Fixed Income Analysis (Hardcover, 3, Revised)

Foreword xv

Preface xvii

Acknowledgments xix

About the CFA Investment Series xxi

PART I Fixed-Income Essentials

CHAPTER 1 Fixed-Income Securities: Defining Elements 3

Learning Outcomes 3

1. Introduction 3

2. Overview of a Fixed-Income Security 4

2.1. Basic Features of a Bond 5

2.2. Yield Measures 10

3. Legal, Regulatory, and Tax Considerations 10

3.1. Bond Indenture 10

3.2. Legal and Regulatory Considerations 18

3.3. Tax Considerations 21

4. Structure of a Bond’s Cash Flows 23

4.1. Principal Repayment Structures 23

4.2. Coupon Payment Structures 28

5. Bonds with Contingency Provisions 34

5.1. Callable Bonds 34

5.2. Putable Bonds 36

5.3. Convertible Bonds 37

6. Summary 41

Problems 43

CHAPTER 2 Fixed-Income Markets: Issuance, Trading, and Funding 45

Learning Outcomes 45

1. Introduction 45

2. Overview of Global Fixed-Income Markets 46

2.1. Classification of Fixed-Income Markets 46

2.2. Fixed-Income Indices 55

2.3. Investors in Fixed-Income Securities 56

3. Primary and Secondary Bond Markets 58

3.1. Primary Bond Markets 58

3.2. Secondary Bond Markets 63

4. Sovereign Bonds 66

4.1. Characteristics of Sovereign Bonds 66

4.2. Credit Quality of Sovereign Bonds 67

4.3. Types of Sovereign Bonds 67

5. Non-Sovereign Government, Quasi-Government, and Supranational Bonds 69

5.1. Non-Sovereign Bonds 69

5.2. Quasi-Government Bonds 70

5.3. Supranational Bonds 70

6. Corporate Debt 71

6.1. Bank Loans and Syndicated Loans 72

6.2. Commercial Paper 72

6.3. Corporate Notes and Bonds 75

7. Short-Term Funding Alternatives Available to Banks 80

7.1. Retail Deposits 80

7.2. Short-Term Wholesale Funds 81

7.3. Repurchase and Reverse Repurchase Agreements 82

8. Summary 86

Problems 88

CHAPTER 3 Introduction to Fixed-Income Valuation 91

Learning Outcomes 91

1. Introduction 91

2. Bond Prices and the Time Value of Money 92

2.1. Bond Pricing with a Market Discount Rate 92

2.2. Yield-to-Maturity 96

2.3. Relationships between the Bond Price and Bond Characteristics 98

2.4. Pricing Bonds with Spot Rates 102

3. Prices and Yields: Conventions for Quotes and Calculations 105

3.1. Flat Price, Accrued Interest, and the Full Price 105

3.2. Matrix Pricing 109

3.3. Yield Measures for Fixed-Rate Bonds 113

3.4. Yield Measures for Floating-Rate Notes 119

3.5. Yield Measures for Money Market Instruments 123

4. The Maturity Structure of Interest Rates 128

5. Yield Spreads 136

5.1. Yield Spreads over Benchmark Rates 136

5.2. Yield Spreads over the Benchmark Yield Curve 138

6. Summary 141

Problems 143

PART II Analysis of Risk

CHAPTER 4 Understanding Fixed-Income Risk and Return 153

Learning Outcomes 153

1. Introduction 154

2. Sources of Return 154

3. Interest Rate Risk on Fixed-Rate Bonds 162

3.1. Macaulay, Modified, and Approximate Duration 162

3.2. Effective Duration 170

3.3. Key Rate Duration 174

3.4. Properties of Bond Duration 174

3.5. Duration of a Bond Portfolio 180

3.6. Money Duration of a Bond and the Price Value of a Basis Point 183

3.7. Bond Convexity 185

4. Interest Rate Risk and the Investment Horizon 195

4.1. Yield Volatility 195

4.2. Investment Horizon, Macaulay Duration, and Interest Rate Risk 197

5. Credit and Liquidity Risk 201

6. Summary 202

Problems 205

CHAPTER 5 Fundamentals of Credit Analysis 211

Learning Outcomes 211

1. Introduction 211

2. Credit Risk 212

3. Capital Structure, Seniority Ranking, and Recovery Rates 214

3.1. Capital Structure 214

3.2. Seniority Ranking 215

3.3. Recovery Rates 217

4. Ratings Agencies, Credit Ratings, and Their Role in the Debt Markets 220

4.1. Credit Ratings 221

4.2. Issuer vs. Issue Ratings 223

4.3. Risks in Relying on Agency Ratings 224

5. Traditional Credit Analysis: Corporate Debt Securities 229

5.1. Credit Analysis vs. Equity Analysis: Similarities and Diff erences 230

5.2. The Four Cs of Credit Analysis: A Useful Framework 230

6. Credit Risk vs. Return: Yields and Spreads 249

7. Special Considerations of High-Yield, Sovereign, and Non-Sovereign Credit Analysis 258

7.1. High Yield 258

7.2. Sovereign Debt 266

7.3. Non-Sovereign Government Debt 270

8. Summary 272

Problems 275

CHAPTER 6 Credit Analysis Models 279

Learning Outcomes 279

1. Introduction 279

2. Measures of Credit Risk 281

3. Traditional Credit Models 283

4. Structural Models 289

4.1. The Option Analogy 290

4.2. Valuation 291

4.3. Credit Risk Measures 292

4.4. Estimation 295

5. Reduced Form Models 297

5.1. Valuation 299

5.2. Credit Risk Measures 300

5.3. Estimation 303

5.4. Comparison of Credit Risk Models 307

6. The Term Structure of Credit Spreads 308

6.1. Coupon Bond Valuation 308

6.2. The Term Structure of Credit Spreads 309

6.3. Present Value of the Expected Loss 311

7. Asset-Backed Securities 315

8. Summary 317

References 318

Problems 318

PART III Asset-Backed Securities

CHAPTER 7 Introduction to Asset-Backed Securities 323

Learning Outcomes 323

1. Introduction 323

2. Benefits of Securitization for Economies and Financial Markets 324

3. The Securitization Process 326

3.1. An Example of a Securitization Transaction 327

3.2. Parties and Their Role to a Securitization Transaction 329

3.3. Bonds Issued 330

3.4. Key Role of the Special Purpose Vehicle 332

4. Residential Mortgage Loans 335

4.1. Maturity 335

4.2. Interest Rate Determination 336

4.3. Amortization Schedule 336

4.4. Prepayments and Prepayment Penalties 337

4.5. Rights of the Lender in a Foreclosure 337

5. Residential Mortgage-Backed Securities 338

5.1. Mortgage Pass-Through Securities 339

5.2. Collateralized Mortgage Obligations 343

5.3. Non-agency Residential Mortgage-Backed Securities 349

6. Commercial Mortgage-Backed Securities 352

6.1. Credit Risk 352

6.2. Basic CMBS Structure 352

7. Non-Mortgage Asset-Backed Securities 355

7.1. Auto Loan Receivable-Backed Securities 356

7.2. Credit Card Receivable-Backed Securities 358

8. Collateralized Debt Obligations 359

8.1. Structure of a CDO Transaction 360

8.2. Illustration of a CDO Transaction 360

9. Summary 363

References 365

Problems 365

PART IV Valuation

CHAPTER 8 The Arbitrage-Free Valuation Framework 371

Learning Outcomes 371

1. Introduction 371

2. The Meaning of Arbitrage-Free Valuation 372

2.1. The Law of One Price 373

2.2. Arbitrage Opportunity 373

2.3. Implications of Arbitrage-Free Valuation for Fixed-Income Securities 374

3. Interest Rate Trees and Arbitrage-Free Valuation 375

3.1. The Binomial Interest Rate Tree 377

3.2. What Is Volatility and How Is It Estimated? 380

3.3. Determining the Value of a Bond at a Node 381

3.4. Constructing the Binomial Interest Rate Tree 384

3.5. Valuing an Option-Free Bond with the Tree 389

3.6. Pathwise Valuation 391

4. Monte Carlo Method 393

5. Summary 395

Problems 396

CHAPTER 9 Valuation and Analysis: Bonds with Embedded Options 401

Learning Outcomes 401

1. Introduction 402

2. Overview of Embedded Options 402

2.1. Simple Embedded Options 403

2.2. Complex Embedded Options 404

3. Valuation and Analysis of Callable and Putable Bonds 407

3.1. Relationships between the Values of a Callable or Putable Bond, Straight Bond, and Embedded Option 407

3.2. Valuation of Default-Free and Option-Free Bonds: A Refresher 408

3.3. Valuation of Default-Free Callable and Putable Bonds in the Absence of Interest Rate Volatility 409

3.4. Effect of Interest Rate Volatility on the Value of Callable and Putable Bonds 412

3.5. Valuation of Default-Free Callable and Putable Bonds in the Presence of Interest Rate Volatility 418

3.6. Valuation of Risky Callable and Putable Bonds 426

4. Interest Rate Risk of Bonds with Embedded Options 432

4.1. Duration 432

4.2. Effective Convexity 440

5. Valuation and Analysis of Capped and Floored Floating-Rate Bonds 444

5.1. Valuation of a Capped Floater 444

5.2. Valuation of a Floored Floater 447

6. Valuation and Analysis of Convertible Bonds 450

6.1. Defining Features of a Convertible Bond 450

6.2. Analysis of a Convertible Bond 453

6.3. Valuation of a Convertible Bond 456

6.4. Comparison of the Risk–Return Characteristics of a Convertible Bond, the Straight Bond, and the Underlying Common Stock 458

7. Bond Analytics 462

8. Summary 463

Problems 465

PART V Term Structure Analysis

CHAPTER 10 The Term Structure and Interest Rate Dynamics 473

Learning Outcomes 473

1. Introduction 474

2. Spot Rates and Forward Rates 474

2.1. The Forward Rate Model 476

2.2. Yield to Maturity in Relation to Spot Rates and Expected and Realized Returns on Bonds 484

2.3. Yield Curve Movement and the Forward Curve 487

2.4. Active Bond Portfolio Management 489

3. The Swap Rate Curve 493

3.1. The Swap Rate Curve 493

3.2. Why Do Market Participants Use Swap Rates When Valuing Bonds? 494

3.3. How Do Market Participants Use the Swap Curve in Valuation? 495

3.4. The Swap Spread 498

3.5. Spreads as a Price Quotation Convention 500

4. Traditional Theories of the Term Structure of Interest Rates 502

4.1. Local Expectations Theory 502

4.2. Liquidity Preference Theory 503

4.3. Segmented Markets Theory 504

4.4. Preferred Habitat Theory 504

5. Modern Term Structure Models 507

5.1. Equilibrium Term Structure Models 507

5.2. Arbitrage-Free Models: The Ho–Lee Model 512

6. Yield Curve Factor Models 515

6.1. A Bond’s Exposure to Yield Curve Movement 515

6.2. Factors Affecting the Shape of the Yield Curve 516

6.3. The Maturity Structure of Yield Curve Volatilities 520

6.4. Managing Yield Curve Risks 521

7. Summary 524

References 525

Problems 525

PART VI Fixed-Income Portfolio Management

CHAPTER 11 Fixed-Income Portfolio Management—Part I 531

Learning Outcomes 531

1. Introduction 532

2. A Framework for Fixed-Income Portfolio Management 532

3. Managing Funds against a Bond Market Index 534

3.1. Classification of Strategies 535

3.2. Indexing (Pure and Enhanced) 536

3.3. Active Strategies 553

3.4. Monitoring/Adjusting the Portfolio and Performance Evaluation 554

4. Managing Funds against Liabilities 555

4.1. Dedication Strategies 555

4.2. Cash Flow Matching Strategies 574

5. Summary 578

Problems 580

CHAPTER 12 Fixed-Income Portfolio Management—Part II 585

Learning Outcomes 585

5. Other Fixed-Income Strategies 586

5.1. Combination Strategies 586

5.2. Leverage 586

5.3. Derivatives-Enabled Strategies 591

6. International Bond Investing 608

6.1. Active versus Passive Management 609

6.2. Currency Risk 611

6.3. Breakeven Spread Analysis 616

6.4. Emerging Market Debt 617

7. Selecting a Fixed-Income Manager 620

7.1. Historical Performance as a Predictor of Future Performance 621

7.2. Developing Criteria for the Selection 621

7.3. Comparison with Selection of Equity Managers 622

8. Summary 624

Problems 625

CHAPTER 13 Relative-Value Methodologies for Global Credit Bond Portfolio Management 633

Learning Outcomes 633

1. Introduction 633

2. Credit Relative-Value Analysis 636

A. Relative Value 638

B. Classic Relative-Value Analysis 638

C. Relative-Value Methodologies 640

3. Total Return Analysis 640

4. Primary Market Analysis 640

A. The Effect of Market-Structure Dynamics 641

B. The Effect of Product Structure 641

5. Liquidity and Trading Analysis 642

6. Secondary Trade Rationales 642

A. Popular Reasons for Trading 643

B. Trading Constraints 645

7. Spread Analysis 647

A. Alternative Spread Measures 647

B. Closer Look at Swap Spreads 648

C. Spread Tools 649

8. Structural Analysis 650

A. Bullets 651

B. Callables 652

C. Sinking Funds 652

D. Putables 653

9. Credit Curve Analysis 654

10. Credit Analysis 655

11. Asset Allocation/Sector Rotation 655

12. Summary 657

Problems 658

Glossary 667

About the Editors and Authors 683

About the CFA Program 691

Index 693