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Fixed Income

This document provides an overview of key concepts in fixed income markets, including: 1) Bond indentures are contracts that define the terms of bonds, and floating rate securities set coupon rates as a reference rate plus or minus a quoted margin. Bonds have risks related to interest rates, credit, liquidity, and other factors. 2) Yield curves can shift in parallel or non-parallel ways. Duration measures the sensitivity of bond prices to changes in yields but is not accurate for portfolios with non-parallel shifts. 3) Treasury securities include bills, notes, and bonds of different maturities. Mortgage-backed securities and collateralized mortgage obligations allow investors to match liquidity preferences.

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222 views3 pages

Fixed Income

This document provides an overview of key concepts in fixed income markets, including: 1) Bond indentures are contracts that define the terms of bonds, and floating rate securities set coupon rates as a reference rate plus or minus a quoted margin. Bonds have risks related to interest rates, credit, liquidity, and other factors. 2) Yield curves can shift in parallel or non-parallel ways. Duration measures the sensitivity of bond prices to changes in yields but is not accurate for portfolios with non-parallel shifts. 3) Treasury securities include bills, notes, and bonds of different maturities. Mortgage-backed securities and collateralized mortgage obligations allow investors to match liquidity preferences.

Uploaded by

api-294072125
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Fixed Income

Bond Indenture = contract


Cap + Floor = Collar
Floating rate securities: New Coupon Rate = reference rate +/- quoted margin
Full or dirty price = clean price + accrued interest
Call protection - period it cannot be called
Non-refundable = cannot be called using proceeds from lower bond issue
Sinking fund = retires X amount per year

Interest Rate Risk (Duration) longer maturity ; lower coupon ; lower yield
Yield Curve Risk; Call Risk; Prepayment Risk; Credit Risk; Liquidity Risk; Exchange rate risk; Inflation Risk;
Volatility Risk; Event Risk; Sovereign Risk
Yield Curve Shifts Parallel shifts VS non-parallel shifts
Parallel all bonds within a portfolio change by the same absolute percent amount
Non parallel = duration is poor approximation of sensitivity of portfolio, must calc key rate durations
Primary Market = underwriting; bought or best efforts; Auction process or private placement
2nd ary market = OTC; exchanges; etc
Duration = - % bond price / % yield
Sovereign Bonds
Treasury Securities:
Bills = no coupons, sell @ discount to par (28, 91, 182 days)
Notes = semiannual coupon (2,3,5,10 years);

Bonds = 20 or 30 years

Treasury Bond / Note: quoted in % and 32s of % face value ex (102-5 is 102 + 3/32 = 1.0215625)
TIPS : Treasury Inflation Protected Securities
Fixed coupon paid semi-annually X % of inflation adjusted par value
TIPS coupon = adjusted par value X stated coupon / 2

MBSs are backed by pools of mortgages.


CMOs: tranches: interest only until previous tranches are paid off, then principle + interest; allows
to match liquidity preferences
Insured bonds: pre-refunded bonds: special escrow account w sufficient treasury securities to
satisfy existing bond obligations.
Structured Medium term notes; step up notes; inverse floater; deleveraged floaters; dual index
floaters; range notes; index amortizing notes;
Commercial paper = 270 days or less
CDOs: pools and tranches like CMOs.

Pure Expectations Theory; Liquidity Preference Theory; Mkt Segmentation Theory


Spot Rates
Absolute Yield Spreads = yield on higher yield on lower
Relative Yield Spread = Absolute Yield Spread / yield on benchmark bond
Yield Ratio = subject bond yield / benchmark bond yield (or 1 RYS)
Expanding economy:

spreads narrow (decline)

Contraction economy: spreads widen (junk bonds need to offer much higher rate)
Current yield = annual cash coupon / bond price
YTM = Annualized IRR (assumes cfs are reinvested at YTM rate and bond is held to maturity)
YTM > coupon -> discount bond;

YTM < Coupon -> premium bond

BEY = 2 X semiannual discount rate OR =


YTC; YTFC; YTPar Call; YTWorst; YT refundings; YT put; CFY
Realized Yield = initial investment only
BEY of Annual =

[(1 + annual YTM)1/2 1] X 2

EAY of Semi

(1 + YTM Semi / 2)2 1

Three year spot rates; deriving forward rates, etc


Nominal yield spread = simple YTM bond YTM treasury

ZVS
= equal amount that must be added to each rate on T spot yield curve to make PV of risky
bonds cash flows equal to its market price
= steeper the spot rate curve, greater the ZVS & nominal S difference
Spot rate curve upward sloping: ZVS ;

S yield curve ive sloping: ZVS < NS

The earlier the principle is repaid, greater the differences in spread measures
OAS = measure used when bonds have embedded options; Spread it would have had if the option was
gone
Z spread OAS = option cost in %
Callable Bonds: Z-spread > OAS and option cost > 0; Putable = ZVS < OAS; option < 0;

Full Valuation = stress testing


Duration / convexity approach
Positive convexity increases more when yields fall than it decreases when yields rise
bonds price falls @ decreasing rate as yields rise.
Duration of a bond @ any yield is slope of price yield relation. (duration is less @ higher yields).
Negative Convexity callable & prepayable securities
Put-able bonds
Effective duration =

(bond price when yields fall + bond price when yields rise)
2 X initial price X ( in yield)
=

V- + V+ - / (2)(Vo)(y)

Macaulay Duration = estimate of a bonds interest rate sensitivity based on time (option free only)
Convexity = measure of curvature of price yield curve
% price

duration effect + convexity effect

{ [ - duration X (y)] + [ convexity X (y)2] } X 100

PVBP = duration X 0.0001 X bond value

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