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CFA_Level 1_06_Fixed Income_2023 Latest
CFA, Level 1, fixed income, latest in 2023, content includes: R1:Fixed-Income Securities:Defining Elements R2:Fixed-Income Markets:Issuance,Trading,and Funding R3: Introduction to Fixed-Income Valuation R4: Introduction to Asset-Backed Securities R5: Understanding Fixed-Income Risk and Return R6: Fundamentals of Credit Analysis
Edited at 2023-07-21 22:48:59
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CFA_Level 1_06_Fixed Income_2023 Latest
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Fixed Income
R1: Fixed-Income Securities: Defining Elements
Essence
A kind of securities
Creditor-debtor relationship
Features
Issue
Supranational organizations
Sovereign (national) governments
Non-sovereign (local) governments
Quasi-government entities
Companies
Maturity
Money Market Securities
Capital Market Securities
Perpetual Bond
Par value
Par value / face value / maturity value / redemption value
Coupon
Annual coupon = coupon rate x par value
Currency
Dual-currency bonds
Currency option bonds
Bond Indenture
Securitization
SPEs/SPVs
Bankcrupcy remote
Source of repayment proceeds
Supranational bond
Sovereign bonds
Non-sovereign government debt
corporate bonds
Securitized bonds
Collateral
Secured bonds
Unsecured bonds
Debentures
Asset-backed
Asset-backed security
Covered bond
Credit enhancement
Internal credit enhancement
Subordination
Overcollateralization
Reserve accounts (cash reserve / excess spread)
External credit enhancement
Surety bond
Bank guarantee
Letter of credit
Cash collateral account
Covenants
Negative convenants
Affirmative covenants
Legal, Regulation and Tax
Sectors of bond market (Global)
National bond markets (country = currency)
Domestic bonds (country = currency = issuer)
Foreign bonds (country = currency != issuer)
Eurobond market (country != currency)
Eurobonds
Ownership known?
Bearer bonds (No)
Registered bonds (Yes)
Tax consideration
Interest
Income portion (interest) taxed at ordinary income tax rate
Capital gain or loss
Taxed lower than ordinary income
Original issue discount (OID) bonds
Taxable interest income each year
No additional capital gains tax liability at maturity
Cash Flow Structure of Principal Repayments
Conventional bond
Bullet bond
Ballon payment
Amortizing bond
Fully amortized bond
Partially amortized bond
Balloon payment risk
Sinking fund provision
retire over time
Pros: less credit risk
Cons: more reinvestment risk
Doubling option/accelerated sinking fund
Cash Flow Structure of Coupon Payments
Fixed rate coupon bond
Step-up coupon bond
must have a call option
Floating rate notes
Coupon rate = reference rate quoted margin (spread)
reference rate reset periodically
quoted margin usually constant
Coupon payments paid in arrears
Floor: coupon shall be above floor rate
Cap: coupon shall be below cap rate
Collar: has both floor and cap limits
Inverse/reverse FRN
Coupon rate = - reference rate quoted margin
Leveraged inverse floaters & deleveraged inverse floaters
Index linked bonds
Index: CPI, PPI
Structure
Interest-indexed bonds
Capital-indexed bonds
Index-annuity bonds
Indexed zero-coupon bonds
Treasury inflation protection securities (TIPS)
Deferred coupon bonds / split coupon bonds
Payment-in-Kind (PIK) coupon bonds
Credit-linked coupon bonds
Equity-linked notes (ELN)
Bonds with Contingency Provisions
Callable bond
Call price
Style
American style
Anytime
European style
date
Bermuda style
several dates specified
Beneficial to issuer
Protect against decline in interest rate
V(callable bond) = V(straight bond) - V(call option)
Putable bond
Beneficial to investors
protect against increase in interest rate
V(putable bond) = V(straight bond) V(put option)
Convertible bond
Conversion ratio
number of shared each bond can be converted into
Conversion price
par value/conversion ratio
Conversion premium = the convertible bond's price - conversion value
Conversion parity
At
Above
Conversion value > convertiable bond's price
Below
Callable convertible bond
Call option for issuer
Convertible option for bondholder
Contingent convertible bond
convert automatically if specific event occurs
Bond with warrants
Warrant is attached option
R2: Fixed-Income Markets: lssuance, Trading, and Funding
Market Classification
Type of issuer
Government and government-related sectors
Corporate sector
Securitized sector
Credit Quality
investment grade
Baa3 by Moody / BBB by S&P
Non-investment grade/high yield
Original maturity
money market
Below 1 year
Capital market
Coupon structure
Fixed-rate bonds
Floating-rate bonds
Primary Market and Secondary Market
Primary bond market
Public offering
Underwritten offering
Syndicated offering
a group of i-bank underwrite
Gray market
Traded prior to offering date
Auction
Shelf registration
Best efforts offering
Private placement
Secondary bond market
Organized exchange
OTC markets
Government-Related and Corporate Bonds
Government-related bonds
Sovereign bonds
On-the-run
most recently issued
Off-the-run
US Treasures
T-bills
within 1 year
T-notes
1-10 years
T-bonds
over 10 years
Non-sovereign
GO (general obligation) / Tax-backed debt
revenue bonds
Quasi-government bonds/Agency bonds
Supranational bonds
Corporate debts
Bank loans
Bilateral loan
1 lender to 1 borrower
Syndicated loan
N lenders to 1 borrower
Commercial paper
Corporate notes and bonds
Medium-term notes (MTNs)
Structured Financial Instruments
Repackage and redistribute risk
Categories
Asset-backed securities (ABS)
Collateralized debt obligations (CDOs)
Capital protected instruments
Guarantee certificate
Yueld enhancement instruments
Credit-linked note (CLN)
Participation instruments
Floating-rate bond
Indirect exposure to index
Leveraged instruments
Inverse floater
Inverse floater coupon rate = C - (L*R)
Short-Term Funding & Repurchase Agreements
Retail deposits
Demand deposits/checking accounts
no interest
Saving accounts
pay interest but not same transactional convenience as demand deposits
money market account
Intermediate between demand deposit and saving accounts
Short-term wholesale funds
Central bank funds
Interbank funds
Large-denomination negotiable certificated of deposit (CD)
Repurchase agreement (Repo)
Rapo rate
Higher
Repo term is longer
Credit quality of collateral security is lower
Collateral security is not delivered to lender
Collateral security is in low demand or high supply
Interest rate for alternative funds are higher
Repo margin/haircut
Higher when
Repo term is longer
Credit quality of collateral security is lower
Credit quality of borrower is lower
Interest rate for alternative funds are higher
R3: Introduction to Fixed-Income Valuation
Pricing bond with a single discount rate
Sport rates
Yield Measures
Yield to Maturity
"Pull to par" effect
Capital gain or loss = sales price - carrying value
Other Yield Measure
Annualized
Over 1 year: annualized and compounded
Within 1 year: annualized but not compounded
Yield measures for fixed-rate bonds
Street convention yield
neglect weekends and holidays
True yield
actuail calendar of weekends and holidays
Required margin/discount margin
Quoted margin
Coupon rate = reference rate /- quoted margin
Status
At premuim
quoted margin > required margin
At par
At discount
Discount yield
Add-on yield
Bond equivalent yield (money market security yield)
Forward rates
2y5y: two years into five-year rate
Quote conventions
Accrued interest
Full price = clean price accumulated interest
Clean price / flat price: agreed price
quoted price
Dirty price / full price: amount paid
paid price
Matrix Pricing
Comparable bonds
Used for inactively-traded or not yet issued bonds
Linear interpolation
Yield Spread
G-spread
Government bond
I-spread
standard swap rate
Z-spread
spread over G-spread
OAS
Option-adjusted spread
OAS = z-spread-option value
R4: Introduction to Asset-Backed Securities
Overview
ABS
MBS
RMBS
Agency RMBS
MPS
CMO
Sequential-pay tranches
Planned amortization class
Non-agency RMBS
CMBS
Other ABS
Auto loan receivable-backed securities
Credit card receivable-backed securities
Collateralized debt obligation
Securitization
Securitized assets
Benefits
Disintermediation
Lower funding cost of borrowers
Enhance risk-adjusted return of investors
increase liquidity of financial assets
Investors better legal claims on underlying
Investors access asset classes matching their risk, return, maturity (tranching)
Mortgaga Loans
Foreclosure
Loan-to-value ratio (LTV)
Rate
Fixed rate
Adjustable or variable rate
Initial period fixed rate
Amortizing loan
Fully amortizing loan
Partially amortizing loan
Balloon: last payment
Interest-only mortgage
Prepayment option
Prepayment penalty
Prepayment risk
Recourse/non-recourse loan
Mortgage Pass-Through Security
RMBS
Agency RMBS
Conforming mortgage
Max size of loan
Max LTV ratio
Loan documentation and insurance required
Mortgage pass-through security (MPS)
Weighted average coupon rate (WAC)
Pass-through rate (net interest, net coupon)
Pass-through rate = mortgate rate - service & insurance fee
Weighted average maturity (WAM)
Weighted average life (WAL)
Scheduled principal repayments and projected prepayments
Non-Agency RMBS
Prepayment
Prepayment effects
Reduce the amount of interest
Reinvest return
Single monthly mortality (SMM) rate
monthly
Monthly prepayment = SMM * (mortgage balance - scheduled principal payment)
Conditional prepayment rate (CPR)
Annualized
Public Security Association (PSA) payment benchmark
100 PSA: CPR increases by 0.2% per month up to 30 months
Factors affecting prepayments
Prevailing mortgage rate
Spread between current and original mortgage rates
Rates fall,refinancing increases
Path of mortgage rates
refinancing burnout
Path dependence
Cannot value MBS with the binomial model
Housing turnover
Increases as rates fall
Increases as economic activity rises
Characteristics of underlying mortgages
Seasoning
Prepayment risk
contract risk
Extension risk
Collateralized Mortgaga Obligations (CMO)
Redistribute cash flows
Sequential-pay tranches
Both receive interest payments
Principal payments are directed to Tranche A until it is completed amortized
Z-tranche: last tranche to receive principal
Contraction and extension risk still exist but been redistributed
Planned amortization class (PAC)
PAC tranches: limited protection against both extension and contraction risk
Support tranches / companion tranches: greater repayment risk
Floating-rate tranches
Floater
Inverse floater
Non-Agency RMBS
require credit enhancements
Internal credit enhancements
Senior/subordinated structures
Reserve funds: cash reserve or excess spread account
Overcollateralization
External credit enhancements
Financial guarantee by a third party
Structuring
Redistribute risk
Time tranching
Credit tranching
Not eliminate but redistribute risk
Shifting interest mechanism
Commercial MBS
Non-recourse loans
Measures of credit quality
LTV ratio
Debt service coverage (DSC) ratio
Call protection
Prepayment lockout
Defeasance
Prepayment penalty points
Yield maintenance charges
Balloon risk
is also referred to as extension risk
Other ABS
Auto loan receivable-backed securities
Refinancing is not a major factor in prepayment
Credit card receivable-backed securities
cash flows consist of finance charges, fees, principal repayments
Locked period: principal is reinvested and only finance charges and fees are paid to investors
Collateralized debt obligation (CDO)
Collateralized bond obligation (CBO)
US high-yield corporate bonds
Structured financial products
Emerging market bonds
Collateralized loan obligation (CLO)
Bank loans
Special situation loans and distressed debt
Covered bonds
senior debt obligations issued by a financial institution and backed by a segregated pool of assets
dual recourse
issuing financial institution
underlying asset pool
Redemption regimes
Hard-bullet covered bonds
Soft-bullet covered bonds
Conditional pass-through covered bonds
R5: Understanding Fixed-Income Risk and Return
Interest rate risk
Source of return
Coupon and principal payments
Reinvestment of coupons
Capital gain or loss
Bond sold above/below constant-yield price trajectory
Carrying value = purchase prices /- amortized amount
Interest rate risk
Coupon reinvestment risk
Market price risk
Investment horizons
Market price risk matters for short-term investment horizon
Horizon yield is negatively related to interest rates
Coupon reinvestment risk matters for long-term investment horizon
Horizon yield is positively related to interest rates
Macaulay duration
weighted avg. time of receipts
Assumption: one-time parallel shift
Interest rate risk & investment horizon
Investment horizon > Maculay duration: Reinvestment risk dominates market price risk
Investment horizon = Macaulay duration: offsets
Investment horizon < Macaulay duration: market price risk dominates
Duration gap = Macaulay duration - investment horizon
Duation gap < 0: reinvestment risk dominates
Duration gap = 0: reinvestment risk offsets market price risk
Duation gap > 0: market price risk dominates
Modified duration
percent change of bond's price when 100 basis points change in YTM
YTM and bond prices move in opposite directions
Linear estimate of price change for its YTM change
Approximate modified duration
ModDur = MacDur / (1 r)
Properties of duration
Interpret duration
Weighted average of time
Percentage change in price of 1% change in yield
Slope of price-yield curve
1st derivative
Properties
Longer time-to-maturity -> higher duration
Higher coupon rate -> lower duration
Higher YTM -> lower duration
Dollar duration
price change in units of currency given a change in YTM
Price value of a basis point (PVBP, DB01): money change when YTM changes 1 basis points
Effective duration
Duration
Yield duration
Macaulay duration
Modified duration
Modified Duration = Macaulay Duration / (1 periodic market yield)
Money duration
Money duration = annual modified duration * full price of bond
Curve duration
Effective duration
Effective duration: sensitivity of bond's price to a change in a benchmark yield curve
Key rate duration
bond's sensitivity to change in benchmark yield curve at a specific maturity segment
to identify shaping risks
to measure sensitivity to nonparallel shift
Analytical duration: mathematical formulas
correlation between benchmark yields and credit spreads
Empirical duration: historical data
Convexity
Definition and application
Benefit of greater convexity
Appreciates more in price
Depreciates less in price
Duration vs Convexity
Greater Duration
Longer time-to-maturity
Lower coupon rate
Lower yield-to-maturity
Greater convexity
Longer time-to-maturity
Lower coupon rate
Lower yield-to-maturity
Callable bond and putable bond
Callable bond
Lower effective duration
Negative convexity
Putable bond
Lower effective duration
Higher positive convexity
R6: Fundamentals of Credit Analysis
Credit Risk
Definition: risk of loss resulting from the issuer failing to make full and timely payments
Expected loss = default probability * loss severity
Loss severity = 1 - recovery rate
Spread risk
Credit migration risk
Market liquidity risk
Yield spread = credit spread liquidity premium
Small spread change
Large spread change
Seniority ranking
First lien loan
Senior secured debt
Senioor unsecured debt
same rating as issuer
Senior subordinated debt
Subordinated debt
Junior subordinated debt
Credit Rating
Muddy
Aaa..Baa3...Ca
S&P and Fitch
AAA...BBB-...CC
Notching: the higher rating, the smaller notching adjustment
Structural subordination: parent company's bonds are subordinated to operating subsidiaries
General Principles of Credit Analysis
4Cs Analysis
Capacity
Industry structure
Industry fundamentals
Company fundamentals
Competitive position
Operation history/track record
management's strategy and execution
Ratios and ratio analysis
Profitability and cash flow measures
EBITDA
Fund from Operation (FFO) = NI from continuing operations dep. & amor. deferred income taxes other non-cash items
Leverage ratios
Debit/Capital
Debit/EBITDA
FFO/debt
FCF after dividends
Coverage ratio
EBITDA / interest expense
EBIT / interest expense
Issuer's liquidity
Cash on balance sheet
Net working capital
Collateral
Covenants
Character
Credit Analysis for Specific Bonds
High Yield Debt
Sovereign Debt
Ability to pay
Willingness to pay
Municipal Debt
General Obligation (GO) bonds
revenue bonds
for specific project financing