM is not the total return of a bond

Time value of money
Bond yield measures
Fundamentals
 From semi-annual to annual yield :
Time Value of
Money
 On a Euromarket :
Fixed Income
Portfolio
Management
Strategies
 On the US or English market :

Time value of money
Bond yield measures
Fundamentals
Time Value of
Money
Fixed Income
Portfolio
Management
Strategies

Time value of money
Bond yield measures
Fundamentals
Time Value of
Money
Fixed Income
Portfolio
Management
Strategies  With annual coupon : 4.72%

Time value of money
Bond yield measures
 Yield to maturity between two coupon payment dates

Fundamentals
 Accrued interest
 Total price = Market price + f . Coupon
 Usually, f = (nbr of days between last coupon and
Time Value of
Money today / nbr total of days between the two coupons)
Fixed Income
Portfolio
Management
Strategies

Time value of money
Bond yield measures

Fundamentals
 Adjusted formula :
Time Value of
Money
Fixed Income
Portfolio
Management
Strategies

Time value of money
Yield to maturity

Fundamentals
Time Value of
Money
Fixed Income
Portfolio
Management
Strategies  NB :
 With a financial calculator, the clean price is used
to compute

Time value of money
Yield to maturity

Fundamentals
Time Value of
Money
Fixed Income
Portfolio
Management
Strategies

Time value of money
Yield to maturity
 Influences on the yield to maturity : the coupon effect

Fundamentals
Time Value of
Money
Fixed Income
Portfolio
Management
=> Calculate bond prices
Strategies

Time value of money
Yield to maturity

Fundamentals
Time Value of
Money
Fixed Income
Portfolio
Management
Strategies => With these prices, calculate YTM

Time value of money
Yield to maturity

Fundamentals
Time Value of
Money
Fixed Income
Portfolio
Management
Strategies => YTM is an average of the spot rates

Time value of money
Yield to maturity

Fundamentals
Time Value of
Money
Fixed Income
Portfolio
Management
Strategies
YTM is an average of the spot rates

Time value of money
Yield to maturity

Fundamentals
Time Value of
Money
Fixed Income
Portfolio
Management
Strategies
 If R0,t are increasing, YTM will underestimate the

corresponding spot rate R0,T
Time value of money
Yield to maturity

Fundamentals
Time Value of
Money
Fixed Income
Portfolio
Management
Strategies
 Bias increase for larger coupon rates

Time value of money
Yield to maturity
Fundamentals
Time Value of
Money
Fixed Income
Portfolio
Management
Strategies

Time value of money
Bond yield measures
 Yield to call
Fundamentals
Time Value of
Money
 Assumes that the bond will be called
 Assumes that all cash flows are received as scheduled
through the call date
Fixed Income
Portfolio
Management
Strategies

Time value of money
Bond yield measures
 Yield to call
Fundamentals
Time Value of
Money
Fixed Income
Portfolio
Management
Strategies

Time value of money
Bond yield measures
 Yield to call
Fundamentals
Time Value of
Money
Fixed Income
Portfolio
Management
Strategies  Yield to call differs from yield to maturity
 Discounting period is shorter
 Final cash flow is generally higher

Time value of money
Bond yield measures
 Japanese current yield

Fundamentals
 Current yield adjusted for capital gain/losses :
Time Value of
Money
Fixed Income
Portfolio
Management
Strategies

Time value of money
Bond yield measures
 Yield to average life
Fundamentals  Full principal repayment supposed to occur on the

average life date
 Useful to compare bonds with a series of principal
repayment with bullet bonds
Time Value of
Money
Fixed Income
Portfolio
Management
Strategies

Time value of money
Bond yield measures

Fundamentals
Time Value of
Money
Fixed Income
Portfolio
Management
Strategies

Time value of money
Bond yield measures

Fundamentals
Time Value of
Money
Fixed Income
Portfolio
Management
Strategies
=> Comparable to bullet bond with maturity = AL

Time value of money
Bond yield measures
 Call-adjusted yield
Fundamentals
 To compare YTM of callable and non-callable

bonds
Time Value of
Money  Price of the non callable bond = price of the
callable bond + value of the call option
 Yield to call = YTM bullet bonds with maturity date

Fixed Income = call date
Portfolio
Management
Strategies  YTM callable bond = YTM bullet bond with price
adjusted for the price of the call

Time value of money
Bond yield measures
 Call-adjusted yield
Fundamentals
Time Value of
Money
Fixed Income
Portfolio
Management
Strategies

Time value of money
Other basic concepts
Fundamentals  Dates essential while determining any rate of interest :
 Commitment date : fixed rate on the loan

 Lending date : money is to be loaned
Time Value of  Repayment date : money is to be repaid
Money
Fixed Income
Portfolio
Management
Strategies

Time value of money
Fundamentals  Spot rates :
 R0,t : Annual interest rate received on a zero

coupon bond maturing at t
Time Value of
Money
 ONE final payment for interest and principal
 Commitment date and lending date are the same

Fixed Income
Portfolio  Generally, spot rates are quoted as annual rates
Management
Strategies

Time value of money
Time Value of
Money
Fixed Income
Portfolio
Management
Strategies

Time value of money
Time Value of
Money
Fixed Income
Portfolio
Management
Strategies

Time value of money
Fundamentals  Forward rates :
 Ft,h : Rate of interest of a bond with commitment

date (0) different from lending date (t)
Time Value of
Money
 Pay only one cash flow
 Generally annual rates

Fixed Income
Portfolio
Management
Strategies

Time value of money
Time Value of
Money
Fixed Income
Portfolio
Management
Strategies

Time value of money
Time Value of
Money
Fixed Income
Portfolio
Management
Strategies

Time value of money
Fundamentals  Relation between spot rate and forward rate
Time Value of
Money
Fixed Income
Portfolio
Management
Strategies

Time value of money
Time Value of
Money
Fixed Income
Portfolio
Management
Strategies

Time value of money
Time Value of
Money
Fixed Income
Portfolio
Management
Strategies

Time value of money
Fundamentals
Time Value of
Money
Fixed Income
Portfolio
Management
Strategies

Time value of money
Fundamentals
Time Value of
Money
Fixed Income
Portfolio
Management
Strategies

Time value of money
Fundamentals
Time Value of
Money
Fixed Income
Portfolio
Management
Strategies

Time value of money
Fundamentals
Time Value of
Money
Fixed Income
Portfolio
Management
Strategies

Time value of money
Fundamentals
Time Value of
Money
Fixed Income
Portfolio
Management
Strategies

Time value of money
Fundamentals
[ ( (1+4.2%)^4 ) / ( (1+4.1%)^3 ) ]-1

Time Value of
Money
Fixed Income
Portfolio
Management
Strategies

Time value of money
Fundamentals
Time Value of
Money
Fixed Income
Portfolio
Management
Strategies

Time value of money
Fundamentals
Time Value of
Money
Fixed Income
Portfolio
Management
Strategies

Time value of money
Term structure of interest rates
Fundamentals
 Relationship between the yields on comparable bonds
with different maturities
Time Value of  Appreciation of the interest rate-maturity relationship

Money
is essential in bond management
Fixed Income
Portfolio
Management
Strategies

Time value of money
Fundamentals
Time Value of
Money
Fixed Income
Portfolio
Management
Strategies

Time value of money
 Problems in building term structure of interest rates

Fundamentals
 Use only zero-coupon bonds (reinvestment risk)
 Some rates are unavailable

Time Value of
Money
 Few corporates zero-coupon bonds
Fixed Income  Practical solution : yield curve

Portfolio
Management
Strategies

Time value of money
Yield curve
Fundamentals
Time Value of
Money
Fixed Income
Portfolio
Management
Strategies

Time value of money
Definitions
Fundamentals
 Term structure : relationship between spot rates and
time to maturity
Time Value of  Yield curve : relationship between yield to maturity and

Money time to maturity
=> To analyze maturity-return relationship, spot rates are

Fixed Income
Portfolio better
Management
Strategies

Time value of money
Definitions
Fundamentals
 Nominal rate = real interest rate + inflation premium +
risk premium
 Real interest rate : compensation for deferring

Time Value of
Money
consumption
 Inflation premium : preserve investor’s purchasing

power over time
Fixed Income
Portfolio  Risk premium : protects investors against all other
Management
Strategies potential negatives

Time value of money
Fundamentals
Time Value of
Money
Fixed Income
Portfolio
Management
Strategies

Time value of money
Fundamentals
Time Value of
Money
Fixed Income
Portfolio
Management
Strategies

Time value of money
Risks should be (sufficiently) similar for useful yield curves :
Fundamentals
 Liquidity risk
 Credit risk
Time Value of
Money
 Call risk
 Coupon rate
Fixed Income  Degree of premium/discount

Portfolio
Management
Strategies

Time value of money
Term structure of interest rates : shapes
Fundamentals
Time Value of
Money
Fixed Income
Portfolio
Management
Strategies

Time value of money
Fundamentals
Time Value of
Money
Fixed Income
Portfolio
Management
Strategies

Time value of money
Term structure of interest rates : shapes
Fundamentals
Time Value of
Money
Fixed Income
Portfolio
Management
Strategies
=> Short maturity : monetary policy; long maturity : inflationary expectations

Time value of money
Fundamentals
Time Value of
Money
Fixed Income
Portfolio
Management
Strategies

Time value of money
Fundamentals
Time Value of
Money
Fixed Income
Portfolio
Management
Strategies

Time value of money
Theories of term structures
 Expectations hypothesis
Fundamentals
 Liquidity preference
 Market segmentation theory

Time Value of
Money
Fixed Income
Portfolio
Management
Strategies

Time value of money
Fundamentals
 Reflects market consensus forecast on future
interest rates levels
Time Value of  Implicit forward rate is an unbiaised estimate of the

Money future spot rate :
Fixed Income
Portfolio
Management
Strategies

Time value of money
Fundamentals
Time Value of
Money
Fixed Income
Portfolio
Management
Strategies

Time value of money
 If all investors choose a rollover strategy, prices

Fundamentals
should adjust
 If implicit forward rates are unbiaised estimate of

future spot rate :
Time Value of
Money  Without transaction costs, each bond is a
perfect substitute for any other bond, whatever its
maturity
Fixed Income
Portfolio
Management
 In this case, these 3 strategies are equivalent :
Strategies
 Buy and hold strategy
 Rollover strategy
 Buy a bond and sell it prior to maturity
Time value of money
Fundamentals
 Explains the slope of the curve : slope = expectation
of rates
Time Value of  Assumptions of this theory :

Money
 Homogenous expectations
 Investors choose between short and long-term
bonds in order to maximise their final expected
Fixed Income
Portfolio
wealth for a given investment period
Management  No transaction costs
Strategies  Bond markets are efficients

Time value of money
 Expectations theories
Fundamentals
 Naive expectations hypothesis :
 Expected returns for any strategy for any
holding period are equal
Time Value of
Money
 Local expectations :
 Refers only to total returns over a (short) period
beginning at the present
Fixed Income
Portfolio  Unbiased expectations :
Management
Strategies
 Forward rates equals future EXPECTED spot
rates

Time value of money
Fundamentals
 Return to maturity expectations :

 Expected return of holding a bond up to maturity
has to be equal to the expected return we would
Time Value of
Money obtain by rolling over a sequence of single-period
bonds over the same horizon
 Yield to maturity version :

Fixed Income  This version deals with periodic returns, while
Portfolio
Management
return to maturity version is concerned with total
Strategies returns over the investment horizon

Time value of money
 In Cox, Ingersoll and Ross (1981) :

Fundamentals
 Only local expectations theory is consistant

with an equilibrium (arbitrage profits for the
Time Value of
others)
Money  The remaining four versions are not equivalent
or consistant with each other with UNCERTAIN
interest rates
Fixed Income  Inconsistency of the naive expectations theory

Portfolio
Management hypothesis
Strategies
 Relation derived for a one year period is
inconsistant with relation derived for a two year
period under the naive expectations hypothesis
Time value of money
 Liquidity preferences
Fundamentals
 In expectation theory, investors don’t have maturity
preference
Time Value of  Liquidity preference theory : investors prefer to hold

Money liquid securities
 Liquidity = convert a bond into cash, minimising the

loss
Fixed Income
Portfolio
Management  Fluctuation risk is higher for long term bonds 
Strategies investors prefer short term securities

Time value of money
Fundamentals
Time Value of
Money
Fixed Income
Portfolio
Management
Strategies

Time value of money
Fundamentals
 Borrowers prefer to issue long to avoid interest
rates fluctuations
Time Value of  Liquidity premium or term premium

Money
 Two factors in the observed term structure of interest
rates :
 Future expected short term spot rates
Fixed Income
Portfolio  A positive liquidity premium
Management
Strategies

Time value of money
Fundamentals
Time Value of
Money
Fixed Income
Portfolio
Management
Strategies

Time value of money
Fundamentals
Time Value of
Money
 Expected return on buy and hold strategy has to be
higher than the expected return on a rollover strategy
Fixed Income  Liquidity premium increase with time

Portfolio
Management
Strategies
 Term structure of interest rate should be mainly upward
sloping

Time value of money
 Market segmentation and preferred habitat theories

Fundamentals
 Bond markets : distinct markets that differ by their
maturity
Time Value of  Issuer and investors have a preferred maturity,

Money
and sufficiently risk-averse to operate ONLY in this
spectrum
Fixed Income  Supply and demand determine the price in the

Portfolio maturity range
Management
Strategies

Time value of money

Fundamentals
Time Value of
Money
Fixed Income
Portfolio
Management
Strategies

Time value of money

Fundamentals
 Risk premium can be positive, negative or zero
Time Value of
Money
 Market clearing price is the interest rate

Fixed Income
Portfolio
Management
 Term structure of interest rates : supply and
Strategies demand of each individual segments
 Flow of funds in the market segments could predict

changes in the term structure of interest rates
Time value of money

Fundamentals
 Explains the four basic term structure :
 Positively sloped : preference for the short term

Time Value of
Money
 Negatively sloped : preference for the long term
 Flat : similar preferences

Fixed Income
Portfolio
Management
 Humped : different preferences for different
Strategies maturities

Time value of money

Fundamentals
 Limits :
 Relative yields should push investors change of

Time Value of
segment for a sufficiently higher yield
Money
 Investor should quit preferred habitat if risk

premium is high enough to cover risks and costs
Fixed Income leaving it
Portfolio
Management
Strategies

Time value of money
Fundamentals  Stochastic process no-arbitrage approaches
 Term structure and bond prices are related to some

stochastic factors
Time Value of
Money  Factors evolves over time according to a particular
hypothesized stochastic process
 No arbitrage opportunity
Fixed Income
Portfolio
Management
Strategies

Time value of money
Fundamentals  Stochastic process no-arbitrage approaches
 Example : Ogden model (1987)
Time Value of
Money
Fixed Income
Portfolio
Management
Strategies

Time value of money
Fundamentals
Time Value of
Money
Fixed Income
Portfolio
Management
Strategies

Time value of money
Fundamentals
Time Value of
Money
Fixed Income
Portfolio
Management
Strategies

Time value of money
Bond price analysis
 Yield spread analysis

Fundamentals
 Yield spread : differential in the yields of two or more
bonds
 Yield spread analysis : causes and consequences of

Time Value of
Money those spreads
 Usually measured against the yield of a treasury

security having comparable maturity
Fixed Income  Highest quality in marketability, credit risk and,
Portfolio
Management
often, tax status
Strategies
 Spread = risk premium
 Spreads : measured in basis points (1bp = 0,01%)

Time value of money
Bond price analysis
Fundamentals  Relative yield spread
Time Value of
Money
 Yield ratio
Fixed Income
Portfolio
Management
Strategies

Time value of money
Bond price analysis
Fundamentals  Types of spreads :
 Type of issuer (Treasury, Corp, financial)

 Credit quality (Rating)
Time Value of
 Maturity
Money
 Coupon
 Determinants of yield spreads :

Fixed Income
Portfolio  Maturity
Management
Strategies
 Credit
 Embedded options
 Tax status
 Liquidity
Time value of money
Fundamentals
Time Value of
Money
Fixed Income
Portfolio
Management
Strategies

Time value of money
Fundamentals
Time Value of
Money
Fixed Income
Portfolio
Management
Strategies

Time value of money
Bond price analysis

Fundamentals
 Determinants of yield spreads :
 Credit
Time Value of
Money  Probability of default
 Expected yield lower than promised yield

Fixed Income
Portfolio
Management
Strategies

Time value of money
Bond price analysis
Fundamentals
Time Value of
Money
Fixed Income
Portfolio
Management
Strategies

Time value of money
Bond price analysis
Fundamentals  Credit spread :
 Tend to widen when the economy is likely to face

recession
Time Value of
Money
 Higher probability of default in recession
 Lower recovery rate

Fixed Income
Portfolio  Formula (p=probability of total payment)
Management
Strategies

Time value of money
Bond price analysis

Fundamentals
 Credit spread :
Time Value of  Formula with recovery rate :

Money
Fixed Income
Portfolio
Management
Strategies

Time value of money
Bond price analysis

Fundamentals
 Embedded options
 Options benefits the party who can choose to

Time Value of
exercise it => yield differential
Money
Fixed Income
Portfolio
Management
Strategies

Time value of money
Bond price analysis

Fundamentals
 Tax status
 Net income matters for investors

Time Value of
Money  Taxable bond has to pay higher yield to
compete with an exempt bond
Fixed Income
Portfolio
Management
Strategies

Time value of money
Bond price analysis

Fundamentals
 Tax status
Time Value of  To compare taxable and non taxable bonds :

Money
Fixed Income
Portfolio
Management
Strategies

Time value of money
Bond price analysis

Fundamentals
 Liquidity
 The greated the expected liquidity, the lower

Time Value of the required yield
Money
 Marketability : broad and deep market
 Time to maturity : at maturity, cash

Fixed Income
Portfolio
Management  Financiability : the issue can be liquid, but is
Strategies
utilized as a collateral to borrow funds

Time value of money
Bond price analysis
 Bond valuation
Fundamentals
 Discounted cash flow method
 Equilibrium concept
Time Value of
Money
Fixed Income
Portfolio
Management
Strategies Example : ZC bond, pay 1000 EUR in 5 years,
discount rate = 7%; 7 year bond ?

Time value of money
Bond price analysis
 Bond valuation
Fundamentals
Time Value of
Money
Fixed Income
Portfolio
Management
Strategies

Time value of money
Bond price analysis
 Bond valuation
Fundamentals
 Generally, discount rate varies from maturity to
maturity
Time Value of
Money
Fixed Income
Portfolio
Management
Strategies

Time value of money
Bond price analysis
 Bond valuation
 Static arbitrage and valuation of coupon bonds
Fundamentals
 A coupon-bearing bond can be visualised as a
portfolio of zero-coupon bonds
Time Value of
Money
Fixed Income
Portfolio
Management
Strategies

Time value of money
Bond price analysis
 Bond valuation
Fundamentals  Static arbitrage and valuation of coupon bonds
 A coupon-bearing bond can be visualised as a

portfolio of zero-coupon bonds
Time Value of
Money  Bond price = price of replicating ZC bond
portfolio
Fixed Income
Portfolio
Management
Strategies
 If the final repayment is not made at par, only the

final cash flow is modified
Time value of money
Bond price analysis
 Bond valuation
Fundamentals
 Semi annual coupon : same formula but :

Time Value of
Money  CFt = cash flow received at the end of the
SEMI-ANNUAL period (ex : 2% on a 4%
coupon)
Fixed Income
Portfolio  R = required rate of the SEMI-ANNUAL
Management period
Strategies
 T : nbr of years x 2

Time value of money
Bond price analysis
 Bond valuation
Fundamentals
 Floating rate bonds :

Time Value of
Money  New coupon = market spot rate for the
next period
 After the coupon payment, bond should

Fixed Income
Portfolio
be at par
Management
Strategies  Short term zero coupon with maturity =
next coupon payment (sell the bond at 100)

Time value of money
Bond price analysis
 Bond valuation
Fundamentals

Time Value of
Money
Fixed Income
Portfolio
Management
Strategies

Time value of money
Bond price analysis
 Bond valuation
Time Value of
Money
Fixed Income
Portfolio
Management
Strategies

Time value of money
Bond price analysis
 Bond valuation
Time Value of
Money
Fixed Income
Portfolio
Management
Strategies

Time value of money
Bond price analysis
 Bond valuation
Fundamentals

Time Value of
Money  Coupon rate not always equal to the market
spot rate for the next period
 Default risk
Fixed Income
Portfolio
Management
 Announcement of the next coupon rate not
Strategies always on the previous-coupon payment date

Time value of money
Bond price analysis
 Bond valuation
 The impact of the coupon rate
Time Value of
 Higher coupon will be worth more than a
Money
lower coupon issue with the same maturity
Fixed Income
Portfolio
Management
Strategies

Time value of money
Bond price analysis
 Bond valuation
Fundamentals  The impact of the discount rate of interest
 Bond price inversely related to the

discount rate of interest
Time Value of
Money
Fixed Income
Portfolio
Management
Strategies

Time value of money
Bond price analysis
 Bond valuation
 Strips markets
Fundamentals
 Separately Traded Registered Interest and

Principal
Time Value of
Money  Zero coupon notes
 Example : Treasury with 10 years to maturity :
Fixed Income  20 zero-coupon from 6 mths to 10 years

Portfolio
Management
 One 10 year zero coupon
Strategies
 Created by financial institutions
Receive a prespecified sum at a prespecified date

Time value of money
Bond price analysis
 Price / yield relationship

Fundamentals
Time Value of
Money
Fixed Income
Portfolio
Management
Strategies

Time value of money
Bond price analysis
Fundamentals  Current yield : focuses solely the coupon return
 Yield to maturity :
Time Value of
Money
Fixed Income
Portfolio
Management
Strategies

Time value of money
Bond price analysis

Fundamentals
 Yield to maturity : proxy for total return if
 All coupon reinvestment at YTM (in reality at

market rate)
Time Value of
Money
 Reinvestment rate risk : long term bonds, high
coupon rate
Fixed Income  If sold before maturity, market rate must = YTM

Portfolio
Management
Strategies  YTM must be expressed in annual equivalent
 Equivalence of YTM and total return not

supported by theory
Time value of money
Bond price analysis

Fundamentals
 Yield to maturity vs total return :
Time Value of
Money
Fixed Income
Portfolio
Management
Strategies

Time value of money
PRICING
Fundamentals
Time Value of
Money
Fixed Income
Portfolio
Management
Strategies

Time value of money
PRICING
Fundamentals
Time Value of
Money
Fixed Income
Portfolio
Management
Strategies

Time value of money
TERM STRUCTURE OF INTEREST RATES
Fundamentals
Time Value of
Money
Fixed Income
Portfolio
Management
Strategies

Time value of money
TERM STRUCTURE OF INTEREST RATES
Fundamentals
Time Value of
Money
Fixed Income
Portfolio
Management
Strategies

Time value of money
Risk measurement
 Bond return : change in price + cash flows + reinvestment

Fundamentals
 Risk of a bond : impact of market factors on return
characteristics
Time Value of  Systematic risk : volatility in total bond return due to

Money interest rate fluctuation
 Increasing interest rate volatility : bond from safe to risky
Fixed Income  Price risk : sell a bond prior to the maturity date
Portfolio
Management
Strategies  Reinvestment risk
 Price risk and reinvestment risk act in opposite directions

Time value of money
Risk measurement
 Instantaneous change in the bond’s yield
Fundamentals  Long maturity bonds are more sensitive
Time Value of
Money
Fixed Income
Portfolio
Management
Strategies

Time value of money
Risk measurement
Fundamentals  Long maturity bonds are more sensitive
 Same relationship if rates decrease
Time Value of
Money
Fixed Income
Portfolio
Management
Strategies

Time value of money
Risk measurement
Fundamentals
Time Value of
Money
Fixed Income
Portfolio
Management
Strategies

Time value of money
Risk measurement
Fundamentals  Low coupon bonds are more volatile
Time Value of
Money
Fixed Income
Portfolio
Management
Strategies

Time value of money
Risk measurement
Fundamentals  Low yield bonds are more volatile
Time Value of
Money
Fixed Income
Portfolio
Management
Strategies

Time value of money
Risk measurement

Fundamentals
 Bond with sinking fund provision less volatile
 Callable bonds are less volatile

Time Value of
Money  Price volatility is not a symmetric phenomenon
Current market yield : 6%
Fixed Income
Portfolio
Management
Strategies

Time value of money
Risk measurement
 Risk measurement tools

Fundamentals
 Time to maturity
 Number of years until bond’s final maturity date

Time Value of
Money
 Long maturity bonds riskier
 Wait longer to recover principal

Fixed Income  More sensitive to interest rate fluctuations
Portfolio
Management
Strategies

Time value of money
Risk measurement
Fundamentals  Time to maturity
 Weak risk tool

 Cash flows prior to final maturity
Time Value of
 Linear relationship between time to maturity
Money
and price volatility
Fixed Income
Portfolio
Management
Strategies

Time value of money
Risk measurement
Fundamentals  Weighted average maturity (average life)
Time Value of
Money
 Only considers principal repayments

Fixed Income
Portfolio  Identical to time to maturity for bullet bonds
Management
Strategies
 Better for Sinking requirement and MBS
 Insensitive to the coupon differentials

Time value of money
Risk measurement
Fundamentals  Weighted average cash flow
Time Value of
Money
 Repayments are considered on a nominal basis

Fixed Income
Portfolio
Management
Strategies

Time value of money
Risk measurement
Fundamentals  Duration and modified duration
 Average time at which the cash flow occur
Time Value of
 Present value of each cash flow
Money
Fixed Income
Portfolio
Management
Strategies

Time value of money
Risk measurement
 Duration (Macaulay’s duration) is mesured in

years
Time Value of
Money
Fixed Income
Portfolio
Management
Strategies

Time value of money
Risk measurement
Time Value of
Money
Fixed Income
Portfolio
Management
Strategies

Time value of money
Risk measurement
 Duration of a ZC = maturity
Time Value of
Money
Fixed Income
Portfolio
Management
Strategies

Time value of money
Risk measurement

Fundamentals
 Duration and modified duration
 Different coupon frequency, sinking fund

Time Value of requirements : same methodology
Money
Fixed Income
Portfolio
Management
Strategies

Time value of money
Risk measurement

Fundamentals
 Interpretations
 Takes into account :

Time Value of
Money  Cash flows
 YTM
P
Fixed Income  Coupon-bearing bond and ZC maturing on the

Portfolio
Management
duration date of the coupon bearing issue
Strategies

Time value of money
Risk measurement
Fundamentals  Interpretations
 Time (in years) at which the total value of the

bond is not sensitive to interest rate variation
Time Value of
Money
 If you sell at the time of its duration, holding
period return = current market yield
Fixed Income
Portfolio
Management
Strategies

Time value of money
Fundamentals
Time Value of
Money
Fixed Income
Portfolio
Management
Strategies

Time value of money
Fundamentals
Time Value of
Money
Fixed Income
Portfolio
Management
Strategies

Time value of money
Risk measurement
Fundamentals  Implicit assumptions
 All cash flows are discounted at k = YTM
Time Value of
 Term structure of interest rate is flat
Money
 Fisher and Weil’s duration
Fixed Income
Portfolio
Management
Strategies

Time value of money
Risk measurement

Fundamentals
 Determinants of duration
 Time to maturity
 Coupon
Time Value of
Money  Accrued interest
 Market yield
 Sinking fund
 Call features
Fixed Income
Portfolio
Management
Strategies

Time value of money
Risk measurement
Fundamentals  Determinants of duration
 D generally positively related to time to maturity
Time Value of
 Maximum value of duration (annual) :
Money
Fixed Income
Portfolio
Management
Strategies

Time value of money
Risk measurement

Fundamentals
Time Value of
Money
Fixed Income
Portfolio
Management
Strategies

Time value of money
Risk measurement

Fundamentals
 D inversely related to the coupon rate of

interest
Time Value of
Money
 Higher coupon lead to a decline in
duration, but at a diminishing rate
Fixed Income
Portfolio
Management
Strategies

Time value of money
Fundamentals
Time Value of
Money
Fixed Income
Portfolio
Management
Strategies

Time value of money
Risk measurement

Fundamentals
 D inversely related to the buildup of accrued

Time Value of interest
Money
 D increases on coupon payment date
Fixed Income
Portfolio
Management
Strategies

Time value of money
Risk measurement

Fundamentals
 D inversely related to the general level of

interest rates (yield level)
Time Value of
Money
 Higher discount rate = lower duration
Fixed Income
Portfolio
Management
Strategies

Time value of money
Risk measurement
Fundamentals  Using duration to approximate price changes
Time Value of  Modified duration (sensitivity)

Money
 Price duration
Fixed Income
Portfolio
Management
Strategies
 Duration : estimating change in the price for SMALL

change in the yield
Time value of money
Fundamentals
Time Value of
Money
Fixed Income
Portfolio
Management
Strategies

Time value of money
Fundamentals
Time Value of
Money
Fixed Income
Portfolio
Management
Strategies

Time value of money
Risk measurement
Initial market yield : 6%; Duration : 7,8 years
 Convexity
Fundamentals
Time Value of
Money
Fixed Income
Portfolio
Management
Strategies

Time value of money
Risk measurement
 Convexity
Fundamentals
Time Value of
Money
Fixed Income
Portfolio
Management
Strategies

Time value of money
Risk measurement
 Convexity
Fundamentals  Duration attempts to estimate convex relationship

with a straight line
 Duration = instantaneous value : Time has an effect

Time Value of
Money
 Will not exhibit the asymmetry in price volatility
 Always underestimate the new price

Fixed Income
Portfolio  Accuracy depends on the convexity
Management
Strategies
 Duration : not for large variation in yield
 Use convexity IN ADDITION to duration

Time value of money
Risk measurement
 Convexity
Fundamentals
Time Value of
Money
Fixed Income
Portfolio
Management
Strategies

Time value of money
Risk measurement
 Convexity
Fundamentals  Option-free bond always has a positive convexity
=> Market yield change has always a positive effect

on price
Time Value of
Money
Fixed Income
Portfolio
Management
Strategies
 Convexity = Rate of change of the slope of the
price-yield curve with respect to yield changes

Time value of money
Risk measurement
 Convexity
Fundamentals
Time Value of
Money
Fixed Income
Portfolio
Management
Strategies

Time value of money
Risk measurement
 Convexity
Fundamentals
Time Value of
Money
Fixed Income
Portfolio
Management
Strategies

Time value of money
Fundamentals
Time Value of
Money
Fixed Income
Portfolio
Management
Strategies

Time value of money
Risk measurement
 Duration and convexity between coupon payment dates
Fundamentals
Time Value of
Money
Fixed Income
Portfolio
Management
Strategies

Time value of money
Risk measurement
 Impact of coupon payments and time lapse on duration
Fundamentals  Duration will suddenly increase at the coupon

payment
Time Value of
Money
Fixed Income
 Duration will decrease linearly with time between two
Portfolio
Management coupon payments
Strategies
 All other things being equal, duration of a portfolio
will vary linearly over time, except when there is a
coupon payment
Time value of money
Risk measurement
 Restrictions on using the duration and convexity
Fundamentals  Duration, bond risk proxy based on three

assumptions :
 A small change in the yield

Time Value of
Money
 A parallel shift in the yield, whatever the maturity
 Instantaneous change in yield

Fixed Income
Portfolio
Management
Strategies  Assumes a flat yield curve
 Functional duration : price sensitivity to a

particuliar rate change
Time value of money
Risk measurement
 Portfolio duration and convexity
Fundamentals  Duration of a bond portfolio is simply the weighted

average of the durations of the individual bonds
Time Value of
Money
 Convexity of a bond portfolio is simply the weighted

Fixed Income average of the convexities of the individual bonds
Portfolio
Management
Strategies

Time value of money
Credit risk
 Likelihood that the security’s issuer will default on

Fundamentals payment of interest and/or principal
 Not able to honor the bond indenture
Time Value of  Factor affecting credit risk

Money
 Economic and financial current and prospective
conditions
Fixed Income
Portfolio
 Economic / Industry / Firm specific considerations
Management
Strategies

Time value of money
Credit risk
 Economic / Industry considerations
Fundamentals  Economic cyclicality
 Growth prospects
Time Value of
 Research & development expenses
Money
 Competition
Fixed Income  Sources of supply

Portfolio
Management
Strategies
 Degree of regulation
 Labor

Time value of money
Credit risk
 Ratio analysis
Fundamentals
 Cash flow from operations (long term)
 Liquidation of some assets

Time Value of
Money  Another source of financing
=> Analysis of balance sheet & income statement

Fixed Income
accounts
Portfolio
Management
Strategies

Time value of money
Credit risk
 Ratio analysis
Fundamentals
 Common size ratios
 Profitability ratios
Time Value of
Money  Liquidity ratios
 Solvency ratios
Fixed Income
Portfolio
 Activity ratios
Management
Strategies

Time value of money
Credit risk
 Credit rating and rating agencies

Fundamentals
 EX : Moody’s, Standard & Poor’s
 Analyse various financial data :

Time Value of
Money  Fundamentals of the company
 Industry data
Fixed Income
Portfolio
 Macro-economic data
Management
Strategies => Probability of the default in interest and/or
principal payments

Time value of money
Credit risk
Fundamentals
Time Value of
Money
Fixed Income
Portfolio
Management
Strategies

Time value of money
Credit risk
Fundamentals  Independant and unbiaised datas
 Directly reflect the probability of default
Time Value of
Money
Fixed Income
Portfolio
Management
Strategies

Time value of money
Credit risk
Fundamentals  Aaa-Baa : Investment quality
 Ba-B : High yield
Time Value of
 Caa-C : May have already defaulted and be moving
Money
towards bankrupcy
 High yield : Fallen angels to new issues

Fixed Income
Portfolio  Bond ratings have a direct effect on the borrowing
Management
Strategies costs of the issuer

Time value of money
EVALUATION AND RISK
Fundamentals
Time Value of
Money
Fixed Income
Portfolio
Management
Strategies

Time value of money
EVALUATION AND RISK
Fundamentals
Time Value of
Money
Fixed Income
Portfolio
Management
Strategies

Time value of money
EVALUATION AND RISK
Fundamentals
Time Value of
Money
Fixed Income
Portfolio
Management
Strategies

Fixed Income Portfolio Management
Strategies
Active Management : to beat the benchmark
 Forecasting returns
Fundamentals
 Parallel shifts of the yield curve
 More or less steep yield curve

Time Value of
Money  Convexity of the yield curve
 Sector spreads
Fixed Income
 Corporate spreads
Portfolio
Management …
Strategies
 Portfolio Construction
 Information ratio maximisation and optimisation

Strategies
Active Management in practice
 Constant duration
Fundamentals
 Mean reversion process
 Interest rates above their average value => to

Time Value of decline
Money
 Match duration of the index until upper trigger limit,
then back to average level of the index duration
Fixed Income  Assumption : mean reverting process in interest

Portfolio
Management rates
Strategies
 Risk : Change in medium term inflation rate =>
adjust the model

Strategies
 Return enhancement
Fundamentals
 Use of a valuation model
 Buy the cheap bonds

Time Value of
Money
 Arbitrage type
 Options overwriting
Fixed Income
Portfolio  Forecast is on the timing of long term interest
Management rates
Strategies

Strategies
Fundamentals
 Minimisation of the value of the bond portfolio
 Liability funding method

Time Value of
Money
Fixed Income
 Two constraints :
Portfolio
Management
Strategies
 IRR of the bond portfolio must equal IRR to discount

present value of the liability
Strategies
Fundamentals
 Minimisation of the value of the bond portfolio
Time Value of
 Maximasing IRR of the bond portfolio
Money
 Homogeneous in terms of quality rating
Fixed Income
Portfolio
Management
Strategies

Strategies
Active Management
 Yield spread strategies

Fundamentals
 Type of issuer
 Credit risk
Time Value of
Money
 Coupon level
 Maturity
Fixed Income
Portfolio
Management
Strategies

Strategies
Active Management

Fundamentals
 Positioning of the portfolio components to gain from
movements in yield spreads
Time Value of  Bond swapping : Sell overvalued bond for

Money
undervalued one
 Credit spread : lower quality trade at a spread

Fixed Income
Portfolio  Tend to widen when recession
Management
Strategies  If economic activity is approaching the peak :
flight to quality

Strategies
Active Management

Fundamentals
 Call provision
 Level of interest rates

Time Value of
Money  Volatility
 Decrease in interest rates : swap callable for

non callable
Fixed Income
Portfolio
Management
Strategies  Forecasting term structure of interest rates
 Bond swapping : buy cheapest bonds based

on these assumptions
Strategies
Active Management
 Yield curve strategies

Fundamentals
 Take advantage of the forecasted movements
 Shift, twist and butterfly of the yield curve

Time Value of
Money
 Yield curve changes : maturity can have a significant
impact on total return of the portfolio
 Bullet strategies / Barbell strategies / Ladder

Fixed Income
Portfolio
strategies
Management
Strategies  Bullet : concentrated on a given point of the yield
curve
 Barbell : extremes of the yield curve

Strategies
Active Management
Fundamentals  Yield curve strategies
 Laddering
Time Value of  Maturity spacing

Money
 Passive portfolio approach
 Wrong maturity risk minimized

Fixed Income
Portfolio  Reinvestment risk minimized
Management
Strategies

Strategies
Active Management
 Yield curve strategies

Fundamentals
Time Value of
Money
Fixed Income
Portfolio
Management
Strategies

Strategies
Passive Management
 Buy and hold

Fundamentals
 Control risk : duration of the portfolio = duration of the index
 Indexation
Time Value of
Money  Differences with equity indexing :
 Benchmarks are broader
 Turnover is larger : bonds mature, new issues

Fixed Income
Portfolio
Management  Illiquidity
Strategies
 Bond futures : rarely on indices but on notional bonds

Strategies
Passive Management
 Indexation
Fundamentals
 Differences with equity indexing :
Time Value of  Synthetic replication is impossible

Money
 Bonds more interchangeable and less

specific than equities
Fixed Income
Portfolio
Management
Strategies

Strategies
Passive Management
 Indexing technology
Fundamentals
 Stratified sampling
Time Value of
 Limit the number of bonds
Money
 Avoid trading too small bond positions
 Avoid being in the illiquid segment

Fixed Income
Portfolio
Management
Strategies

Strategies
Passive Management
Fundamentals
 Stratified sampling
 Building index portfolio

Time Value of
Money
 Benchmark partitioned into cells based
on characteristics (sector, maturity,
duration, quality)
Fixed Income
Portfolio  Select a limited number of bonds in
Management each cells
Strategies
 Average characteristics and appropriate

weight
Strategies
Passive Management
Fundamentals
 Optimised sampling
 Overcome the drawbacks of the stratified

Time Value of
Money
sampling approach
 Giving ex-ante measure of the tracking

error
Fixed Income
Portfolio  Optimiser : risk trade-off between
Management
Strategies factors and transaction costs
 Choose the level of tracking error

Strategies
Passive Management
 Immunisation
Fundamentals  Increase in interest rates :
 Lower value of the bond portfolio
Time Value of  Higher return on the coupon reinvestment

Money
 Balance price risk and reinvestment risk
Fixed Income
Portfolio
Management
Strategies

Strategies
Passive Management
 Immunisation
Fundamentals
Time Value of
Money
Fixed Income
Portfolio
Management
Strategies

Strategies
Passive Management
 Immunisation
Fundamentals
 Short time horizon : effect on the bond price is higher
 Long time horizon : effect of reinvestment of coupons

Time Value of is higher
Money
 Time-horizon for which the final wealth will be the

same, whatever initial interest rate variation
Fixed Income  If time horizon = duration : investor not affected by
Portfolio
Management interest rates variations
Strategies
 Create portfolio with duration = time horizon of the
investor

Strategies
Passive Management
 Immunisation
Fundamentals
 Portfolio has to be rebalanced whenever a coupon
payment comes due
Time Value of  Portfolio should be rebalanced for each change in

Money interest rates
 Reinvestment of coupon can affect immunization

equilibrium
Fixed Income
Portfolio
Management
=> Immunization has to be dynamic (rebalance
Strategies
frequently)

Strategies
Passive Management
 Immunisation
Fundamentals
Time Value of
Money
Fixed Income
Portfolio
Management
Strategies

Strategies
Passive Management
Fundamentals
 Immunisation
 Tradeoff between frequent rebalancing and

minimizing the transaction costs
Time Value of
Money  Protects against loss but eliminates benefits
from interest rate variation
Fixed Income
 Based on duration : assumes parallel shift of the
Portfolio flat interest rate term structure
Management
Strategies
 Time-passing and yield changing : portfolio
non-immunized

Strategies
Passive Management
 Liability Funding
Fundamentals
 Funding a given set of future liabilities
Time Value of  Build bond portfolio to fund the liability stream

Money
 Compensate the interest rate risk on the liability
side
Fixed Income
Portfolio
Management
Strategies

Strategies
Passive Management
Fundamentals
 Immunisation
Time Value of
 Fund a liability stream and control for
Money parallel shifts in the yield curve
 L = Present value of the liability stream

Fixed Income
Portfolio
 A = Present value of the cash-flow stream
Management from the bond portfolio
Strategies

Strategies
Passive Management
Fundamentals
 Single period immunisation
 Goal : fund the liability and avoid risk of a

Time Value of parallel shift of the interest rate term structure
Money
 Solution : buy zero coupon bonds
 Problem : such ZC bonds may not exist, so use

Fixed Income of ordinary bonds
Portfolio
Management
Strategies

Strategies
Passive Management
Fundamentals
 Both liability and bond portfolio should be discounted at

Time Value of
the same rate (IRR)
Money
 Duration of bond portfolio and liability are equal (single
period : duration = maturity)
Fixed Income  Limited to parallel movements

Portfolio
Management  Convexity
Strategies
 Infinite number of portfolios with duration = T, choose
the bond with cash-flow around the liability maturity =>
less sensitive to non-parallel shifts
Strategies
Passive Management
Fundamentals
 Dispersion of bond portfolio around its

Time Value of
Money duration :
Fixed Income
Portfolio
Management
Strategies  The smaller the dispersion, the smaller the risk
 Immunisation = dynamic strategy

Strategies
Passive Management
Fundamentals
 Multiperiod immunisation
 Fund a stream of several liabilities

Time Value of
Money
 Technique for a single liability to each of the
several liabilities
 Identify the duration of the liability stream

Fixed Income
Portfolio
Management 
Strategies
 Risk of discontinuities if large liability matures at
a specific time (dynamic readjustment of the bond
portfolio duration)
Strategies
Passive Management
Fundamentals
 Surplus immunisation
Time Value of  Investor owns assets in excess of the present

Money value of his liabilities
S=A–L
Fixed Income
Portfolio  To immunise :
Management
Strategies  Positive surplus : Duration of A should be
smaller

Strategies
Passive Management
Fundamentals  Liability Funding
 Cash flow matching

Time Value of
Money  Create a bond portfolio whose stream of
cash flows exactly matches stream of
liabilities
Fixed Income  Create a ZC for each liability and maturity

Portfolio
Management
Strategies

Strategies
Passive Management
Fundamentals
 With normal bonds : iterative process

Time Value of
Money
Fixed Income
Portfolio
Management
Strategies

Strategies
Passive Management
Fundamentals
 Linear programming techniques : least-cost cash

Time Value of
Money flow matching
 Drawbacks :
Fixed Income
 Difficulties of perfect date matching
Portfolio
Management  Difficult exact amount matching (rounding in
Strategies the bond quantities)

Strategies
Passive Management
Fundamentals
 Asymmetric cash matching
 Cash flows on the bond portfolio matures only

BEFORE
Time Value of
Money
 Build a non-callable bond portfolio of
homogeneous characteristics
 Cumulative bond cash flow larger than cumulative

Fixed Income
Portfolio cash flow of the liabilities (any liabilities is funded)
Management
Strategies  Amount and maturity of cash flows should match
as far as possible (limit term structure risk factor)

Strategies
Passive Management
Fundamentals
 Asymmetric cash matching
 Technique : minimising the value of the portfolio : the

Time Value of cheapest portfolio is also the best cash flow match
Money
 Only with bonds of the same quality
 Cash in advance to fund liabilities

Fixed Income
Portfolio  Reinvestment based on an assumption for cash rate
Management
Strategies  Reinvestment risk if cash is actually smaller
 Take advantage of the evolution of the term structure

to build an even cheaper bond portfolio
Strategies
Passive Management
Fundamentals
 Symmetric cash matching
 If you can borrow cash for a short period,

Time Value of
Money bond cash flow can occur AFTER
 Bond portfolio with cash flows AROUND the

maturity of liabilities
Fixed Income
Portfolio
Management  Can be cheaper depending on the borrowing
Strategies costs

Strategies
Portfolio construction based on a factor model
 Volatility of the term structure => MFM for better risk control
Fundamentals
 Model specification
 Single factor duration model

Time Value of
Money
Fixed Income  For instantaneous change in yield

Portfolio
Management  Ignore the interest accrual
Strategies
 Assume that duration is constant through time

Strategies
Fundamentals  Single factor duration model
 Relates volatility of a bond return to the volatility of its

current yield
Time Value of  Duration = factor exposure of the bond
Money
 Assumptions :
 Term structure is flat

Fixed Income
Portfolio  Only small parallel shifts
Management
Strategies  Explains 75% of the variance of non-callable US Treasury
bond return
 Quality of the forecast can be improved with convexity

Strategies
 Full term structure MFM

Fundamentals
 Return of a bond is a weighted average of the return of

Time Value of
Money the discount bonds
Fixed Income
Portfolio  Z = exposure of a bond to all discount bonds
Management  W = covariance matrix for the return of the set of discount
Strategies bonds
 Fully predictive risk model

 Not convenient for complicated movements in the curve
Strategies
 The shift, twist and butterfly MFM
 Smaller number of factors => easier to model movements of the

Fundamentals
term structure
 Risk : loosing risk explanation
Time Value of  Factors :

Money
 Return of the shift factor
 Return of the twist factor
 Return of the butterfly factor
Fixed Income
Portfolio
Management
Strategies

Strategies
 The shift, twist and butterfly MFM
Fundamentals  If RS > 0 : parallel shift in the term structure (positive

return on discount bonds => discount yields declined)
 If RT > 0 : positive return on short term maturities,

Time Value of negative on long term (steeper curve, positive twist)
Money
 If RB > 0 : Positive return on both end of maturities.
Negative on intermediate (more concave curve)
Fixed Income
Portfolio
Management
Strategies
 W = 3 x 3 covariance matrix of the shift, twist and

butterfly returns
Strategies
 Summary and needed enhancements

Fundamentals
Time Value of
Money
Fixed Income
Portfolio
Management  There are other risks than movements in the term structure
Strategies
 Existence of options, sinking fund provisions
 Default risk
 Tax
Strategies
 Summary and needed enhancements

Fundamentals
 Specific part in the explanation of the return of

a bond is relatively small
Time Value of
Money  Bonds are more interchangeable
 Less emphasis on diversification

Fixed Income
Portfolio
Management
Strategies

Strategies
Fundamentals
 Interest rate anticipation strategies
 Active bond management : scenario for the

forecast of the movements of the yield curve
Time Value of
Money
 Build a portfolio with risk exposure consistant
with his prediction of the term structure
movements
Fixed Income
Portfolio
Management
Strategies

Strategies
Fundamentals  Interest rate anticipation strategies
 Forecast downward parallel shift of the term structure

=> More exposed to the shift factor than the
Time Value of benchmark
Money
 Forecast steeper term structure :
=> Exposure to the twist factor higher than the
benchmark
Fixed Income
Portfolio
Management
 Forecast more concave term structure :
Strategies => Exposure to the butterfly factor higher than
the benchmark
 Overweight sector, rating, …

Strategies
Fundamentals  Interest rate anticipation strategies
 Build bond portfolio
Time Value of  Duration, convexity consistent with his

Money
scenario
 Risk model
Fixed Income
Portfolio  Optimiser to minimise tracking error with
Management constrains on risk exposures
Strategies
 Forecast factor returns => maximise forecasted

risk adjusted active return of the bond portfolio
Strategies
Computing the hedge ratio : the modified duration method
 Hedge bond portfolio with future contracts

Fundamentals
 Optimal hedge ratio :
Time Value of
Money
 Assumes only parallel shifts in the yield curve
Fixed Income
 Risk if big differences between MDS and MDF
Portfolio
Management
Strategies  Omits convexity (convexity between CTD and asset being
hedged)
 Optimal number of contracts change with CTD

Strategies
Computing the hedge ratio : the modified duration method
 Number of future contracts :

Fundamentals
Time Value of
Money
Fixed Income
Portfolio
Management
Strategies
 Short hedge : Sell interest rate futures to « freeze » low
interest rates today

Strategies
Fundamentals
Time Value of
Money
Fixed Income
Portfolio
Management
Strategies

Strategies
Fundamentals
Time Value of
Money
Fixed Income
Portfolio
Management
Strategies

Strategies
EVALUATION AND RISK
Fundamentals
Time Value of
Money
Fixed Income
Portfolio
Management
Strategies

Strategies
EVALUATION AND RISK
Fundamentals
Time Value of
Money
Fixed Income
Portfolio
Management
Strategies

Strategies
EVALUATION AND RISK
Fundamentals
Time Value of
Money
Fixed Income
Portfolio
Management
Strategies

Strategies
EVALUATION AND RISK
Fundamentals
Time Value of
Money
Fixed Income
Portfolio
Management
Strategies

Strategies
EVALUATION AND RISK
Fundamentals
Time Value of
Money
Fixed Income
Portfolio
Management
Strategies

Strategies
EVALUATION AND RISK
Fundamentals
Time Value of
Money
Fixed Income
Portfolio
Management
Strategies

Strategies
EVALUATION AND RISK
Fundamentals
Time Value of
Money
Fixed Income
Portfolio
Management
Strategies

Strategies
EVALUATION AND RISK
Fundamentals
Time Value of
Money
Fixed Income
Portfolio
Management
Strategies

Strategies
Fundamentals
Time Value of
Money
Fixed Income
Portfolio
Management
Strategies

Strategies
Fundamentals
Time Value of
Money
Fixed Income
Portfolio
Management
Strategies

Strategies
Fundamentals
Time Value of
Money
Fixed Income
Portfolio
Management
Strategies

Strategies
Fundamentals
Time Value of
Money
Fixed Income
Portfolio
Management
Strategies

Strategies
Fundamentals
Time Value of
Money
Fixed Income
Portfolio
Management
Strategies

Strategies
Fundamentals
Time Value of
Money
Fixed Income
Portfolio
Management
Strategies

Strategies
Fundamentals
Time Value of
Money
Fixed Income
Portfolio
Management
Strategies

Strategies
Fundamentals
Time Value of
Money
Fixed Income
Portfolio
Management
Strategies

Strategies
Fundamentals
Time Value of
Money
Fixed Income
Portfolio
Management
Strategies

Strategies
Fundamentals
Time Value of
Money
Fixed Income
Portfolio
Management
Strategies

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Fixed Income : Valuation and Analysis

Fundamentals  Debt of a borrower (issuer) towards a lender (bondholder)

Fixed Income : Valuation and Analysis- 2

 Name – Coupon – Maturity

Fixed Income  Coupon payment : coupon rate x face value

Fixed Income : Valuation and Analysis- 3

Fixed Income : Valuation and Analysis- 4

Fundamentals  Market value

 Percentage of the face value

Fixed Income : Valuation and Analysis- 5

Fixed Income : Valuation and Analysis- 6

Fixed Income : Valuation and Analysis- 7

 To compare bonds => Clean price

 Buy or Sell : pro-rata basis of the coupon added to the

 Dirty price = clean price + accrued interest

Fixed Income  Accrued interest =

Fixed Income : Valuation and Analysis- 8

Japan Semi-annual Actual/365

France Annual Actual/Actual

Germany Annual Actual/Actual

Australia Semi-annual Actual/Actual

Italy Semi-annual Actual/Actual

Fixed Income : Valuation and Analysis- 9

Fixed Income : Valuation and Analysis- 10

 Putable bonds : bondholder has the right

Fixed Income : Valuation and Analysis- 11

Fixed Income  Dual currency bonds :

Fixed Income : Valuation and Analysis- 12

Types of fixed income securities

Fixed Income : Valuation and Analysis- 13

Money market instruments :

Fundamentals  Short term debt securities

 Very large denominations

Fixed Income  Interest earned expressed on the bank discount basis

Fixed Income : Valuation and Analysis- 15

Money market instruments :

Fundamentals  Treasury bills

 Discount with respect to the face value

 Competitive auction : bid is filled if price entered is

 Interest rate and credit risk very low

Fixed Income : Valuation and Analysis- 16

Money market instruments :

 Short term unsecured debt

 Issued by large and well-known companies

Fixed Income : Valuation and Analysis- 17

Money market instruments :

 Commercial bills of exchange whose credit risk

 Accepting institution is obligated to pay

Fixed Income The bank receive a fee

Fixed Income : Valuation and Analysis- 18

Money market instruments :

 Certificate of deposit (CD)

 Time deposit with a bank

 Usually a given period of time

 Cannot be withdrawn, but can be sold over the

Fixed Income : Valuation and Analysis- 19

 Maturity higher than 1 year

 Treasury notes : up to 10 years

Fixed Income : Valuation and Analysis- 20

 Issued by private and public corporations

 Usually, interest payments are semi-annual

 Bond indenture can be very specific and complex

 Classification based on the nature of the issuer :