abcd

Fixed Income Seminar

Michael P. Ryan, CFAManaging Director

Chief Fixed Income Strategist

abcd

Fixed Income Market

• Market Sectors and Security Structure

• Term Structure of Interest Rates

• Yield, Valuation and Risk Measures

• Critical Role of the Federal Reserve

• Fiscal Policy Impact

• Factors Impacting Interest Rates

abcd

Market Sectors andSecurity Structure

abcd

Assessing Debt

• Public vs. Private

• Marketable vs. Nonmarketable

• Fixed Rate vs. Floating Rate

• Investment Grade vs. Speculative

• Domestic vs. Global

• Dollar vs. Non-dollar

abcd

Market Sectors

• Treasury ($3.0 trillion)

• Municipal ($1.6 trillion)

• U.S. Corporate ($3.8 trillion)

• Mortgage Related ($4.1 trillion)

• Federal Agency ($2.1 trillion)

• Asset Backed ($1.3 trillion

• Money Market ($2.5 trillion)

abcd

Credit Market Composition: Year End 1991

MBS18%

Corporate18%Agency

5%

Treasury30%

ABS1%

Money Mkt12%

Municipal16%

abcd

Credit Market Composition: Year End 2002

MBS22%

Corporate21%

Agency11%

Treasury16% ABS

7%

Money Mkt14%

Municipal9%

abcd

Security Structures

• Notes and Bonds

• Bills and Discount Notes

• Pass-Throughs and Self Amortizing Securities

• Collateralized Trust Structures

• Zero Coupon Bonds

• Inflation Protected Securities

• Floating Rate Notes

• Special Structures

abcd

Security Structures

• Bullet / Callable

• Fixed / Floating

• Cash Pay / Discount

• Risk Free / Spread Product

• Convertible / Noncovertible

abcd

Term Structure ofInterest Rates

abcd

Term Structure of Interest Rates

• Time Value of Money

• Spot Rates

• Forward Rates

• Yield to Maturity

• Different Shapes of the Yield Curves

• Determinants of Curve Shape

abcd

The price of any security is determined by the presentvalue of each future cash flow when discounted by

the appropriate interest rate.

PV = FV * [(1/1+I)^^n]

Time Value Review

abcd

The spot rate is the discount rate at which eachindividual cash flow will be discounted by in order to

determine the current price (present value) of allfuture cash flows.

PV = CF1/(1+y1)^1 + CF2/(1+y2)^2 +CF3/(1+y3)^3+…CFn/1+yn)^n

Spot Rate

abcd

The forward rate is the implied future spot rate forsome defined period determined by using currentobserved spot rates for two distinct time periods.

FR = (1+y2)^ / (1+y1) - 1

Forward Rate

abcd

The single discount function that can be determinedand applied to each future cash flow so that the

present value of these cash flows equals the currentmarket price for a bond (internal rate of return).

PV = CF1/(1+y)^1 + CF2/(1+y)^2 +CF3/(1+y)^3+…CFn/1+y)^n

Yield to Maturity

abcd

Positive (Normal) Curve

0%

1%

2%

3%

4%

5%

6%

3 mo 2 yr 5 yr 10 yr 30 yr

abcd

Flat Yield Curve

0%

1%

2%

3%

4%

5%

6%

3 mo 2 yr 5 yr 10 yr 30 yr

abcd

Inverted Yield Curve

0%

1%

2%

3%

4%

5%

6%

3 mo 2 yr 5 yr 10 yr 30 yr

abcd

Determinants of Term Structure

• Market Segmentation

• Expectations Hypothesis

• Liquidity Premium

• Preferred Habitat

abcd

Yield, Valuation andRisk Measures

abcd

Standard Yield Measures

• Current Yield

• Yield to Maturity

• Yield to Call

• Yield to Worst

abcd

Current Yield

• Advantages: Current yield provides a true current“asset yield.”

• Limitations: Measure ignores the amortization ofmarket premiums and accretion of marketdiscount through the maturity date.

• Assessment: Current Yield is the simplest and mostlimited of the different yield measuresused in assessing the valuation of fixedincome securities.

•• Current YieldCurrent Yield = Coupon / Market Price

abcd

Yield to Maturity

• Advantages: Allows for the discounting of cash flows at asingle rate. Addresses issue of market premium and discounts. Provides a basis forcomparing securities with different couponsand maturities.

• Limitations: Single discount rate function (IRR solution) implicitly ignores the term structure of interest rates for discounting individual cashflows. Strict yield to maturity calculation makes no allowances for early calls and/or self-amortizing securities.

• Assessment: YTM and modified versions of this measure (yield to call, yield to worst) are the standardby which fixed income securities are compared.

•• Yield to MaturityYield to Maturity = The single discount function that can bedetermined and applied to each future cash flow so that thepresent value of these cash flows equals the current marketprice for a bond (internal rate of return).

abcd

Yield to Call

• Advantages: Allows for the discounting of cash flows at asingle rate. Addresses issue of market premium and discounts. Provides a basis forcomparing securities with different couponsand call dates. Explicitly targets yield to specified early retirement dates.

• Limitations: Single discount rate function (IRR solution) implicitly ignores the term structure of interestrates for discounting individual cash flows.Strict yield to maturity calculation makes noallowances for early calls and/or self-amortizing securities.

•• Yield to CallYield to Call = The single discount function that can bedetermined and applied to each future cash flow so that thepresent value of these cash flows through the first call dateequals the current market price for a bond (internal rate ofreturn).

abcd

Yield to Call (continued)

• Assessment: YTM and modified versions of this measure (yield to call, yield to worst) are the standardby which fixed income securities are compared.

abcd

Yield to Worst

• Advantages: Allows for the discounting of cash flows at asingle rate. Addresses issue of market premium and discounts. Provides a basis forcomparing securities with different coupons,maturities and call dates. Makes allownacesfor early call dates, early amortization and final maturities.

• Limitations: Single discount rate function (IRR solution) implicitly ignores the term structure of interestrates for discounting individual cash flows.Yield to worst is less stable yield measure thanYTM. As probability of bond being called changes, YTM can shift substantially based upon most likely event outcome.

•• Yield to WorstYield to Worst = The single discount function that can bedetermined and applied to each future cash flow so that thepresent value of these cash flows through either the maturitydate or first call date (whichever is lower) equals the currentmarket price for a bond (internal rate of return).

abcd

Yield to Worst (continued)

• Assessment: YTM and modified versions of this measure (yield to call, yield to worst) are the standardby which fixed income securities are compared.

abcd

Valuation Measures

• Spread to Treasury Curve

• Spread to Swap Curve

• Options Adjusted Spread

• Breakeven / Volatility

• Arbitrage Based Measures

abcd

Assessing Risk

• Interest Rate Risk

• Reinvestment Risk

• Liquidity Risk

• Credit/Default Risk

• Horizon Risk

• Basis Risk

abcd

Measuring Interest Rate Risk

• Maturity

• Duration

• Effective Duration

• Convexity

abcd

Maturity

0

20

40

60

80

100

120

1 2 3 4 5 6 7 8 9 10

abcd

Maturity

0

20

40

60

80

100

120

1 2 3 4 5 6 7 8 9 10

abcd

Duration

•• DurationDuration: The weighted average time to receipt of the cashflows from an individual security or portfolio when thosecash flows are weighted by their present values as a percentof the present value of all cash flows for the security orportfolio.

MacauleyMacauley Duration Duration (in years) = SUM (n, t=1) [t * PVCFt / k * PVCF]

t = period the cash flow is expected to be receivedn = number of periods to maturityk = number of payment per yearPVCFt = present value of cash flow in period t discounted by the

YTMPVCF = total present value of the cash flow of the bond where

the present value is determined using the YTM (price ofthe bond).

abcd

Duration

Modified DurationModified Duration = Macauley Duration / (1 + coupon/k)

Such that for small changes in yield,

Percentage price ∆ = —Modified Duration * yield ∆ * 100

abcd

Duration

0

20

40

60

80

100

120

1 2 3 4 5 6 7 8 9 10

abcd

Duration

0

20

40

60

80

100

120

1 2 3 4 5 6 7 8 9 10

abcd

Convexity

4.75

4.85

4.95

5.05

5.15

5.25

95 97 99 101 103 105

abcd

Convexity

4.7

4.8

4.9

5

5.1

5.2

5.3

95 97 99 101 103 105

abcd

Convexity

949596979899

100101102

4.75 4.85 4.95 5.05 5.15 5.25

abcd

Critical Role of theFederal Reserve

abcd

Critical Role of the Federal Reserve Bank

• Reserve Requirements

• Discount Rate Targeting

• Open Market Operations (FOMC)

• Fed Funds Rate

• Policy Bias

• Lender of Last Resort

• Non-traditional policy measures

abcd

Fiscal Policy Impact

abcd

Fiscal Policy Impact

• Deficits/surpluses vs. Real Rates

• Cyclical Impact

• Financing Mix

• Technical Factors

abcd

Factors ImpactingInterest Rates

abcd

Factors Impacting Interest Rates

• Business Cycle

• Demand for Capital

• Inflation

• Fed Policy

• Fiscal Policy

• Foreign Exchange Rates

• Technical Factors