Fixed Income

JuiceNotes TM
- By FinTree
eBook 8
Fixed Income
CFA® Level 1 JuiceNotesTM 2017

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Fixed-income Securities: Defining Elements

LOS a Basic features of a fixed-income security
Issuers of bonds Supranational entities - Issued by organizations that
operate globally. Eg. World Bank, IMF etc.
Sovereign governments (national) - Issued by national
government entities. Eg. US T-bills
Nonsovereign governments (local) - Issued by non
national government entities. Eg. California state bonds
Quasi-government entities - Agencies that are owned
and sponsored by governments. Eg. postal services
Corporations - Financial companies & nonfinancial

companies
Bond maturity Perpetual bonds - No maturity. Make periodic interest

payments but do not promise to repay the principal
Original maturity < 1 Yr - Money market securities
Original maturity > 1 Yr - Capital market securities
Par value Also referred to as the face value/maturity

value/redemption value/principal value
e
Bond price < Par value - Trading at discount
Bond price > Par value - Trading at premium
re
Coupon payments Coupon is always calculated on Par value
Payments could be annual, semi-annual, quarterly or
monthly
Zero coupon bonds - Make no interest payments.
Bonds are issued at discount and redeemed at par
Currencies Dual-currency bond - Coupon payment in one currency

nT
and principal repayment in another

Currency option bond - Bondholder has a choice of two
currencies
LOS b Content of bond indenture
A legal contract between the issuer (borrower) and investor (lenders) is called bond indenture
Fi
It defines obligations of and restrictions on the borrower

Covenants - Provisions in the bond indenture
LOS c Affirmative Negative

covenants covenants
Actions that borrower Prohibitions on the

promises to perform borrower
Eg. Make timely interest Eg. Restrictions on

and principal payments additional borrowing
LOS d Considerations that affect the issuance and
trading of fixed-income securities
Domestic bonds - They are issued in issuer’s home country and currency
Foreign bonds - Issued by foreign issuers but denominated in the currency
of the country where they trade
Eurobonds - Issued outside a country and denominated in a currency
other than that of the countries in which they trade
Global bonds - Eurobonds that trade in a country other than the country
that issues the currency the bond is denominated in and
in Eurobond market
Issuing entities - Government, corporations etc.

Securitized bonds - Bonds issued by special purpose
entities (SPEs)
Sources of Repayment - Sovereign bonds - Repaid by the tax receipts of the
issuing country
Nonsovereign government bonds - Repaid by general
taxes, revenues of a specific project or fees dedicated to
bond repayment
Corporate bonds - Repaid from cash generated by the
firm’s operations
Collateral and Credit
Enhancements -
e
Unsecured bonds (debentures) - Represent a claim to
overall assets and cash flows of the issuer
Secured bonds - Backed by a claim to specific assets.
Reduces default risk. They are senior to unsecured bonds
re
Collateral - Those specific assets used in issuing secured
bonds
Covered bonds - Similar to Asset backed securities (ABS)
but the underlying assets remain on the B/S of the issuing
company
Credit enhancement - Internal or external
nT
Internal credit enhancement methods -

Overcollateralization, excess spread, dividing bond issue
into tranches and cash reserve fund
External credit enhancements - Surety bonds, bank
guarantees and letters of credit
Taxation - Interest income - Taxed at the same rate as ordinary

income. For municipal bonds is usually tax-exempt
Fi
Capital gains - Taxed at capital gains tax rate
LOS e Structure of CFs of fixed income securities

Typical bond Bullet structure - Periodic interest payments and principal value at maturity
structure - Balloon payment - Final interest payment + Principal at
maturity
Amortizing structure - Part of principal is paid at each payment date
Fully amortizing structure - Equal payments
Partially amortizing structure - Balloon payment of
remaining principal at maturity
Sinking fund provision - Requires the issuer to retire a portion of a bond issue at
specified times
Floating-rate notes Their interest rate is dependant on market rate (reference rate)
FRN coupon = Reference rate (LIBOR) + margin
Variable-rate note - Margin is not fixed

Interest rate cap - Limit on how high the coupon rate can rise
Benefits the issuer (borrower)
Interest rate floor - Minimum rate that investor receives
Benefits the lender (investor)
Inverse floater(FRN) - Coupon rate Ç when reference rate È
Other coupon structures

Step-up coupon bonds - Coupon rate increases over time according to a
predetermined schedule
Credit-linked coupon bond - If credit quality È Coupon rate Ç (Double Jeopardy Bonds)
Payment-in-kind (PIK) bond - Allows the issuer to make coupon payments by increasing
principal amount of the outstanding bonds
Deferred coupon bond - Coupon payments do not begin until a period of time after
issuance
e
Index-linked bond - Coupon payments and/or a principal repayment is based on
a commodity index, equity index or some other index
Inflation-linked bonds - Most common type
re
Principal protected bonds - Indexed bonds that do not pay
less than their original par value at maturity
LOS f Contingency provisions affecting the timing and/or

nature of cash flows of fixed-income securities
nT
Ê Contingency provision - An action that may be taken if contingency actually occurs

These provisions in bond indentures are referred to as embedded options
Ê Callable bonds - Issuer can buy back the bond from bondholder (value to the issuer)
Ê Putable bonds - Bondholder can sell the bond back to issuer (value to the bondholder)
Ê Convertible bonds - Option to exchange the bond for shares (value to the bondholder)
Owners of these bonds have downside protection. Often referred to as hybrid security
Fi
Even if the share price increases to a level where the conversion value is significantly above
the bond’s par value, bondholders might not convert the bonds to common stock because the
interest yield > dividend yield on common shares received through conversion. For this
reason, many convertible bonds have call provision
Ê Warrants - Holder of a warrant has right to buy the firm’s common shares at a given price
over a given period of time
Ê Contingent convertible bonds (CoCos) - Bonds that convert from debt to common shares
automatically if a specific event occurs
Fixed-income Markets: Issuance, Trading And Funding

LOS a Classifications of global fixed-income markets
Type of Credit Original Coupon Tax

Currency Geography Indexing
issuer quality maturity structure status
BBB and above - Fixed rate or Developed Municipal bonds -

Investment grade floating rate markets - Less Tax exempt, lower
bonds riskier yield
BB and below - Emerging markets

Junk bonds - More riskier
Government, Money USD, Euro etc. Index-linked

corporation market, bonds
etc. capital market
securities
LOS b Use of reference rates in floating-rate debt

Most widely used reference rate is London Interbank Offered Rate (LIBOR)
è
è
è
It is a rate at which one bank lends another bank
For short term
Currency is USD
e
Characteristics of US LIBOR
re
è Issued out of US
è It is an add-on rate
è No compounding of interest rate
è Different LIBOR exist for different maturities
è 360 day convention is used
Reference rate must match the frequency of the coupon

nT
Eg. If a bond’s interest rate is reset twice a year, appropriate reference rate is 6-month LIBOR
LOS c Mechanisms available for issuing bonds in primary markets

Public offering - Bonds are sold to the public
Private placement - Bonds are sold only to qualified investors
Underwritten offering - Entire bond issue is purchased by the
Fi
investment bank (underwriter)

Best efforts offering - Investment bank does not commit to
purchase the whole issue
LOS d Secondary markets

Markets where previously issued bonds trade
Most bonds are traded in dealer markets (OTC markets)
Liquid issues - Difference between bid-ask price is narrower
Less liquid issues - Difference between bid-ask price is wider
Settlement cycle:
Government bonds - T+1

Corporate bonds - T+2 or T+3
LOS e Securities issued by sovereign governments

Sovereign (national) governments issue bonds that are backed by the taxing power
Sovereign governments may issue the bonds denominated in their own currency or
foreign currency
LOS f Securities issued by
Supranational Non-sovereign Quasi-government

agencies governments entities
Backed by taxing authority Yields are marginally

High credit quality, (local) or revenues from a higher than those of
liquid specific project sovereign bonds
LOS g Types of debt issued by corporations
Bank debt
Commercial
paper
e Corporate
bonds
re
Term maturity
Bilateral loan - Loan It is a short term structure - All bonds
given by only one unsecured debt issued mature on the same
bank by creditworthy date
nT
companies
Syndicated loan - Loan Serial maturity
given by a group of It is used to fund structure - Bonds
banks working capital mature on different
dates
LOS h Short-term funding alternatives available to banks

Fi
Customer deposits - Short-term funding source

Certificates of deposit (CDs) - Another short-term funding source. CDs mature
on specific dates. Negotiable CDs can be sold
Central bank funds market - Banks may buy or sell excess reserves
deposited with their central bank
Interbank funds - Funds loaned by one bank to another
LOS i Repurchase agreements
One party sells a security to a counterparty with a commitment to buy it back at a later
date at a specified (higher) price
Repo rate - Annualized percentage difference between selling and buying price
Repo margin (haircut) - Difference between the market value and the amount loaned
Reverse repo - Bond dealer lends funds instead of borrowing
Repo margin will be lower if, Repo rate will be lower if,
Ÿ Borrower has high credit quality Ÿ Collateral is delivered

Ÿ Higher quality of collateral Ÿ Higher quality of collateral
Ÿ Maturity is shorter Ÿ Maturity is shorter
Ÿ Security is in short supply and high demand Ÿ General interest rates are lower
Eg. Sells a security @ 93 (Market Value = 97)

Bond
Lender
dealer
Promise to buy back @ 96 after 3 months

Bond
Lender
dealer
3
Repo rate =
e
93
= 3.22%
Repo margin = 97 − 93 = 4
re
nT
Fi
Introduction To Fixed-Income Valuation

LOS a Calculating bond price using YTM
MV of bond is PV of future CFs discounted at current YTM (Yield-to-maturity)
Eg. Calculate the bond price when
Maturity = 4 Yrs Coupon rate = 10% YTM = 12% Face value = 1000
N = 4 PMT = 100 I/Y = 12 FV = 1000 CPT PV = −939.25
LOS b Relationship b/w bond price, coupon rate, maturity and YTM
ª If YTM Ç Price of the bond È
ª If Coupon rate > YTM - Premium bond

ª If Coupon rate < YTM - Discount bond
ª Price-yield relationship is convex
ª Longer maturity - Price is more sensitive to a change in yield
LOS c Calculating bond price using spot rates
Eg.
e
Spot rates - 1-Yr - 4% 2-Yr - 5% 3-Yr - 6% 4-Yr - 7%
Face value - 1000 Calculate price of the bond
re
60 60 60 1060
Price = + + +
(1 + 0.04)1 (1 + 0.05)2 (1 + 0.06)3 (1 + 0.07)4
Price = 57.69 + 54.42 + 50.37 + 808.66
= 971.14
LOS d
nT
Flat price Accrued Full price

(Clean price) interest (Dirty price)
It is the quoted price of a bond Can be calculated using

Transaction price
actual/actual convention (govt.
Full Price − Accrued interest bonds) or 30/360 convention
Includes accrued interest
Fi
(Corp. bonds)
Eg. YTM = 15% Face value = 1000 Coupon rate = 20%
0 5 5.7 6 10
Price of the bond at year 5 - FV = 1000 PMT = 200 N = 5 I/Y = 15 PV = 1167
Full price of the bond (5.7) - 1167 × (1 + 0.15)0.7 = 1287

Flat price of the bond (5.7) - 1287 − (200 × 0.7) = 1147
LOS e Matrix pricing
Method of estimating YTM of the bonds that are not traded
Rating must be same but coupon rate does not have to be same
Eg. Determine YTM of a non traded BB rated, 5% annual-pay
bond that has 4 years remaining until maturity
YTMs of similar bonds are:
BB rated, 3 year annual-pay, 6% coupon bond - 5.5%
BB rated, 6 year annual-pay, 7% coupon bond - 6.5%
3-year bond - 5.5% Difference in 3 years - 1%

6-year bond - 6.5% Difference in 1 year - 0.33%
YTM of non traded bond = 5.5 + 0.33 = 5.83%
LOS f Yield measures

For annual coupon bond
Effective earning yield = Yield to maturity
For semi-annual coupon bond
Effective earning yield > Yield to maturity
Eg. Annual coupon bond Semi-annual coupon bond

Face value = 1000 Coupon rate = 15%
Maturity = 8 yrs. Market value = 800
FV = 1000 PMT = 150 N = 8 PV = −800
CPT I/Y = 19.73 e Face value = 1000 Coupon rate = 17%
Maturity = 10 yrs. Market value = 870
FV = 1000 PMT = 85 N = 20 PV = −870
CPT I/Y = 10.03 x 2 = 20.06
re
EAY = (1 + 10.03)2 − 1 = 21.06%
EAY > YTM
Street convention - Yield calculated using the stated coupon payment dates
True yield - Yield calculated after considering weekends and holidays
nT
Street convention yield > True yield
Annual Coupon Annual coupon + Disc. amort. − Prem. amort.

Current yield - Simple yield -
Bond price Bond price
Semi-annual bond Semi-annual bond

Face value = 1000 Coupon rate = 10% Face value = 1000 Coupon rate = 10%
Maturity = 10 yrs. Market value = 850 Maturity = 10 yrs. Market value = 900
Fi
Discount amortized = 100/5 = 20

100 100 + 20
Current yield = Simple yield =
850 900
Current yield = 11.76% Simple yield = 13.33%
Yield to call (YTC) Yield to worst (YTW)

Eg. Face value = 1000 Coupon rate = 10% Market value = 1020 Lowest of YTM and YTCs is called
Callable in four years at 103 YTW
YTC - FV = 1030 PMT = 100 N = 4 PV = −1020 I/Y = 10.01%
Floating-rate note yields
ª FRN yield = LIBOR + Quoted margin
ª Coupon rate for the next period is set using the current reference rate
(LIBOR) for the reset period
ª Values of FRNs are more stable than those of fixed-rate debt of similar
maturity because the coupon interest rates are reset periodically
ª Issuer with more credit risk - Quoted margin is higher

ª Issuer with less credit risk - Quoted margin is lower
ª Required margin (discount margin) - Margin that brings FRN to its par value
ª Credit quality Ç - Quoted margin > Required margin

When this happens we say that FRN is trading at premium
ª Credit quality È - Quoted margin < Required margin

When this happens we say that FRN is trading at discount
Money market instrument yields
ª Yield can be quoted on discount basis or add-on basis

ª These may be 360-day or 365-day
e
ª US T-bills - Quoted as discount bond and is based on 360-day convention
ª Libor and bank CDs - Quoted as add-on yield
ª Appropriate yield measure for money market instruments - Bond equivalent yield
re
LOS g
Yields Spot rates
nT
Maturities Maturities
Yield curve Spot curve
Displays yields for different maturities Yield curve for single payments in the future
Fi
Coupon rates Forward rates
Maturities Maturities
Par curve Forward curve
Constructed from the spot curve Displays yields for same maturities
LOS h Calculating forward rates using spot rates
Eg. Spot5 = 15% Spot7 = 20% Calculate 2-yr forward rate, 5 years from now
Formula Logic Magic

(Approx.)
100 358.31 20 x 7 = 140
20%
(1 + 20%)7
√ (1 + 15%)5
− 1
0 7 0 7
100 201.13 358.31 15 x 5 = 75 65

15%
0 5 7 0 5 7
33.47% 33.47% 65/2 = 32.5%
LOS i Yield spread

It is the difference between yields of two bonds
Benchmark spread - Yield spread relative to a benchmark bond
G-spread - Yield spread relative to a government bond
Interpolated spread (I-spread) - Yield spread relative to a swap rate
e
Z - spread eg. Risky bond, Face value = 1000 Coupon rate = 10% Maturity = 4 yrs Market value = 860
Spot rates (treasury) - Year 1 - 10%, Year 2 - 11%, Year 3 - 12%, Year 4 - 15%
re
100 100 100 1100
860 = + + +
(1 + 10% + z-spread)1 (1 + 11% + z-spread)2 (1 + 12% + z-spread)3 (1 + 15% + z-spread)4
Z-spread is determined by trial and error method

nT
Option adjusted spread
Bond - A Bond - B
(With call option) YTM = 16.48%
Face value = 1000 Face value = 1000

Option adjusted Option risk
Coupon rate = 10% Coupon rate = 10% yield
Fi
YTM = 15% YTM = 16.48%
Maturity = 5 Yrs Maturity = 5 Yrs 15% 1.48%
Market Value = 832 Market Value = 790

Introduction To Asset-backed Securities

LOS a Benefits of securitization
Securitization is a process in which an entity (SPE) purchases financial assets such

as mortgages, loans etc. and sells them in the form of securities to investors
Primary benefits:
Œ Reduction in funding costs
Increase in the liquidity of financial assets
Other benefits:
ª Provides higher risk-adjusted returns for investors

ª Investors’ legal claim to the mortgages is stronger
ª After securitization securities are actively traded
ª Banks are able to lend more because the bank receives proceeds when its
financial assets are securitized
ª Securatization has led to financial innovation
ª Provides diversification and risk reduction compared to purchasing whole loans
LOS b Securitization process

Mortgages, loans are sold
Bank
e
Receives cash
Special purpose
entity (SPE)
re
Servicer
Mortgages and loans Known as ‘trust’ and is set
(assets) are removed from up specifically for buying
the B/S these loans and selling ABS
to investors
May use cash proceeds to
nT
make more loans Services the loans
Principal and interest payment

received on loans is used to pay
servicing fees to the servicer
and then to ABS owners
Trust may issue ABS in several classes (tranches)

Fi
Waterfall structure - Each tranche of ABS is paid sequentially
SPE is a separate legal entity and buyers of ABS do not have claim on other assets of the bank
LOS c Typical structures of securitizations

è In ‘tranches’ structure - Some tranches bear more risk while other bear less
è Credit tranching (senior/subordinate structure) - Losses are first absorbed by the tranche
with lowest priority
è Time tranching - First tranche receives all principal repayments from underlying assets up to
the principal value of the tranche
LOS d Residential mortgage loans
Collateral of the loan is residential real estate
Loan amount
Loan-to-value ratio (LTV) - x 100
Value of collateral real estate
If Ç LTV, then borrower’s equity È
For lenders,
ª Loans with low LTVs is less riskier (because borrower loses more in case of default)
ª If the property value is high compared to the loan amount, lender is more likely to
recover the amount loaned if borrower defaults
Prime loans - Mortgages with high LTV ratios, made to borrowers of high credit quality
Subprime loans - Mortgages to borrowers of lower credit quality
Characteristics of residential mortgage loans:
ª Maturity - Typically 15-30 yrs

ª Interest rate - Fixed rate, adjustable rate or convertible
ª Amortization - Fully amortizing, partially amortizing or interest-only
ª Prepayment provisions - Some loans have prepayment penalty
ª Foreclosure - Non-recourse and recourse loans
LOS e & f Residential mortgage backed securities (RMBS)
e
ª Agency RMBS - Issued by GNMA, FNMA and Freddie Mac. Agency RMBS are
mortgage pass-through securities. Generally high quality.
re
ª Non-agency RMBS - Issued by private companies. Non-agency RMBS typically
include credit enhancement
ª Collateralized mortgage obligations (CMOs) - Collateralized by pools of RMBS.

They are structured with tranches
ª In sequential-pay CMO -
nT
Ÿ First tranche to be paid principal has most contraction risk

Ÿ Last tranche to be paid principal has most extension risk
ª Planned amortization class (PAC) tranches - A PAC tranche is structured to

make predictable payments, regardless of actual prepayments. PAC tranches
have both reduced contraction and extension risk
ª Prepayment risk - Uncertainty about timing of the principal CFs from the ABS
Fi
ª Contraction risk - Risk that loan principal will be repaid more rapidly than
expected (when interest rates decrease)
ª Extension risk - Risk that loan principal will be repaid more slowly than
expected (when interest rates increase)
LOS g Commercial mortgage backed securities (CMBS)
ª CMBS are backed by income-producing real estate properties such

as shopping malls, office buildings, apartments etc.
ª RMBS loans are repaid by homeowners whereas CMBS loans are

repaid by real estate investors
ª CMBS are typically structured as non-recourse loans
ª There is a two level call protection (loan level and structural level)
ª Two key ratios to assess credit risk

Œ Debt-to-service-coverage ratio
Loan-to-value ratio
LOS h Non-mortgage ABS

ABS may backed by financial assets other than mortgages. Eg. Auto loan ABS and
credit card ABS
Auto loan ABS Credit card ABS
ª Backed by credit card

ª
ª
ª
Backed by automobile loans
Typically fully amortizing
Shorter maturities than
RMBS e receivables
ª Non-amortizing (revolving
debt)
ª Have a lockout period
during which only interest
re
is paid
LOS i Collateralized debt obligations (CDOs)

nT
è Collateral is a pool of debt obligations that is managed by a collateral manager
è Collateralized bond obligations (CBOs) - When collateral securities are corporate and
emerging market debt
è Structured finance CDOs - Collateral is ABS, RMBS, other CDOs and CMBS
è Collateralized loan obligations (CLOs) - Backed by leveraged bank loans

Fi
è Synthetic CDOs - Collateral is portfolio of credit default swaps (CDS) on structured securities
RFR + Selling CDS
è CDOs have 3 tranches - Senior bonds, mezzanine bonds, and subordinated bonds
Understanding Fixed-Income Risk And Return

LOS a Sources of return from fixed-rate bond
Œ Coupon and principal payments
Reinvestment of coupons
Ž Capital gain/loss if bond is sold before maturity
An investor always earns at YTM, if he holds the bond till maturity and reinvests at YTM
Interest rate risk (market price risk) - Uncertainty about bond’s price
Reinvestment risk - Uncertainty about income from reinvestment of coupon payments
Shorter investment horizon - Interest rate risk > reinvestment risk

Longer investment horizon - Interest rate risk < reinvestment risk
Increase in YTM decreases the bond price but increases reinvestment income
LOS b
Macaulay Modified Effective
duration duration duration
Weighted average maturity of

a bond portfolio
e
Approx. measure of %∆ in
bond’s price for a 1% change
in YTM
Appropriate measure of risk
for bonds with embedded
options (callable/putable)
re
Weights are based on
discounted CFs Modified duration - Effective duration -
Macaulay duration - V− − V+ V− − V+
∑ Weights x Maturities 2 × V0 × %∆ in yield 2 × V0 × ∆ yield curve
For ZCBs, Macaulay duration = Bond maturity

nT
For Fixed coupon bond, Macaulay duration < Bond maturity
Macaulay duration > Modified duration

Macaulay duration
Modified duration can also be calculated as -
(1 + YTM)
V− = Higher bond price V+ = Lower bond price V0 = Base price

Fi
Eg #1 Macaulay duration
Maturity Cash flow Disc. CF Weights Weighted avg.

Face value = 1000
Coupon rate = 15% 1 150 136.36 16.83% 0.17
Maturity = 4 yrs
2 150 113.42 14.04% 0.28
Spot1 = 10% 3 150 86.8 10.74% 0.33
Spot2 = 15%
Spot3 = 20% 4 1150 471.04 58% 2.32
Spot4 = 25% Macaulay
Total 807.63 3.1
duration
Eg #2 Modified duration
Face value = 1000

Coupon rate = 10%
− 1% Maturity = 10 Yrs + 1%
9% YTM = 10% 11%
+ 6.4% − 5.9%
1064 1000 941
6.4 + 5.9
Modified duration =
2
= 6.15
Interpretation - If yield changes by 1%, bond price will change by 6.15%
LOS c Why effective duration is the most appropriate measure

of interest rate risk for bonds with embedded options ?
e
Embedded options have uncertain future CFs, because of which PV calculations for
bond value based on YTM cannot be used
re
LOS d Key rate duration (partial duration)
Parallel shift in yield curve Nonparallel shift in yield curve
nT
Duration Key rate duration
Key rate duration - Measure of sensitivity of price of a bond to a change in spot

rate for a specific maturity. It captures shaping risk.
LOS e Effect of maturity, coupon and yield on duration

Bond price Bond price
Fi
Variable Effect
Maturity Ç Duration Ç
Coupon Ç Duration È
YTM Ç Duration È Yield Yield

Callable bond Putable bond
(Lower duration (Lower duration
Callable bond - Lesser duration when yields È at lower yield) at higher yield)
Putable bond - Lesser duration when yields Ç
Optionality of bond will never increase the duration

LOS f Duration of portfolio
Calculating weighted Calculating weighted

average number of average of durations of
periods until the individual bonds in the
portfolio’s cash flows portfolio
will be received
Yield measure - Cash flow

This approach is used in
yield (IRR of the bond
practice
portfolio)
Not useful for a portfolio Useful for a portfolio that

that contains bonds with contains bonds with
embedded options embedded options
Weights are based on full

price of each bond
Limitation - For portfolio
e duration to ‘make sense’

the YTM of every bond
in the portfolio must
change by the same
re
amount (parallel shift)
LOS g Money Price value of

duration a basis point
Aka dollar duration

Money change in the full price of
nT
a bond when YTM changes by

Money duration -
one basis point (0.01%)
Modified duration × Full price
Money duration × % ∆ in YTM = Change in bond price (absolute amount)
Eg. Market value = $1050 Modified duration = 6 ∆ in yield = 50 bps
Money duration = Modified duration × Full price

Fi
= 6 × 1050
= $6300
Change in bond price = Money duration × % ∆ in YTM

= 6300 × 0.5%
= $31.25
PVBP = 0.5% ª $31.25

0.01% ª $0.625
LOS h Convexity
Face value = 1000
Coupon rate = 10%
− 1% Maturity = 10 Yrs + 1%
9% YTM = 10% 11%
+ 6.4% − 5.9%
1064 1000 941
Convexity refers to the curvature of a bond’s price-yield relationship
Due to convexity(+ve), bond price increases more for a given change in yield as
compared to decrease(%) for same change in yield
Increase in yield causes price to decrease at decreasing rate and

Decrease in yield causes price to increase at increasing rate
LOS i
e
Calculating % ∆ in the full price of a bond
% ∆ full price of bond = −Duration(∆Y) + 1/2 × Convexity(∆Y)2
re
LOS j Term structure of yield volatility and duration
Term structure of yield volatility - Relationship between maturity and yield volatility
Short-term yields may be more volatile than long-term yields

nT
LOS k Relationship between bond’s HPR, duration and investment horizon

FV = 1000 Coupon = 12.55% YTM = 5%
Price risk Reinvestment

dominates risk dominates
−1583 1000
Fi
0 3 7 10
Macaulay duration
Realized Realized yield is Realized yield

1 YTM = 9%
yield is lower close to 5% is higher
Realized yield Realized yield is Realized

2 YTM = 2%
is higher close to 5% yield is lower
Duration gap = Duration gap =

+ve −ve
−1583 1000
0 3 7 10
Macaulay duration
Duration gap =
Zero
LOS l How changes in credit spread and liquidity affect YTM
Bond’s spread to benchmark curve has two components

Credit risk premium and Liquidity premium
Given change in any of these components will have direct impact on YTM
e
re
nT
Fi
Fundamentals Of Credit Analysis

LOS a & b
Credit risk Possibility of failure of a borrower to make timely and full
payments of interest or principal. It has two components
Default risk - Probability that borrower (issuer) fails to pay
interest or repay principal
Loss severity (loss given default) - Value a bond investor will
lose if the issuer defaults. 1 − Recovery rate
Expected loss Default risk × loss severity
Recovery rate % of bond value investor receives, if issuer defaults
Downgrade risk Possibility that spreads will increase because the issuer has
(Credit migration risk) become less creditworthy
Liquidity risk Risk of receiving less than market value
Spread risk Possibility that bond’s spread will widen due to downgrade
risk or liquidity risk or both
LOS c Seniority rankings

Seniority ranking - Bond’s priority of claims to the issuer’s assets
e
General seniority rankings
First lien
re
Senior secured debt
Junior secured debt
Senior unsecured debt
Senior subordinated debt
Subordinated debt
Junior subordinated debt
nT
All debt within the same category is said to rank pari passu. They have same
priority of claims
Lower seniority ª Higher credit risk ª Higher YTM
Since bankruptcies are costly and take a long time to settle, strict priority of
claims may not be followed
Fi
LOS d Issuer credit ratings Issue credit ratings

Called as Corporate Family
Ratings (CFR) Called as Corporate Credit
Ratings (CCR)
Based on the overall
creditworthiness of the company Based on credit risk of specific
debt issue
Issuers are rated on their senior
unsecured debt
Notching It is the practice by rating agencies of assigning different ratings
to bonds of the same issuer
Structural Bonds of parent company are subordinate to bonds of subsidiary

subordination company
LOS e Risks in relying on ratings from credit rating agencies
Credit ratings Rating agencies Event risk is Credit ratings lag

are dynamic are not perfect difficult to assess market pricing
Credit ratings Rating agencies Specific risks of a Market prices and

change over time cannot always judge company or industry credit spreads
credit risk accurately are difficult to change much faster
predict and than credit ratings
incorporate into
credit ratings
LOS f 4 Cs of traditional credit analysis

Œ Capacity - Borrower’s ability repay its debt obligations. Three levels of assessment -
Industry structure, industry fundamentals and company fundamentals
More important for less creditworthy companies

e
Collateral - Assets pledged against a debt, available to creditors in case of default.
Ž Covenants - Provisions in bond indenture. They protect lenders. Affirmative/negative

re
Character - Management’s professional reputation and the firm’s history of debt
repayment
LOS g Financial ratios used in credit analysis

nT
Profit and Leverage Coverage

Cash Flows Ratios Ratios
EBITDA Debt/capital
Funds from operations (FFO) Debt/EBITDA EBITDA/interest expense.
Free cash flow before dividends FFO/debt EBIT/interest expense

Fi
Free cash flow after dividends FCF after dividends/debt
LOS h Evaluating credit quality

Indicators of lower credit risk (higher credit rating) -
È Leverage, Ç Interest coverage, and Ç free cash flow
Analyst should consider underfunded pensions and off-balance-sheet financing

while calculating leverage ratios
LOS i Factors that influence level and volatility of yield spreads
ª Credit cycle - Credit spreads narrow as credit cycle improves. Credit spreads widen
as credit cycle deteriorates
ª Economic conditions - Spreads narrow as economy strengthens and spreads widen

as economy weakens
ª Financial market performance - Spreads narrow in strong-performing markets,

spreads widen in weak-performing markets
ª Broker-dealer capital - Spreads narrow when broker-dealers provide sufficient

capital, Spreads widen when capital becomes scarce
ª Market demand and supply - Spreads narrow when demand > supply, spreads widen
when demand < supply
Yield spreads on lower-quality issues tend to be more volatile than spreads on higher-quality issues
LOS j Special considerations when evaluating different debts
High yield debt Sovereign debt Non-sovereign debt
More likely to default

than investment grade
e
Credit risk includes
country’s ability and Analysis is similar to
re
bonds willingness to pay analysis of sovereign
debt
Analysis should focus Credit risk is lower for
on liquidity, projected bonds issued in Focus is on local
financial performance, country’s own currency economy and its effect
debt structure and than for bonds issued on tax revenues
debt covenants in foreign currency
nT
Fi

Fixed Income

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JuiceNotes TM

CFA® Level 1 JuiceNotesTM 2017

Fixed-income Securities: Defining Elements

Corporations - Financial companies & nonﬁnancial

Bond maturity Perpetual bonds - No maturity. Make periodic interest

Par value Also referred to as the face value/maturity

Currencies Dual-currency bond - Coupon payment in one currency

and principal repayment in another

LOS b Content of bond indenture

It deﬁnes obligations of and restrictions on the borrower

LOS c Afﬁrmative Negative

Actions that borrower Prohibitions on the

Eg. Make timely interest Eg. Restrictions on

Issuing entities - Government, corporations etc.

Internal credit enhancement methods -

Taxation - Interest income - Taxed at the same rate as ordinary

Capital gains - Taxed at capital gains tax rate

LOS e Structure of CFs of ﬁxed income securities

Variable-rate note - Margin is not ﬁxed

Other coupon structures

LOS f Contingency provisions affecting the timing and/or

Ê Contingency provision - An action that may be taken if contingency actually occurs

Fixed-income Markets: Issuance, Trading And Funding

Type of Credit Original Coupon Tax

BBB and above - Fixed rate or Developed Municipal bonds -

BB and below - Emerging markets

Government, Money USD, Euro etc. Index-linked

LOS b Use of reference rates in ﬂoating-rate debt

Reference rate must match the frequency of the coupon

LOS c Mechanisms available for issuing bonds in primary markets

investment bank (underwriter)

LOS d Secondary markets

Government bonds - T+1

LOS e Securities issued by sovereign governments

LOS f Securities issued by

Supranational Non-sovereign Quasi-government

Backed by taxing authority Yields are marginally

LOS g Types of debt issued by corporations

LOS h Short-term funding alternatives available to banks

Customer deposits - Short-term funding source

Reverse repo - Bond dealer lends funds instead of borrowing

Ÿ Borrower has high credit quality Ÿ Collateral is delivered

Eg. Sells a security @ 93 (Market Value = 97)

Promise to buy back @ 96 after 3 months

Introduction To Fixed-Income Valuation

Eg. Calculate the bond price when

N = 4 PMT = 100 I/Y = 12 FV = 1000 CPT PV = −939.25

ª If YTM Ç Price of the bond È

ª If Coupon rate > YTM - Premium bond

ª Price-yield relationship is convex

ª Longer maturity - Price is more sensitive to a change in yield

LOS c Calculating bond price using spot rates

Price = 57.69 + 54.42 + 50.37 + 808.66

Flat price Accrued Full price

It is the quoted price of a bond Can be calculated using

Eg. YTM = 15% Face value = 1000 Coupon rate = 20%

Price of the bond at year 5 - FV = 1000 PMT = 200 N = 5 I/Y = 15 PV = 1167

Full price of the bond (5.7) - 1167 × (1 + 0.15)0.7 = 1287

3-year bond - 5.5% Difference in 3 years - 1%

YTM of non traded bond = 5.5 + 0.33 = 5.83%

LOS f Yield measures

Eg. Annual coupon bond Semi-annual coupon bond

Street convention yield > True yield