Fixed Income - Final

Fixed Income Securities
CFA Level 1 (Dec 2010)
J K Shah Classes 1
Study Session 15
Basic Concepts
60. Features of Debt Securities
61. Risks Associated with Investing in Bonds
62. Overview of Bond Sectors and Instruments
63. Understanding Yield Spreads
J K Shah Classes 2
61. Features of Debt Securities
3
Bond Indentures
 A bond indenture is a contract between borrower and lender which specifies all the obligations
of the borrower / issuer of a fixed income security and right of the lender.
 It contains various Dos and Don’ts on the borrowers called covenants
Don'tsNegative Covenants Positive Covenants Dos

 Restrictions on asset sales
 Negative pledge of collateral
 Restrictions on additional borrowings
 Promises by the borrower to
Maintain financial ratios
 Timely payment of principal
and interest
J K Shah Classes 4
Bond Features (Par Value, Market Value, Coupon Rate, Yield, Maturity)
 Bond Terms: Face value/ par value/ maturity value, Quoted Price/Market Price, Dollar Price
Par Value Quoted Price Dollar Price Coupon Payment

(in % term)
$ 1,000, 6% bond .905 905 60
$ 5,000, 6.5% bond 1.0275 5137.5 325
$ 10,000, 6.25% .7063 7063 625
bond
$ 1,00,000, 5.95% 1.1334 113,343.75 5950
bond
 Coupon rate: Annual % of par value
J K Shah Classes 5
Bond Features
 Maturity:
No of years remaining prior to final payment of the bond or no of years for which the debt is
outstanding. The day on which the bond will cease to exist.
1-5 yrs -- Short term
5-12 yrs – Intermediate Term
12 + -- Long term
Maturity is very important for bond for 3 reasons
 Indicates the time over which the interest would be paid and principal amount paid by the issuer
 Yield offered depends on the maturity
 Price of the bond will fluctuate over the life of the bond
J K Shah Classes 6
Coupon Structures
 Zero-coupon bonds
These bonds are that do not pay periodic interest. They pay the par value at maturity and the interest
results from the fact that zero coupon bonds are initially sold at a price below par value
Issue Price of $ 100 bond Whether a case of Zero coupon bond

$ 110 No as Issue Price not < face value
$ 95 Yes as Issue Price < face value
$ 100 No as Issue Price not < face value
 Deferred coupon
They carry coupons but initial coupon payments are deferred for some period. The coupon payments
accrue at a compound rate over the deferred period and are paid as a lump sum at the end of that period
J K Shah Classes 7
 Step-up notes
Coupon rate increase over time at a specified rate. The increase may take
place one or more time during the life of the issue.
J K Shah Classes 8
Coupon Structures
 Deferred coupon
They carry coupons but initial coupon payments are deferred for some period. The coupon
payments accrue at a compound rate over the deferred period and are paid as a lump sum at the
end of that period or in some cases the increased rate of coupon is paid after deferment period.
J K Shah Classes 9
Floating-Rate Securities
 It’s a security with variable coupon payment over the maturity period. They are
bonds for which the coupon interest payments over the life of the security vary
based on a specified interest rate or index.
 Coupon formula
Reference rate + margin
e.g., LIBOR + 1.5%, annualized rates
 Cap: Maximum on formula rate
 Floor: Minimum on formula rate
J K Shah Classes 10
6 month LIBOR Interest
rate as on Rate
Coupon
Jan 10 6
Jul 10 6.5
Reset = 6 month LIBOR on reset date + 1%
Formula
Jan 11 4
Jul 11 7
Jan 12 9 Duration!!!?
Cap Rate = 9%
Floor Rate = 6%
T(0) T(1) T(2) T(3) T(4)

Jan 10 Jul 10 Jan 11 Jul 11 Jan 12
3.5% 3.75% 3% 4% 4.5%
J K Shah Classes 11
Accrued Interest
 When a bond trades between coupon dates, the seller is entitled to receive any interest earned
from the previous coupon date through the date of the sale
 Paid to a bond seller
 Portion of the next coupon interest payment already earned by the seller
 Full price = clean price + accrued interest
Days Since Last Coupon

X Coupon Payments
AI = Days Between Coupon
Full Price / Dirty Price = Clean Price + AI
or
Clean Price = Full Price / Dirty Price - AI
J K Shah Classes 12
 Redemption / Retirement of Bonds - Amortizing and
Non amortizing Bonds
 Nonamortizing securities pay only interest until maturity, then the par value is
repaid. Its also called Bullet Maturity.
 Coupon Treasury bonds

 Most corporate bonds
Maturity
Date of Date
Issue Dec 14
Jan 10 $ 10 $ 10 $ 10
$10
+
$ 100
J K Shah Classes 13
J K Shah Classes 14
J K Shah Classes 15
Prepayment Option
 On an amortizing security, such as a mortgage
 Prepayments are repayment of principal in excess of

scheduled principal payments
 Its beneficial for issuer / borrower
J K Shah Classes 16
Call Provisions
 Issuer can repay principal prior to maturity
 Call protection for some period
 Call prices typically decrease over time (e.g., 15-year bond: callable after 5 years
@ 102 and callable after 10 years @ par)
J K Shah Classes 17
Refunding
 Refunding is calling (redeeming) a bond using the proceeds
of a lower cost issue

Bond can be callable but not refundable ; such bonds are
more beneficial for the lender than pure callable bond.
J K Shah Classes 18
Sinking Fund
 Sinking fund redemptions are calls of a portion of an outstanding
bond issue, typically at par
 Premium bonds: Cash paid to trustee, bonds to be retired chosen by

lottery
 Discount bonds: Bonds can be purchased and delivered to trustee to

be retired
J K Shah Classes 19
Redemption Prices
 Call prices are regular redemption prices
 Sinking fund redemptions and redemptions under other

provisions are special redemption prices
(e.g., redemptions due to forced asset sales)
J K Shah Classes 20
Embedded Options
Benefiting Benefiting
Issuer / Lender
Borrower
 Call Provision  Put Provision

 Prepayment Option  Conversion Option
 Caps  Floors
 Accelerated Sinking Fund
J K Shah Classes 21
Embedded Options
Issuer/Borrower
Call Provision
Prepayment Option Issuer/Borrower
Put Provision Buyer
Caps Issuer/Borrower
Floors Buyer
Conversion Option Buyer

22
Margin Buying and Repurchase Agreements
 Margin buying: Borrowing funds to purchase securities. The

securities are the collateral for the margin loan
 Repurchase agreement: An institution sells a security with a
commitment to buy it back at a specified higher price
 Repo rate: The interest rate implied by the two prices
 Overnight repo: Repurchase agreement for one day
 Term repo: Agreement covering a longer period
Most bond-dealer financing is achieved through repurchase
agreements rather than margin loans
J K Shah Classes 23
Risks Associated
with
Investing in Bonds
24
Bond Risks
1. Interest rate risk 7. Liquidity risk
2. Yield curve risk

8. Exchange-rate risk
9. Inflation risk
3. Call risk
10. Volatility risk
4. Prepayment risk
11. Event risk
5. Reinvestment risk
12. Sovereign risk
6. Credit risk
J K Shah Classes 25
Bond Discounts and Premiums
 Yield = coupon rate → bond price at par
 Yield < coupon rate → bond price over par bond priced at a premium
 Yield > coupon rate → bond price under par bond priced at a
discount
J K Shah Classes 26
Market Yield vs. Bond for an 8%
Coupon Bond Coupon Mkt Yield
At the time
8% 8%
BOND of issue
VALUE
After 30
8% <8%
days
After 60
8% >8%
days
PREMIUM
TO PAR
PAR VALUE
DISCOUNT TO PAR
6% 7% 8% 9% 10% MARKET YIELD 27

Factors affecting Interest Rate Risk
Maturity Coupon & Call Option &

Yield Put Option
Higher Maturity  Higher Interest Add any option  Interest Rate

Rate Risk Risk down
Lower Maturity  Lower Interest Remove Option  Interest Rate

Rate Risk Risk up
Lower Coupon  Higher Interest

Rate Risk
Higher Coupon  Lower Interest
Rate Risk
28
Price – Yield Curves for Callable and
Noncallable Bond
Coupon Payment : 8%
Yield at the time of issue : 8%
Call Price : 105
Price
As the yield falls, the value of

embedded call increases
$110CALL OPTION
VALUE
CALL PRICE
Price of Option Free Bond
$105
ISSUE PRICE
$100
CALLABLE BOND VALUE
$95
6% 7% 8% 9% Yield
Floating-Rate Securities
 Coupon is periodically reset based on a reference rate

(plus a fixed margin)
 Has interest rate risk between reset dates
 Price may differ from par at reset if:

 Credit quality of issuer changes after issuance
 Margin over reference rate no longer
appropriate
30
Measure Interest Rate Risk
With Duration
 Duration is the approximate percentage price change for a
1% change in yield.
% change in bond price

 Duration = - yield change in %
J K Shah Classes 31
Price Impact of Yield Changes
 Based on the duration of 4.29:

 If the yield goes up 0.25%, price goes down by
4.29(0.25%) = 1.0725%
 For a bond valued at $2.5 million, a yield change
of 0.25% leads to an approximate change in
value of 1.0725% (2.5 mil) = $26,812.50
 Dollar duration of a bond is approximate change
in value for a 1% change in yield,
0.0429 (2.5 mil) = $107,250
J K Shah Classes 32
Duration and Yield Curve Risk
 Portfolio duration is an approximation of the price
sensitivity of a portfolio to a parallel shift of the yield
curve (yields on all the bonds change by the same percent)
 For a non-parallel shift in the yield curve, the yields on

different bonds in a portfolio can change by different
amounts
 Yield curve risk: The interest rate risk of a portfolio of

bonds that is not captured by the duration measure
J K Shah Classes 33
Yield Curve Risk
YIELD A NON PARALLEL SHIFT
A PARREL SHIFT
INITIAL YILED CURVE
YIELD CURVE
MATURITY
J K Shah Classes 34
Callable and Pre payable Securities
 Callable securities are likely to be called when interest

rates are low
 Principal repayment on pre payable securities is faster

when interest rates are low
 Investors must reinvest principal when rates are low
J K Shah Classes 35
Factors Affecting Reinvestment Risk
Reinvestment risk is higher when:
1. Coupon is higher
2. Bond has a call feature
3. A security is amortizing
4. A security contains a prepayment option

36
Forms of Credit Risk
 Bond ratings indicate relative probability of default

 Downgrade risk: Probability of ratings decrease
 Default risk: Probability of default
 Credit spread risk: Risk of increase in spread to
Treasuries to compensate for given default risk (bond
rating)
The higher the rating (e.g., AA vs. A), the lower the
market yield.
37
Liquidity Risk
 The bid-ask spread indicates the liquidity of the market for a

security
 A decrease in liquidity will increase the bid-ask spread, lead to a

lower sale price, and decrease the returns on the position
 Even if an investor plans to hold the security until maturity,

marking the security prices to market will result in lower returns
when liquidity decreases (bids fall)
J K Shah Classes 38
Exchange Rate Risk
 If an investor buys a security denominated in a foreign (to the

investor) currency
 Depreciation of the foreign currency reduces the returns to a dollar-based

investor
 Exchange rate risk: Actual cash flows from the investment may be worth more
or less than was expected when the bond was purchased
J K Shah Classes 39
Inflation Risk
 Inflation (purchasing power) risk: Prices of goods and services increase more
than expected
 An increasing price level decreases the amount of real goods and services that
bond payments will purchase
 When expected inflation increases, nominal yields rise, values of debt

securities fall
J K Shah Classes 40
Effects of Yield Volatility
 Increase in yield volatility increases option values
 Increases value of putable bond =

(option-free bond value + put value↑)
 Decreases value of callable bond =

(option-free bond value – call value↑)
J K Shah Classes 41
Event Risk
 Disasters (e.g., hurricanes, earthquakes, or industrial accidents)
can impair the ability of a corporation to meet its debt obligations
 Corporate restructurings may result in bond-rating downgrades
 Regulatory issues may cause large cash expenditures to meet new

regulations
 New regulations prohibiting financial institutions from holding a

certain type of security can lead to a volume of sales that decreases
prices for the whole sector
J K Shah Classes 42
Overview of Bond Sectors and Instruments
43
Government Securities
Sovereign debt: Bonds issued by central governments; domestic,

foreign, or Eurobond.
U.S. Treasury securities considered essentially free of default

risk.
Sovereign (non US) debts of other countries are considered to

have varying degrees of credit risk.
Local Currency Debt Rating:
J K Shah Classes 44
Sovereign Debt Issuance Methods
 Regular cycle auction—single price: Highest price (lowest yield) at
which the entire issue can be sold awarded to all bidders (e.g., U.S.
Treasury debt)
 Regular cycle auction—multiple price: Winning bidders receive the

bonds at the prices they bid
 Ad hoc auction system: Government auctions new securities when

market conditions are advantageous
 Tap system: Auction of bonds identical to previously issued bonds,

periodically, no regular cycle
45
U.S. Treasury Securities –
Issued by US dept of treasury
Fixed Principal
TIPs Treasuries Tips
Treasuries
Coupon Strip
T T Notes T Bonds
Bill
 Zero Coupon Principal Strip
 Less than 12 months maturity  > 10 yrs maturity
Cash Management Bills  Semi Annual Coupon
 1 to 10 yrs maturity
Semi Annual Coupon 46
Quotation of T. Bond / Notes in the secondary
market
T Bonds and notes are quoted in percentage and 32 nd of 1% of face value
e.g. a quote of 102-5 (or 102:5) for a $ 1,000 bond means
= 102% + 5/32% of par (*1000)
= 1.0215625 * $1,000
= 1021.5625
Now Calculate for 103-7 and 97:6
103-7 = $1000 * (103+ 7/32) % = $1032.1875
97:6 = $1000 * (97+ 6/32) % = $97.1875
47
U.S. Treasury Securities
 Treasury Inflation Protected Securities (TIPS)
 Coupon rate is fixed
 Par value is adjusted for inflation
semiannual payment = ½ coupon rate × inflation

adjusted par value
2010 H1 Find out the 2010 H2 coupon

FV: $1,000 payment?
Coupon Rate : 3%
Annual Inflation Rate : 4% Inflation Rate : 1%
Adjusted Par value : $ 1,000 * 1.02

Coupon payment : $ 1,020 * 1.5% = 15.3
Adjusted Par value : $ 1,020 * 1.01
Coupon payment : $ 1,030.2 * 1.5% = 15.453
J K Shah Classes 48
TIPS
On the date of maturity
 Holder to get par value, if adjusted value is lower than

par value
 Holder to get such adjusted value if the adjusted value

if higher than the par value
J K Shah Classes 49
On- and Off-the-Run Treasuries
 On-the-run issues:
Most recent auction issues, most liquid, actively traded
 Off-the-run issues:
Older issues (replaced by more recent issues)
J K Shah Classes 50
Stripped Treasury Securities
 A type of zero-coupon bond created from Treasury notes and bonds;

the pieces (coupon payments and the principal payment) are
separated
 Coupon strips are denoted ci

 Principal strips are denoted pi
 STRIPS (zeros) are taxed on implicit interest
J K Shah Classes 51
Securities Issued by Federal Agencies
 Federally related institutions (e.g., GNMA, TVA)

 Exempt from SEC Registration
 Backed by US Govt.; hence risk free
 Government-sponsored enterprises (Sallie Mae, Freddie Mac, Fannie Mae)

 Although privately help, created by US congress; a little credit risk
 Agency securities, very little credit risk
 Debentures: Securities not backed by collateral, unsecured bonds
J K Shah Classes 52
Mortgage-Backed Securities
Passthrough
CMOs STRIPS
Securities
Securitization :
 to increase debt attractiveness,

increasing fund availability
 Decrease yield as they are backed by pool of mortgages
Cash flow in the form of Interest payment , principal payment and prepayments
J K Shah Classes 53
Passthrough
CMOs STRIPs
Securities
Derivative Mortgage Principal and

Proportionate payment to all the
Product Interest Strips
security holder
More complex Structure PO to benefit from
Some diversification due to pool
prepayment
of mortgage Different Tranches (slices) with
different claim IO to lose in case of
prepayments
Some diversification due to pool of
mortgage
Redistribution of prepayment risk and

maturity
Same over all risk 54

 CMO Tranche example – Sequential Tranches
 Tranche I receives interest on its outstanding principal and all

principal payments until the tranche is completely paid off
 Tranche II receives interest on its outstanding principal and

begins receiving all principal payments when Tranche I is paid
off
 Tranche III receives only interest until Tranches I and II are

paid off, then receives all remaining principal payments
J K Shah Classes 55
Prepayment Risk
 Risk of receiving principal repayment in excess of scheduled

principal payments
 May lead to more funds to be reinvested when rates for reinvestment

are low—reinvestment risk
 When rates increase, prepayments slow
J K Shah Classes 56
Motivation for Creating a CMO
 Alter maturity range and redistribute prepayment risk to make

securities attractive to different institutional investors
 Creating a CMO does not alter the overall risk of prepayment
 Goal is lower overall cost of funds
J K Shah Classes 57
Special Types of Municipal Bonds
Normally coupon payment is exempt & capital gain is taxable at federal level
Instate bonds are tax free at state and federal level; where as out of state bonds are
taxable at state level and federally exempt.
State Municipal Bonds must meet certain federal criteria to be exempt from
federal tax
 Insured bonds
Backed by insurance policies in the event of defaults, insured for life of issue, lowers yield,
increases liquidity
 Prerefunded bonds
Collateralized with escrow of Treasury securities which will support bond payments
J K Shah Classes 58
Special Types of Municipal Bonds
Tax Backed bonds /

General Obligation Revenue Bond
(GO)bonds
Backed by the taxing capacity of Supported only by the revenues

the issues from the projects covered
Limited Tax GO Obligation to pay interest / principal

Unlimited Tax GO only from the project revenue
Double barreled bond More risky than GOs
Appropriation backed bonds
59
Corporate Bonds
 Rating
 Secured bonds: first claim against specific collateral (mortgage debt,

collateral trust bonds)
 Debenture bonds: unsecured bonds, no specific collateral (debentures)
 Credit enhancements bonds: Third Party guarantee, Letter of credit, Bond

Insurance; Ensure the strength of the party enhancing credit
 Bonds have a priority of claims over both preferred and common

stockholders in the event of bankruptcy
J K Shah Classes 60
Corporate Debt Securities
Corporate Bonds are normally Medium-Term Notes (MTN)

Sold at once Continuously offered by agent
Sold on firm commitment basis Buyers can customize
Single coupon and maturity 9 months to 30+ years
Fixed, floating, or structured
Structured Notes
MTN combined with derivative, “rule busters”

Corporate Deposit
Create a security to some institutional investors
Short term (<270 days)
Unsecured
Like Zero Coupon
No SEC registration required
J K Shah Classes 61
Corporate Debt Securities
 Commercial paper
2 to 270 days
Pure discount
Not liquid
Sold through dealers or by the company itself
 Directly placed paper

Sold to large investors without going through an agent
Select group of regular commercial paper buyers
 Dealer placed paper

Sold to purchase through commercial paper dealer
Large investments firms have commercial paper desk
J K Shah Classes 62
Debt Securities Issued by Banks
 Negotiable CDs
Days to 5 years
Secondary market
Domestic (U.S.) and Eurodollar
Issued primarily in London – LIBOR
 Bankers acceptances
Created to guarantee payment for shipped goods
Short-term
Pure discount
Few dealers, liquidity risk
J K Shah Classes 63
Asset-Backed Securities (ABS)
 Debt securities backed by financial assets

(e.g., mortgages, auto loans, credit card receivables)
 Firm sells assets to Special Purpose Vehicle
 Separate entity, bankruptcy remote
 SPV issues securities
 Can have better rating (lower yield) than firm’s debt
 Reduce funding costs
J K Shah Classes 64
Asset-Backed Securities (ABS)
Sources of External Credit Enhancements
 Corporate guarantees: Which may be obtained from a bank fee
 Bank letters of credit: Which may be obtained from a bank for a fee
 Bond insurance (insurance wrap): Which may be obtained from an insurance

company or a provider specializing in underwriting such structures.
J K Shah Classes 65
Collateralized Debt Obligations
 Tranches
Created based on seniority of claims to cash flows from collateral
Collateral is a pool of other debt obligations –e.g. business loans, mortgages, asset-
backed securities, other CDOs etc.
 Arbitrage CDOs
Profit from cash flow spread
 Balance Sheet CDOs

To reduce loans on balance sheet (banks)
66
Primary and Secondary Markets
 Primary market:
Newly created debt securities
Firm commitment: Investment banker purchases the entire issue and resells it
Best efforts basis: Investment banker agrees to sell all of the issue that they can
Private placement (Rule 144A offering): Sold to a small number of investors, issue is not
registered for sale to the public
 Secondary market: Sales of existing securities through exchanges, OTC (dealer)

markets, or electronic trading networks
J K Shah Classes 67
Understanding Yield Spreads
J K Shah Classes 68
Federal Reserve’s Interest Rate Policy Tools
(Monetary Policy)
 Discount rate
 Open market operations (most common)
 Bank reserve requirements
 Persuading banks to tighten or loosen their credit policies
LOS 63.a 69
Yield Curve Shapes LOS 63.b
YIELD YIELD
NORMAL
FLAT
YIELD TERM TO MATURITY YIELD TERM TO MATURITY
HUMPED
INVERTED
TERM TO MATURITY TERM TO MATURITY 70

LOS 63.c
Term Structure Theories
 Pure Expectations Theory

Yield curve shape determined by expectations about future short-term rates
 Liquidity Preference (Premium) Theory

In addition to above expectations, investors also require a risk premium for
holding long term maturity bonds
Greater premium (yield) required for longer maturities; may take any shape;
 Market Segmentation Theory

Supply and demand for specific maturity ranges determines interest rates;
any shape
71
LOS 63.c
Liquidity Premium
YIELD
YIELD CURVE WIT H LIQUIDITY PREFERENCES
LIQUIDITY PREMIUM
YIELD CURVE WITHOUT LIQUIDITY PREFERENCES (PURE EXPECTATIONS)
MATURITY
J K Shah Classes 72
LOS 63.c
Liquidity Premium Added to Decreasing
Expected Rate
YIELD
LIQUIDITY PREFERENCES YIELD CURVE
LIQUIDITY PREMIUM
PURE EXPECTATIONS YIELD CURVE

(SHORT-TERM RATES EXPECTED TO DECLINE)
MATURITY
J K Shah Classes 73
LOS 63.d
Treasury Spot Rates
YTM is the single disc rate which makes the PV of the bond’s promised cash flow
equal to its market price
Actually the discount rate for cash flow which come at different time periods are
typically not same
Spot rate curve is not horizontal
Treasury spot rates : Appropriate discount rate for single payments of

various maturities from Treasury securities.3
And the spot rates for different time periods that correctly value the cash
flows from treasury bond are called arbitrage free Treasury Spot rate
Curve
74
LOS 63.d
Treasury Spot Rates
FV : 100$ FV : 1000$
Coupon : 10% Coupon : 8%
Spot rates: Spot rates:
1 yr = 8% 1 yr = 9%
2yrs = 9% 2yrs = 10%
3yrs = 10% 3yrs = 11%
Compute the value of the bond…. Compute the value of the bond….
100 100 1100

Price = + +
1.08 1.09 2
1.103
J K Shah Classes 75
LOS 63.e
Yield Spread Measures
Absolute spread = Yield of higher yield bond – yield of lower yield bond
6.75 – 6.5 = .25 bsp
Relative Yield Spread = Absolute Spread / yield on the benchmark bond

.25/6.5 = 3.8%
Yield ratio = Bond yield / Benchmark bond yield

6.75 / 6.5 = 1.038
Yield of Bond X : 6.5% Yield of Bond X : 6.5%
Yield of Bond Y : 6.75% Yield of Bond Y : 6.75%
X is the benchmark yield X is the benchmark yield

LOS 63.f
Credit Spreads
 Difference between yields of bonds that differ only in credit rating
 Often quoted as a spread to Treasuries
 Credit spreads narrow during expansions and widen during

contractions/recessions
J K Shah Classes 77
LOS 63.g
Embedded Options and Spreads
 Including a put, conversion, or exchange option with a

corporate bond reduces required yield and decreases yield
spread relative to Treasuries
 Including a call option increases required yield and increases

yield spread relative to Treasuries
J K Shah Classes 78
LOS 63.h
Liquidity and Yield
 Investors prefer more liquidity so less liquid issues have

greater required yields and greater yield spreads relative to
Treasuries, which are very liquid
 Larger issues typically have more liquidity and therefore,

lower yields and lower yield spreads than otherwise identical
smaller issues
J K Shah Classes 79
LOS 63.i
After-Tax and Taxable Equivalent Yields
The after – tax yield on a taxable security can be calculated as:
 After – tax yield = taxable yield x (1 – marginal tax rate)
 Taxable equivalent yield = tax- free yield /(1- marginal tax rate)
J K Shah Classes 80
LOS 63.j
After-Tax and Taxable Equivalent Yields Example
Bond A : tax free rate of 4.5%

Bond B: taxable rate of 6.75%
Investor marginal tax rate is 35%
Tax Equivalent Yield = 4.5/(1-.35) = 6.92%
After tax return =.0675*(1-0.35) = 4.39%
Either approach gives the same answer she should buy

the tax free bond.
4.50%>4.39% & 6.92% < 6.75%
J K Shah Classes 81
LOS 63.c
LIBOR and Funded Investors
 LIBOR – London Interbank Offer Rate

Most important reference rate for floating-rate securities
 A funded investor borrows short term (typically at LIBOR) to

finance an investment position
Profits depend on funding costs
J K Shah Classes 82
Introduction to the Valuation of Debt Securities
J K Shah Classes 83
Study Session 16
64. Introduction to the Valuation of Debt Securities

65. Yield Measures, Spot Rates, and Forward Rates
66. Introduction to the Measurement of Interest Rate Risk
J K Shah Classes 84
Introduction to the Valuation of Debt Securities
J K Shah Classes 85
3-Step Bond Valuation Process
Bond value = present value of future cash flows, coupons and

principal repayment
Step 1 : Estimate cash flows
Step 2 : Determine the appropriate discount rate

The risk factors of uncertainty about the receipt of cash flow .
Liquidity risk, interest rate risk, call/prepayment risk, credit risk/default
risk, etc.
Step 3 : Calculate present values of promised cash flows
86
Difficulties in Estimating the Cash Flow Stream
 The principal repayment stream is not known with certainty (for e.g. lower rates
will increase prepayments of mortgage pass-through securities, and principal will
be repaid earlier)
 The coupon payments are not known with certainty. With floating securities,
future coupon payments' depends on the path of interest rates
 The bond is convertible or exchangeable into another security
87
Valuing an Annual-Pay Bond Using a Single Discount Rate
 Term to maturity = 3 years
 Par = $1,000
 Coupon = 10% annual coupon

 Discount rate 12%
J K Shah Classes 88
8% Annual-Pay Bond Cash Flows
Year Year Year Year

0 1 2 3
100 100 100

1,000
J K Shah Classes 89
LOS 63.d
Bond Value: 10% Coupon, 12% Yield
FV : 1000$
Coupon : 10%
Yield : 12%
Compute the value of the bond….
100 100 1100

Price = + +
1.12 1.12 2
1.123
J K Shah Classes 90
Same (8% 3-yr.) Bond With a Semiannual-Pay
Coupon
PMT = coupon / 2 = $80 / 2 = $40

N = 2 × # of years to maturity = 3 × 2 = 6
I/Y = discount rate / 2 = 12 / 2 = 6%
FV = par = $1,000
N = 6; I/Y = 6; PMT = 40; FV = 1,000;

CPT PV = –901.65
91
9% 3-Year Bond
With Semiannual Coupon Payments
40 40 40 40 40 1040
+ + + + +
1.06 1.06 1.06 1.06 1.06 1.06
=901.65
J K Shah Classes 92
Price-Yield Relationship
Semiannual-Pay 8% 3-yr. Bond
At 4%: I/Y = 2% N = 6 FV = 1,000 PMT = 40 CPT

PV = $1,112.03
At 8%:I/Y = 4% N = 6 FV = 1,000 PMT = 40 CPT

PV = $1,000.00
At 12%:I/Y = 6% N = 6 FV = 1,000 PMT = 40 CPT

PV = $901.65
J K Shah Classes 93
Price Change as Maturity Approaches
As maturity nears,
the bond value
reaches FV.
Bond
Value ($)
A premium bond (e.g. a 6% bond trading at YTM of 3%)

1,085.458
A par value bond( e.g. a 6% bond trading at YTM of 6%)

1,000.00
A discount bond ( e.g. a 6% bond trading at YTM of 12%)
852.480
Time
J K Shah Classes 94
Value Change as Time Passes – Problem
6% 10-year semiannual coupon bond is priced at $864.10 to yield 8%

N = 20, PMT = –30, FV = –1,000, I/Y = 4% PV = 864.10
1. What is the value after 1 year if the yield does

not change?
N = 18, PMT = –30, FV = –1,000, I/Y = 4% PV = 873.41
2. What is the value after 2 years if the yield does

not change?
N = 16, PMT = –30, FV = –1,000, I/Y = 4% PV = 883.480
J K Shah Classes 95
Calculate a Zero-Coupon Bond Price
$1,000 par value zero-coupon bond matures in 3 years and with a

discount rate of 8%
TVM Keys:
N = 3 × 2 = 6, PMT = 0, FV = 1,000,
I/Y = 8 / 2 = 4 CPT PV = –790.31
Mathematically: 1000 =$790.91

(1.04)6
J K Shah Classes 96
Arbitrage-Free Bond Prices
 Dealers can separate a coupon Treasury security into separate cash

flows (i.e., strip it)
 If the total value of the individual pieces based on the arbitrage-free

rate curve (spot rates) is greater or less than the market price of the
bond, there is an opportunity for arbitrage
 The present value of the bond’s cash flows (pieces) calculated with
spot rates is the arbitrage-free value
J K Shah Classes 97
Arbitrage-Free Pricing Example
Market Price of a 1.5-year 6% Treasury note

is $984
Value cash flows using (annual) spot rates
of 6 months = 5%, 1-yr. = 6%, 1.5 yr. = 7%
Maturity Annual Spot Semi-Annual Cash Flow per

Rate spot Rate ($1,000)
0.5years 5% 2.5% $30
1.0years 6% 3.0% $30
1.5years 7% 3.5% $1050
98
Valuing the Pieces Using Spot Rates
 6 mo. 12 mo. 18 mo.
30 30 30
+ + =986.55
1.025 (1.03)2 (1.035)3
 Buy the bond for $984, strip it, sell the pieces for a total of
$986.55, keep the arbitrage profit = $2.55
J K Shah Classes 99
Arbitrage Process
 Dealers can strip a T-bond into its individual cash flows or combine
the individual cash flows into a bond
 If the bond is priced less than the arbitrage free value: Buy the bond,
sell the pieces
 If the bond is priced higher than the arbitrage-free value: Buy the
pieces, make a bond, sell the bond
J K Shah Classes 100

Yield Measures, Spot Rates, and Forward
Rates
Sources of Bond Return
 1. Coupon interest
 2. Capital gain or loss

when principal is repaid
 3. Income from reinvestment of cash

flows J K Shah Classes 102
Traditional Measures of Yield
 Nominal yield (stated coupon rate)

 Current yield
Yield to maturity
Yield to call
Yield to refunding IRR-based yields
Yield to put
Yield to worst
Cash flow yield
YTM for an Annual-Pay Bond
 Consider a 6% , 3years annual pay bond priced at

943$
60 60 1060
943 = + +
(1 +YTM) (1+YTM) (1+YTM)
2 3
 TVM functions: N = 3, PMT = 60, FV = 1,000,

 PV = –943, CPT I/Y = 8.22%
 Priced at a discount → YTM > coupon rate
YTM for a Semiannual-Pay
Bond
 With semiannual coupon payments, YTM is 2 × the
semiannual IRR
COUPON 1 COUPON 2 COUPON N + PAR VALUE

 PRICE = + +…+
(1+YTM/2) (1+YTM/2)2 (1+YTM/2)N

Semiannual-Pay YTM Example
 A 3-year 5% Treasury note is priced at $1,028
 N = 6 PMT = 25 FV = 1000 PV = –1,028
 CPT I/Y = 2% YTM = 2 × 2% = 4%
The YTM for a semiannual-pay bond is called a

Bond Equivalent Yield (BEY)
 Note: BEY for short-term securities in

Corporate Finance reading is different.
Current Yield
(Ignores Movement Toward Par Value)
annual coupon payment

 CURRENT YIELD =
current price
For an 8%, 3- years (semiannual pay) bond price

901.65
80
CURRENT YIELD= = 8.873 YTM =
12%
Yield to First Call or Refunding
 For YTFC substitute the call price at the first call
date for par and number of periods to the first call
date for N
 Use yield to refunding when bond is currently

callable but has refunding protection
 Yield to worst is the lowest of YTM and the YTCs

for all the call dates and prices
Yield to Call – Problem
 Consider a 10-year, 5% bond priced at $1,028
 N = 20 PMT = 25 FV = 1,000 PV = –1,028

 CPT → I/Y = 2.323% × 2 = 4.646% = YTM
 If it is callable in two years at 101, what is the YTC?

 N=4
 PMT = 25 FV = 1,010
 CPT → I/Y = 2.007%
 × 2 = 4.014% = YTC
 PV = –1,028 J K Shah Classes 109
Yield to Put and Cash Flow
Yield
 For YTP substitute the put price at the first put date
for par and number of periods to the put date for N
 Cash flow yield is a monthly IRR based on the

expected cash flows of an amortizing (mortgage)
security

Assumptions and Limitations
of Traditional Yield Measures
 1. Assumes held to maturity (call, put, refunding,
etc.)
 2. Assumes no default
 3. Assumes cash flows can be reinvested at the

computed yield
 4. Assumes flat yield curve (term structure)

Required Reinvestment Income
 6% 10-year T-bond priced at $928 so YTM = 7%
 1st: Calculate total ending value for a semiannual

compound yield of 7%, $928 × (1.035)20 = $1,847
 2nd: Subtract total coupon and principal

payments to get required reinvestment income
 $1,847 – (20 × $30) – $1,000 = $247

Factors That Affect
Reinvestment Risk
Other things being equal, a coupon bond’s

reinvestment risk will increase with:
 Higher coupons—more cash flow to

reinvest
 Longer maturities—more of the value of the
investment is in the coupon cash flows and interest
on coupon cash flows

Annual-Pay YTM
to Semiannual-Pay YTM
 Annual-pay YTM is 8%, what is the equivalent
semiannual-pay YTM (i.e., BEY)?
( 1.08 – 1) x 2 = 7.846%

Semiannual-Pay YTM
to Annual-Pay YTM
 Semiannual-pay YTM (BEY) is 8%, what is the
annual-pay equivalent?
 Semiannual yield is 8/2 = 4%. Annual-pay

equivalent (EAY) is:
0.08 2
1+ - 1 = 8.16%
2

Theoretical Treasury Spot Rates
 Begin with prices for 6-month, 1-year, and 18-month Treasuries:
 6-month T-bill price is 98.30, 6-month discount rate is

 1.73% BEY = 2 × 1.73 = 3.46%
 1-year 4% T-note is priced at 99.50
20 1020 20 1020
+ =995 995 - = 975.34
?
Theoretical Treasury Spot Rates
 Begin with prices for 6-month, 1-year, and 18-

month Treasuries:
 1.5-year 4.5% T-note is priced at 98.60
 By “bootstrapping,” we calculated the 1-year spot

rate = 4.52% and the 1.5-year spot rate = 5.52%
Valuing a Bond With Spot Rates
Use the spot rates we calculated to value a 5% 18-

month Treasury Note.
25 25 1025
+ + = 993.09
(1.0173) (1.0226)2 (1.0276)3

Nominal and Zero-Volatility Spreads
 Nominal spreads are just differences in YTMs
 Zero-volatility (ZV) spreads are the (parallel)

spread to Treasury spot-rate curve to get PV =
market price
 Equal amounts added to each spot rate to get PV =

market price

Option-Adjusted Spreads
 Option-adjusted spreads (OAS) are spreads that take
out the effect of embedded options on yield, reflect
yield differences for differences in risk and liquidity
 Option cost in yield% = ZV spread% – OAS%
 Option cost > 0 for callable, < 0 for putable
Must use OAS for debt with embedded options

Forward Rates
 Forward rates are N-period rates for borrowing/lending at some
date in the future
 Notation for one-period forward rates:
F0 is the current one-period rate S1

1
F1 is the one-period rate, one period from now

1
F2 is the one-period rate, two periods from now

1
F1 is the two-period rate, one

2 J K Shahperiod
Classes from now 121
Spot Rates and Forward Rates
(1+ S3)3 = (1+ S1) (1+ 1F1) (1+ 1F2)
(1+ S3)3 = (1+ S1) (1+ 1F2)2
(1+ S3)3 = (1+ S2) (1+ 1F2 )
Cost of borrowing for 3 yr. at S3 should equal cost of:
 Borrowing for 1 yr. at S1, 1 yr. at 1F1, and 1 yr. at 1F2
 Borrowing for 1 year at S1 and for 2 years at 1F2
 Borrowing for 2 years at S2Jand for 1 year at 1F2

K Shah Classes 122
Forward Rates From Spot Rates
 S = 4% , S = 5%, CALCULATE F
2 4 1 2
(1+S3)3 (1.05)3
- 1 = 1F2 so, - 1 = 7.03%
(1+S2)2 (1.04)2
 Approximation: 3 × 5% – 2 × 4% = 15% – 8% = 7%

Forward Rates From Spot Rates
S = 4% , S = 5%, CALCULATE F
2 4 2 2
(1+S4)4 (1.05)4
- 1 = 2F2 SO - 1 = 6.01%
(1+S2)2 (1.04)2
 Approximation: 4 × 5% – 2 × 4% = 20% – 8% = 12%

12% / 2 = 6%
 2F2 is an annual rate, so we take the square root above and divide by two for the
approximation

Spot Rates From Forward Rates
 Spot rate is geometric mean of forward rates
(1 + S1) (1+ 1F1) (1+ 1F2)1/3 – 1 = S3)
 Example: S1 = 4%, 1F1 = 5%, 1F2 = 5.5%
 3-period spot rate =

(1.04) (1.05)(1.055) 1/3 – 1 = S3= 4.8314%
Approximation: (4+5+5.5) = 4.833

J K Shah Classes 3 125
Valuing a Bond
With Forward Rates
 1-year rate is 3%, 1F1 = 3.5%, 1F2 = 4%
 Value a 4%, 3-year annual-pay bond
40 40 1040
+ + = 1014.40
(1.30) (1.30)(1.035) (1.30)(1.035)(1.04)
1+S1 ( 1+ S2)2 (1+ s 3)3

Introduction to the
Measurement of Interest
Rate Risk

Measuring Interest Rate Risk
 Full valuation approach: Re-value every bond based on an interest rate change scenario
 Good valuation models provide precise values
 Can deal with parallel and non-parallel shifts
 Time consuming; many different scenarios
 Duration/convexity approach: Gives an approximate sensitivity of bond/portfolio values to

changes in YTM
Limited scenarios (parallel yield curve shifts)
Provides a simple summary measure of interest rate risk

Option-Free Bond Price-Yield Curve
Price (% of Par)
For an option-free bond

the price-yield curve is
convex toward the origin.
110.67
100.00 Price falls at a decreasing

rate as yields increase.
90.79
YTM
7% 8%
J K Shah Classes
9% 129
Callable Bond Value
Price (% of Par)
Negative
option-free bond convexity
call option
value
102
callable bond
Yield
Negative Convexity y' Positive Convexity
Callable bond = option-free value – call option

Price-Yield for Putable Bond
Price
Less interest rate

sensitivity
putable bond
value of the put option
option-free bond
Yield
y'

Computing Effective Duration
Price at YTM – ∆y Price at YTM + ∆y
v_ - v+
Duration =
2(V0) (∆y)
Current price
Change in YTM
Computing Effective Duration
Example: 15-year option-free bond, annual 8%
coupon,
trading at par, 100
Interest rates ↑ 50bp, new price is 95.848
V+
Interest rates ↓ 50bp,
V– new price is 104.414
104 .41 4  95.848

8.
57
2 10 0 0.005
Effective duration is:
current price 50 basis

J K Shah Classes points 133
Using Duration
 Our 8% 15-year par bond has a duration of 8.57
Duration effect = –D × Δy
 If YTM increases 0.3% or 30bp, bond price

decreases by approximately:
–8.57 × 0.3% = –2.57%

Duration Measures
 Macaulay duration is in years
Duration of a 5-yr. zero-coupon bond is 5
1% change in yield, 5% change in price
 Modified duration adjusts Macaulay duration for

market yield, yield up → duration down
 Effective duration allows for cash flow changes as

yield changes, must be used for bonds with
embedded options
Effective Duration
 Both Macaulay duration and modified duration are based on the
promised cash flows and ignore call, put, and prepayment options
 Effective duration can be calculated using prices from a valuation

model that includes the effects of embedded options (e.g., call
feature)
 For option-free bonds, effective duration is very close to modified

duration
 For bonds with embedded options, effective duration must be used

Duration Interpretation
 1. PV-weighted average of the number of years
until coupon and principal cash flows are to be
received
 2. Slope of the price-yield curve (i.e., first derivative

of the price yield function with respect to yield)
 3. Approximate percentage price change for a 1%

change in YTM: The best interpretation!
Bond Portfolio Duration
 Duration of a portfolio of bonds is a portfolio-value-
weighted average of the durations of the individual
bonds
DP = W1D1 + W2D2 +……+WnDn
 Problems arise because the YTM does not change

equally for every bond in the portfolio

Convexity Adjustment
 Consider an 8% 20-year Treasury bond priced at

$908 so that it has a YTM of 9%
 For a 50 bp increase in YTM, price = $866.80
 For a 50 bp decrease in YTM, price = $952.30
 Duration = (952.3 – 866.8)/(2x908x0.005)= 9.42

139
J K Shah Classes
Convexity Adjustment
 Using duration estimated price for a 1% decrease in
YTM is $993.53 (908 x 1.0942)
 Using duration estimated price for a 1% increase in

YTM is $822.47 (908 x (1- 0.0942))
 Actual price for a 1% decrease $1000 (YTM 8%)
 Actual price for a 1% increase $828.41(YTM 10%)

The Convexity Adjustment
Duration-based estimates of new bond prices
are below actual prices for option-free bonds
Price
$1,000.00 Prices based on duration

$993.53 are underestimates of actual prices.
$908.00
$828.41
$822.47
Actual price-yield curve
Price estimates based
on a duration of 9.42
YTM
8% 9% 10%
Convexity Effect
 To adjust for the for the curvature of the bond
price-yield relation, use the convexity effect:
+ Convexity (∆y)2
 Assume convexity of the bond = 68.33

 Convexity (∆y)2 = 68.33(0.01)2 = 0.006833
y=1.00%
 So our convexity adjustment is + 0.6833% for a
yield increase or for a yield decrease
Duration-Convexity Estimates
 For a yield decrease of 1.0% we have:
–9.42 (–0.01) + 68.33 (–0.01)2 = +10.103%

New Price $908 x 1.10103 = $999.74
 For a yield increase of 1.0% we have:
–9.42 (0.01) + 68.33 (0.01)2 = –8.737%

New Price $908 x (1- 0.08737) = $828.67
 Convexity adjustment improved both estimates!

Modified and Effective Convexity
 Like modified duration, modified convexity assumes expected

cash flows do not change when yield changes
 Effective convexity takes into account changes in cash flows

due to embedded options, while modified convexity does not
 The difference between modified convexity and effective

convexity mirrors the difference between modified duration
and effective duration

Price Value of a Basis Point
 A measure of interest rate risk often used with portfolios is
the price value of a basis point
 PVBP is the change in $ value for a 0.01% change in yield
 Duration × 0.0001 × portfolio value = PVBP
Example: A bond portfolio has a duration of 5.6 and value of

$900,000
PVBP = 5.6 × 0.0001 × $900,000 = $504


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Fixed Income Securities

CFA Level 1 (Dec 2010)

60. Features of Debt Securities

61. Risks Associated with Investing in Bonds

62. Overview of Bond Sectors and Instruments

63. Understanding Yield Spreads

Don'tsNegative Covenants Positive Covenants Dos

Par Value Quoted Price Dollar Price Coupon Payment

 Coupon rate: Annual % of par value

Maturity is very important for bond for 3 reasons

Issue Price of $ 100 bond Whether a case of Zero coupon bond

T(0) T(1) T(2) T(3) T(4)

3.5% 3.75% 3% 4% 4.5%

Days Since Last Coupon

Full Price / Dirty Price = Clean Price + AI

Clean Price = Full Price / Dirty Price - AI

 Coupon Treasury bonds

 Prepayments are repayment of principal in excess of

 Its beneficial for issuer / borrower

 Call protection for some period

 Premium bonds: Cash paid to trustee, bonds to be retired chosen by

 Discount bonds: Bonds can be purchased and delivered to trustee to

 Call prices are regular redemption prices

 Sinking fund redemptions and redemptions under other

 Call Provision  Put Provision

Prepayment Option Issuer/Borrower

Put Provision Buyer

Conversion Option Buyer

 Margin buying: Borrowing funds to purchase securities. The

2. Yield curve risk

6% 7% 8% 9% 10% MARKET YIELD 27

Maturity Coupon & Call Option &

Higher Maturity  Higher Interest Add any option  Interest Rate

Lower Maturity  Lower Interest Remove Option  Interest Rate

Lower Coupon  Higher Interest

As the yield falls, the value of

 Coupon is periodically reset based on a reference rate

 Has interest rate risk between reset dates

 Price may differ from par at reset if:

% change in bond price

 Based on the duration of 4.29:

 For a non-parallel shift in the yield curve, the yields on

 Yield curve risk: The interest rate risk of a portfolio of

YIELD A NON PARALLEL SHIFT

INITIAL YILED CURVE

 Callable securities are likely to be called when interest

 Principal repayment on pre payable securities is faster

 Investors must reinvest principal when rates are low

Reinvestment risk is higher when:

2. Bond has a call feature

4. A security contains a prepayment option

 Bond ratings indicate relative probability of default

 The bid-ask spread indicates the liquidity of the market for a

 A decrease in liquidity will increase the bid-ask spread, lead to a

 Even if an investor plans to hold the security until maturity,

 If an investor buys a security denominated in a foreign (to the

 Depreciation of the foreign currency reduces the returns to a dollar-based

 When expected inflation increases, nominal yields rise, values of debt

 Increase in yield volatility increases option values

 Increases value of putable bond =

 Decreases value of callable bond =

 Corporate restructurings may result in bond-rating downgrades

 Regulatory issues may cause large cash expenditures to meet new

 New regulations prohibiting financial institutions from holding a