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Fixed Income Flashcards

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1
Q

Fixed Income

Basics

Indenture definition

A

The Indenture is the contract between the bond issuer and the bond-holder.

Sometimes it exists between the issuer and a trustee who sits between issuer and holder.

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2
Q

Fixed Income

Basics

Bankruptcy Remote definition

A

This means if a comany issues bonds through an SPV which holds assets as collateral, the bondholders can’t go after the assets of the main company, only the SPV issuing the bonds.

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3
Q

Fixed Income

Basics

Covered Bonds

A

Bonds issued by banks which are fully backed by residential or commercial mortgage loans or loans to public sector entities.

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4
Q

Fixed Income

Basics

3 types of internal credit enhancement

A
  • Tranche Structure (senior tranches get paid first, subordinated tranches bear credit risk)
  • Overcollateralization ($105m assets to collateralise $100m of bonds)
  • Excess spread (income from assets is higher than cost of the debt)
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5
Q

Fixed Income

Basics

External credit enhancement

A

This means third party guarantees of the debt, such as surety bonds, bank guarantees and letters of credit.

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6
Q

Fixed Income

Basics

Internal vs External Bonds

Domestic vs Foreign Bonds

Global bond

A

Internal bond market is also known as the national bond market.

Within it there are domestic bonds issued by domestic firms and foreign bonds (eg Yankee bonds, Samurai bonds) issued by foreign companies.

The external bond market is also known as offshore or eurobonds, issued under international law to holders in mutiple countries in any currency.

A global bond is issued in the international market and at least one national market.

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7
Q

Fixed Income

Basics

Bullet Bond

Amortising Bond (balloon payment)

Sinking Fund Arrangement

Call Provision

A

Bullet bond - principal repaid in one go at the end

Amortising bond - principal repaid with interest over life of the bond, a balloon payment is a big repayment of remaining principle at the end

Sinking fund arrangement - A portion of the bonds are bought back each year, usually at lower of face value and market price.

A call provision allows the issuer to retire the issue before maturity.

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8
Q

Fixed Income

Basics

Inverse Floater

Credit-linked coupon bonds

Payment-in-kind coupon bonds

A

The rate of an inverse floater falls when the floating rate rises.

Credit-linked bonds coupon rates change depending on the credit rating of the issuer.

Payment-in-kind bonds allow the issuer to pay coupons with additional amounts of the bond issue rather than cash.

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9
Q

Fixed Income

Embedded Options

Deferred call option

How to partial calls work?

Putable option

Convertibles - Conversion value, premium

A

Deferred call option allows the issuer to buy back the issue, but only after a certain time has elapsed.

If only part of the issue is called it will be allocated on a pro-rata or random basis.

Putable options allow bond holders to sell the bonds back to the company at a set price.

Conversion value is the market price of the shares * conversion ratio (so value of shares if you converted now). Conversion premium is the difference between the bond price and the conversion value. Conversion parity is when this is zero (time to convert!).

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10
Q

Fixed Income

Primary Issuance

4 types of public issuance

A
  • Underwritten - investment bank takes the risk of whole issue via a firm commitment underwriting
  • Best effort offerings - bank just acts as a broker, charging a commission for best efforts
  • Shelf registrations - issuer files the bonds with a regulator before offering, thus can issue new bonds without a new offerig circular
  • Auctions - often yield the most money, enable sales direct to public without using I-banks
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11
Q

Fixed Income

Private placement & secondary market

Private Placement

Settlement on secondary market

A

Private placement is to a single or small group of investors directly. Not registered so SEC requires them to be sophisticated investors.

Secondary market bond settlement is T+3 for corporate, T+1 for govies.

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12
Q

Fixed Income

Sovereign Bonds

Definition

Name for latest US treasury bond issuance

Non-sovereign bonds

Quasi-government bonds

Supranational bonds

A

Sovereign bonds are those issued by a countries government, they can be domestic, foreign or eurobonds. Unsecured and funded out of tax revenue.

Latest US treasury issuance is the on-the-run issue.

Non-sovereign means local government (low credit risk).

Quasi-government are issued by political subdivisions of the government (low credit risk).

Supranational are issued by global agencies like the world bank.

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13
Q

Fixed Income

Corporate Debt

Bilateral/syndicated loan

Commercial Paper (pricing basis)

Medium Term Notes (MTNs)

A

Bilateral loans have one lender and one borrower, syndicated means one borrower issuing to lots of lenders.

Commercial paper is short term debt issued by corporates. US usually done on discount basis, European on interest paying basis.

Medium term notes are continuously offered over a period of time by an issuer (9 months to 30 year maturities).

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14
Q

Fixed Income

Repurchase Agreements

Definition

Repo names based on maturity

What is the rate like?

Reverse repurchase agreement

Repo margin

A

Sale of an asset with an agreement to repurchase at fixed price (effectively a collateralised loan).

1 day is overnight repo, >1 day is term repo.

The rate is lower for certain collateral that is in demand. Overall lower than bank funding due to being collateralised.

From the lenders perspective it is called a reverse repo.

Repo margin is value of collateral minus amount of cash lent (lower for short maturity, high quality collateral and high credit quality).

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15
Q

Fixed Income

Pricing

Describe price/yield relationship

A

Described as positive convexity

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16
Q

Fixed Income

Pricing

Maturity and Coupon effect on “volatility”

A

Longer maturity and smaller coupon leads to greater price volatility (ie impact on bond price of a change in rates)

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17
Q

Fixed Income

Pricing

Arbitrage-free approach

A

Arbitrage-free approach means discounting each cash flow of the bond at it’s own spot rate (rather than using one discount rate for all cash flows) and gives a true arbitrage-free value for the bond.

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18
Q

Fixed Income

Pricing

How to calculate the flat/full (dirty) price

A

Easiest way is to calculate the price at the last coupon date then apply interest rate up to the current date:

PVFULL = PV * (1 + r)t/T

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19
Q

Fixed Income

Pricing

Matrix Pricing

A

Matrix pricing is used to price bonds with similar features (e.g. maturity, type of issuer, credit rating, coupon) and gives a general yield level to the entire category (as required yield over benchmark).

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20
Q

Fixed Income

Pricing

Which type of yields are not compounded?

A

Money market instruments use simple rates that are not compounded, other instruments use compounded rates.

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21
Q

Fixed Income

Pricing

Difference between:

Yield to maturity

Bond equivalent yield

Effective annual rate

A

Yield to maturity is the rate per payment period, ignoring how long the payment period is. So YTM of 1 year zero coupon bond priced at 90 is 11.1% with annual compounding or 5.4% with semi-annual.

Bond equivalent yield is YTM * # periods in a year, so 11.1% for annual or 10.8% semi-annual.

Effective annual rate is the proper comparable rate, so 11.1% for both annual and semi-annual.

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22
Q

Fixed Income

Pricing

Relationship between bond equivalent yield and periodicity

A

Due to compounding, bond equivalent yield and periodicity (number of periods per annum) are inversely related.

Since the bond equivalent yield ignores compounding and simply multiplies yield to maturity by # periods, the more periods there are the higher the ignored compound effect and lower the value.

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23
Q

Fixed Income

Pricing

Street convention

True yield

Government equivalent yield

A

Street convention assumes payments are made on scheduled dates ignoring weekends & holidays.

True yield is calculated with consideration of weekends and holidays.

Governement equivalent yield uses actual/actual basis.

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24
Q

Fixed Income

Pricing

Current Yield

Simple Yield

example of 2 year 5% bond $978 price against $1000 face value

A

Current yield is a basic measure relating the coupon amount to the current price (e.g. for 5% 2-year bond priced at $978 it’s 5%*$1000/$978 = 5.11%).

Simple yield is similar but incorporates the straight-line amortisation of the discount/premium (so 5.11% + $22/$1000/2 = 6.21%).

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25
Q

Fixed Income

Pricing

For callable bonds: Yield to first call

Yield to worst

Option-adjusted yield

A

Yield to first call calculates the YTM based on the assumption that the bond will be called at the first callable date.

Yield to worst is the lowest potential yield based on the bond being called at any of its call dates.

Option-adjusted yield is YTM after adding the theoretical value of the call option to the price.

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26
Q

Fixed Income

Pricing - Floating-rate notes

Quoted Margin

Discount Margin

A

Quoted margin on a floating rate note is the specific yield spread over or under the benchmark.

Discount margin (aka required margin) is the spread required by investors to which quoted margin must be set to acheive par value on rate reset date. Changes relate to credit risk of the issuer.

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27
Q

Fixed Income

Pricing- Money Market

Calculation for PV given Discount Rate

Calculation for PV given Add On Rate

A

PV = FV * (1 - DR * (days/year))

PV = FV / (1 + AOR * (days/year))

Where FV is face value (redemption value), PV is price of the bond today, days is the given maturity in days and year is the assumed # days in a year (360 or 365)

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28
Q

Fixed Income

Pricing - Money Market

Calculating Discount Rate and Add On Rate

A

DR = (years/days) * (FV - PV)/FV

AOR = (years/days) * (FV - PV)/PV

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29
Q

Fixed Income

Pricing - Money Market

How to calculate bond equivalent yield of money market instrument

A

BEY for money market is simply the add-on rate calculated on a 365 day basis.

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30
Q

Fixed Income

Pricing

Spot Rate and Curve

A

A spot rate is a yield on a zero-coupon bond. A series of spot rates (spot curve) can be used to discount the cash flows of a bond.

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31
Q

Fixed Income

Pricing

Par Curve

Forward Rate/Curve

Forward naming convention

A

A par curve is a sequence of YTMs such that each bond is priced at par, it is obtained from the spot curve. Bonds used to derive the curve must have same credit risk, periodicity, annual yields etc.

Forward rate is the rate on a loan beginning in the future. A forward curve is a series of these rates with the same time frame (ie different loan maturities but loans starting on the same date).

A 1y2y forward is a 2yr loan starting in 1yr.

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32
Q

Fixed Income

Pricing - Spreads

G spread

I spread

Z spread

OAS (above or below z spread?)

A

G spread - spread over/under a government bond rate (aka nominal spread)

I spread - spread over/under the standard swap rate in that currency and tenor

Z spread - constant yield spread over benchmark spot curve, such that PV of cash flows matches bond price (so price bond cashflows based on spot curve adjusted for a spread)

Option adjusted spread - z spread minus option value (note option value positive for callable bonds, negative for putable bonds)

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33
Q

Fixed Income

Asset Backed Securities

What is securitisation?

A

Securitisation repackages simple debt instruments into complex structures and uses the cash flows from them to issue bonds.

It allows investors to have access to mortgages and other pools of assets, allows banks to shift assets off their balance sheet and allows borrowers to pay lower costs.

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34
Q

Fixed Income

Asset Backed Securities

Who is the originator?

How is it structured?

A

The originator is the seller of the collateral (e.g. the bank that sells the mortgages on its books).

Structured by creating an SPV which is bankruptcy remote from the originator.

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35
Q

Fixed Income

Asset Backed Securities

Prepayment Tranching

Credit Tranching

A

Prepayment tranching is when cash flows from the securitised assets are divided so that some bond holders receive repayment of principal before others, eg collateralised mortgage obligations. Some investors prefer the risk from shorter maturities.

Credit tranching involves issuing senior and subordinated classes of debt, so losses are allocated to sub debt first.

36
Q

Fixed Income

Asset Backed Securities

Mortgages

Curtailment

Prepayment Risk

Lockout Period

A

Curtailment is when a mortgage is partially prepayed (i.e. pay off a portion of your mortgage before maturity).

Prepayment risk is the risk to holders of mortgage debt that the borrower prepays their borrowing and you get your cash back now.

The period of time over which there is a prepayment penalty to the borrower is the lockout period, or penalty period.

37
Q

Fixed Income

Asset Backed Securities

Mortgage pass-through securities

Agency/non-agency versions

A

A mortgage pass through security is when mortgages are pooled and shares or participation certificates are sold from the pool.

Agency pass-throughs are quasi-governmental, such as Ginnie May (backed by US government credit) and Fannia Mae (not backed by US).

Non-agency or private-label are created by banks or private companies.

38
Q

Fixed Income

Asset Backed Securities

Mortgages

Conditional Prepayment Rate

Single-monthly mortality rate

Relation to scheduled repayments

A

CPR is the assumed annual rate of prepayment for a given pool of mortgages, eg CPR of 8% means 8% of remaining principal it expected to be repaid each year.

SMM is the percentage of a pool’s remaining principal expected to be repaid each month (monthly version of CPR).

They don’t include scheduled repayments, only prepayments. To calculate SMM divide prepayment in the month by the opening principal balance LESS the scheduled repayments in that month (i.e. based on scheduled closing principal for the month).

39
Q

Fixed Income

Asset Backed Securities

Mortgages

Public Securities Association Prepayment Benchmark

A

Public Securities Association Prepayment Benchmark is a benchmark for expected CPR rates.

Mortage pool CPRs are quoted relative to the PSA speed.

eg if PSA rate is 6% and your pool has a CPR of 9%, your speed is 150% PSA.

40
Q

Fixed Income

Asset Backed Securities

Mortgages

Weighted Average Coupon (WAC)

Weighted Average Maturity (WAM)

A

WAC and WAM are simply weighted average of coupon rate and maturity in the pool, weighted by outstanding principal.

41
Q

Fixed Income

Asset Backed Securities

Mortgages

Two components of prepayment risk

A

Contraction Risk - Risk that as interest rates decline, prepayments speed up and timing of pass-through securitys cash flows is shortened. Cash flow must be reinvested at a lower rate than the original contract, thus reinvestment rate risk is high. Upside potential limited.

Extension Risk - The risk that as rates rise, prepayments slow. Funds tied up when rates rise preventing reinvestment. Duration increases and value of the securities falls more than a non-callable bond.

42
Q

Fixed Income

Asset Backed Securities

CMOs

Sequential-pay tranche structure

Effect on prepayment risk

A

Sequential-pay tranches involve several tranches (A, B, C, D) which have their principal repaid in order.

Coupons received might be distributed across tranches based on principal outstanding, whilst repayments and prepayments are directed to tranche A first, then tranche B when A is fully paid off etc.

Earlier tranches have protection from extension risk at the cost of later tranches, whilst later tranches have protection from contraction risk.

43
Q

Fixed Income

Asset Backed Securities

CMOs

Planned amortisation class tranches structure

A

The PAC tranches in the CMO have a specified repayment schedule which is achieved by having support or companion tranches which absorb the contraction or extension risk.

There is a lower and upper PAC collar (prepayment rates expressed as PSA, eg 100PSA, 150PSA) within which the PAC will receive its specific repayment schedule. There is an initial collar, and as time passes and actual prepayments are seen a new effective collar will be calculated.

There can be multiple PAC tranches with sequential characteritstics (eg P-A, P-B, P-C,…).

44
Q

Fixed Income

Asset Backed Securities

Credit Enhancements - which ABS type?

External/Internal

A

All non-agency ABS are credit enhanced.

An external credit enhancement is a guarantee by a monoline insurance company, letter of credit from a bank or guarantee by seller of the assets.

An internal credit enhancement is a tranche structure that protects some investors against default.

45
Q

Fixed Income

Asset Backed Securities

Internal Credit Enhancements

Senior-subordinated structure

Reserve Account, Excess Spread Account

Over collateralisation

A

To avoid the subordinated tranche getting prepaid early due to fast prepayment (thus losing protection for the senior holders), early prepayments are directed to the senior debt (100% in years 1 to 5) and stepped up over time to redirect part to the sub debt.

A reserve account is when some cash flows are diverted into a reserve account to protect against default or missed payments. Excess spread accounts charge a spread of say 50bps between what they receive and what they pay to divert to a reserve account.

Over collateralisation means that the assets backing the securities cover > 100% of the bonds issued.

46
Q

Fixed Income

Asset Backed Securities

Commercial Mortgage Backed Securities

Credit measures

Debt-to-service coverage ratio

Load-to-value ratio

A

CMBS are backed by a pool of commercial mortgage loans on corporate real estate.

The DSC is net operating income/debt service. Greater than 1.00 has a lower default chance.

LTV is ratio of the loan amount to collateral property value.

47
Q

Fixed Income

Asset Backed Securities

CMBS

Call protection - structure vs loan level

Treasury make-whole

Treasury defeasance

A

Structure level call protection is in the tranche structure of the CMBS, for example sequential-pay tranches.

Loan level call protection comes from provisions in the underlying loans. e.g. prepayment lockout (2-5 yrs typically) or prepayment penalties.

Treasury make-whole is a prepayment penalty that requires a premium on prepayment that would recreate the lost yield if reinvested in treasuries.

Treasury defeasance is similar put instead of prepaying the loan, the borrower substitutes treasury securities to replicate the mortgage cash flows.

48
Q

Fixed Income

Asset Backed Securities

CMBS

Balloon Risk

Responses

A

CMBS are typically balloon loans, with big repayments due at the end. The risk that the final payment can’t be made (e.g. due to collateral asset value being too low) is balloon risk.

Lender may extend the loan over a period of time called a “workout period”. Loan will be modified and a higher “default interest rate” will be charged.

49
Q

Fixed Income

Asset Backed Securities

Non-mortgage ABS

Auto loan receivable backed securities

A

Backed by car loans.

Prepayment risk due to reposession, early payoff, insurance settlement from crash, vehicle sale (refinancing is rare).

50
Q

Fixed Income

Asset Backed Securities

Non-mortgage ABS

Credit card receivable backed securities

Lockout period

Early amortisation

A

Backed by credit card debt

Can be fixed or floating.

Lockout period is the length of time that principal repayments are reinvested in new receivables rather than returned.

Early amortisation is a type of credit enhancement. If delinquencies increase or the excess spread (issuers net profit after deducting fees) falls below a certain level.

51
Q

Fixed Income

Asset Backed Securities

CDOs

CLOs, CBOs

3 tranches and their nature

A

CLOs/CBOs are collateralised loan/bond obligations, types of CDO (loans as in bank loans).

Senior tranche - 70 to 80% of the deal receives a floating payment

Subordinated/Mezzanine tranches - recieve a fixed coupon

Equity tranche - provides equity protection to the other tranches, recives any remaining interest

52
Q

Fixed Income

Asset Backed Securities

CDOs

Fixed/Floating risk

A

The collateral pays fixed rates but senior debt gets floating rates so the collateral manager needs to protect against rate risk by buying swaps.

53
Q

Fixed Income

Asset Backed Securities

CDOs

Cash CDOs

A

Cash CDOs involve a portfolio of cash assets (eg loans, corporate bonds, ABS, mortgage backed securities).

54
Q

Fixed Income

Asset Backed Securities

CDOs

Motivation - Arbitrage vs Balance Sheet

A

Arbitrage transactions are motivated by trading collateral assets to maximise return to the equity tranche (as well as repaying the lower yielding debt holders).

Balance sheet transactions are motivated by banks trying to get credit risk off their books.

55
Q

Asset Backed Securities

CDOs

What is the difference between a CDO and an asset backed security?

A

In a CDO the “collateral manager” needs to buy and sell debt obligations from the CDO’s portfolio of assets (the collateral) in order to generate the cashflows to pay off the tranches of the CDO.

Not just a passive “pass-through” style ABS.

56
Q

Fixed Income - Risk

3 sources of return

A
  • Receipts of promised coupon and principal
  • Reinvestment income from reinvesting coupons at the prevailing rate
  • Capital gains/losses if the bond is sold before maturity
57
Q

Fixed Income - Risk

How to calculate total return on a bond

eg 8% annual 4yr bond with 10% market rate

A

Use financial calculator.

Return is 100 principal plus 4 8% coupons plus reinvestment income.

[8 * (1+10%)3] + [8 * (1+10%)2] + [8 * (1+10%)1] + 8 + 100

= 137.128

58
Q

Fixed Income - Risks

2 types of fixed income investment risks

A

Reinvestment risk - Future interest rates may be less than YTM. The two significant factors are maturity (longer maturity = more risk) and coupon rate (higher coupon rate = more risk).

Note zero coupon bonds have no reinvestment risk.

Market Price risk - The risk that the bond prices falls if it has to be sold before maturity.

59
Q

Fixed Income - Risks

Duration

What is it?

Two types of duration

A

Duration aims to reveal the “true maturity” of a bond (i.e. coupon bonds shorter than zero coupons since some money is received back sooner).

Yield duration - Statistics which measure the sensitivity of bonds price to the bonds own YTM (eg Macaulay duration, modified duration, money duration and price value of a bp).

Curve duration - Measure sensitivity of bonds price to the benchmark yield curve (ie effective duration).

60
Q

Fixed Income - Risks

Duration

Macaulay Duration

A

Macaulay duration is the weighted average time to receipt of each cash flow, weighted by the PV of each cash flow.

61
Q

Fixed Income - Risks

Duration

Modified Duration

Relation to Macaulay Duration

A

Modified Duration is the sensitivity of the full bond price to a change in YTM. So approximate it by shifting YTM up and down a bit and doing a sensitivity calc.

Modified Duration = Macaulay Duration / (1 + r)

Where r is the coupon rate per period (note if coupons are paid continuously r = 0 and Modified = Macaulay).

62
Q

Fixed Income - Risks

Duration

Effective Duration

Why used for imbedded options?

A

Effective duration is very similar to modified duration but based on a change to the yield curve rather than a change to the bonds YTM. It can be calculated using a pricing model.

This method must be used for imbedded options because the change in the curve impacts the optionality therefore need a pricing model to take this into account (sensitivity to yield-to-worst doesn’t work).

63
Q

Fixed Income - Risks

Duration

Key rate duration

A

Rather than sensitivity to the bonds YTM or the curve as a whole, key rate duration is the sensitivity of the bonds full price to changes in a single spot rate (with all other spot rates unchanged).

64
Q

Fixed Income - Risks

Duration

Profile of Macaulay/Modified Duration over time

MacDur of zero-coupon and perpetuities

A

Both Mac and Mod fall as time goes by but jump on coupon payment dates (as a big chunk with low rate sensitivity drops off).

Zero-coupon bonds have a macaulay duration equal to maturity.

Perpetuities have a macaulay duration of (1+r)/r

65
Q

Fixed Income - Risks

Duration

Mac/Mod dur relation to:

Coupon Rate

YTM

Time to maturity

A

Coupon rate and YTM are inversely related to mac/mod duration (big coupons or big discounting weight early payments more heavily, reducing duration).

Time to maturity and mac/mod dur usually positively related:

  • Always positively related if bonds priced at par or a premium
  • Usually positively related if priced at a discount, except sometimes long-term low coupon bonds
66
Q

Fixed Income - Risks

Duration

Relationship of bond price to yield for a callable bond

A

At low yields probability of the bond being called by the issuer rises and price becomes negative convex to yield, at high yields behaves like a normal bond.

67
Q

Fixed Income - Risks

Duration

Relationship of putable bond price to yield

A

Always positively convex.

At low yields behaves like a normal bond, as yields rise the probability of investors putting the bond rises and the putable bond price stays above the put price.

68
Q

Fixed Income - Risks

Bond Portfolio Duration

Weighted average of cash flows

Weighted average of durations

A

Weighted average of individual cash flows is rarely used since it can’t be used on bonds with embedded options or floating rates. Not commonly calculated.

Weighted average of durations of the individual bonds is weighted by market value, is simple to calculate and commonly used.

69
Q

Fixed Income - Risks

Bond Portfolio Duration

Interpretation

Assumptions

A

Weighted average duration for bond portfolio tells you the expected change in market value of the portfolio for a change in yield.

Critical assumption is that the yield to maturity of each bond must change together for this to be accurate (i.e. parallel shift in YTM).

70
Q

Fixed Income - Risks

Duration

Money duration

Price value of a basis point (PVBP)

A

Money (or dollar) duration is simply the absolute price change for a change in YTM.

Money duration = dirty price * modified duration

PVBP is the absolute change in price for a one bp move in YTM, so basically same as money duration but for a 1bp move only.

71
Q

Fixed Interest - Risks

Duration

Calculation to approximate bond convexity

A
72
Q

Fixed Income - Risks

Duration

Calculation of change in yield with convexity adjustment

A

AnnModDur is the Modified Duration

AnnConvexity is the Convexity amounts calculated

73
Q

Fixed Income - Risks

Duration

Effect of IR volatility on bond prices

A

Direct interest rate risk is quite well known and measured primarily via duration statistics for a given instrument.

IR volatility however also results in increased interest rate risk.

74
Q

Fixed Income - Risks

Duration

Investment Horizon

Duration Gap

Price risk vs reinvestment risk

A

Duration gap is the difference between the investors investment horizon and the Macaulay duration of the bond.

If investment horizon is greater than Mac Duration then reinvestment risk dominates price risk (and vice versa).

If they’re the same then the two risks are in balance.

75
Q

Fixed Income - Risks

YTM affected by:

Benchmark yield change - 2 parts

Spread over benchmark change - 2 parts

A

Benchmark yield affected by:

  • Expected inflation rate
  • Expected real rate of interest

Spread over benchmark affected by:

  • Credit risk of issuer
  • Liquidity of the bond (transaction costs)
76
Q

Fixed Income - Credit

2 components of credit losses

Calculate expected loss

A

Default Probability

Loss severity (aka loss given default LGD), equal to 1 - recovery rate.

Expected loss = default prob * loss severity

77
Q

Fixed Income - Credit

2 components of credit risk

A

Downgrade Risk

Market Liquidity Risk (bid-ask spread on an issuers bonds widens)

78
Q

Fixed Income - Credit

Which bond issuances does a companies credit rating relate to?

How are other debt classes determined?

A

Senior unsecured obligations

Credit rating agencies may “notch up” secured debt or “notch down” sub debt

79
Q

Fixed Income - Credit

4 C’s of credit analysis

A
  • Capacity - ability to pay. Must consider industry structure, industry fundamentals and finally company fundamentals
  • Collateral - not just for secured debt, other assets held by the company are effectively collateral for unsecured debt
  • Covenants
  • Character - ethical reputation and business qualifications/operating record of management
80
Q

Fixed Income - Credit

High-Yield

More appropriate method of credit analysis for high yield debt

A

Since high yield debt returns are between investment grade debt and equity returns, characteristics are similar to both.

Equity-Like Approach might be more useful. Calculation of enterprise value with EBITDA, debt/EBITDA can show the level of equity cushion beneath an issuer’s debt.

81
Q

Fixed Income - Credit

Sovereign Debt

Two key issues

5 areas in framework for analysis

A

Key issues are governments ability to pay and willingness to pay. More likely to default on foreign currency issues so need to rate them differently.

Framework:

  • Institutional effectiveness & political risks
  • Economic structure & growth prospects
  • External liquidity & international investment position
  • Fiscal performance, flexibility and debt burden
  • Monetary flexibility
82
Q

Fixed Income - Credit

Municial Debt

2 basic types of municipal bonds

A

General obligation - depends on creditworthiness of municipality, similar to sovereign analysis.

Revenue bonds - support specific projects, similar to corporate bond analysis - can underlying cash flows support debt servicing.

83
Q

MBS

Calculate SMM from CPR

A

SMM = 1 - (1 - CPR)1/12

Single month mortality

Conditional prepayment rate

So key is not to do (1 + CPR)1/12 - 1, but deduct CPR from 1 instead.

84
Q

Treasury Inflation Protected Security

For a $10,000, 1.75% real rate TIPS, if inflation in first 6 months is 3% what will the payment be?

A

TIPS adjust the principal amount to take into account inflation so principal is:

$10,000*(1+3%/2) = $10,150

Payment is $10,150 * 1.75%/2

85
Q

Capital Market Security

Definition

A

A fixed income security with original maturity > 1yr

86
Q

Bonds

If a bond is trading at an ex-coupon price, what does it mean?

A

That when it trades, the seller retains the NEXT coupon.

Not the same as divs where it means the coupon that just went ex is kept by the seller.

87
Q

Relative Yield Spread

How is it calculated?

A

Calculate:

(Big yield - small yield) / small yield

so it’s just the absolute yield spread but in terms of percentage of the smaller yield.

CFA (10 decks)

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