Lecture 1 Introduction to Fixed Income Securities_3pgs

7/31/2019 Lecture 1 Introduction to Fixed Income Securities_3pgs

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FINN 6211

Lecture

1

Introduction to

FINN 6211

Outline of Lecture

• This purpose of this lecture is to provide

you with an introduction to fixed‐income

markets. In particular we discuss:

– Why study fixed income securities

– What is meant by “fixed income”

– Fixed Income Terminology

– What are the major fixed‐income markets and

the unique features of instruments in each

market

– Risks in

Fixed

Income

Securities

2

Why Study Fixed Income Securities?

• Two‐thirds of the market value of all securities that are outstanding in the world are classified as fixed‐

income securities.

• Most

participants

in

corporate

and

financial

sectors

par c pa e n e xe ‐ ncome secur es mar e o

varying degrees. For example:

– Corporations issue commercial paper.

– Corporations invest in Treasury bonds.

– Government and municipals issue debt.

3



FINN 6211

Debt Securities Market

• Issuers

• Financial Intermediaries

• Investors

4

Issuers of Debt Securities

• Governments and agencies

• Corporations

• Commercial Banks

• States and Municipals

• Special‐purpose Vehicles

• Foreign Institutions

5

Objectives of Issuers

• To sell securities at a fair value

• To issue debt securities that best suit their

needs

• To ave iqui secon ary mar ets in t eir

securities

• To have flexibility in modifying their securities

after issuance

6



FINN 6211

Financial Intermediaries

• Primary dealers

• Investment banks

• Credit rating agencies

• Credit and liquidity enhancers

7

Objectives of Financial Intermediaries

• Market‐making activities in the primary

market: auction, underwriting, and

distribution

•

• Risk management and asset liability

management

8

Investors

• Governments

• Pension funds

• Insurance

companies• Mutual funds

• Commercial banks

• Foreign institutions

• Retail investors

9



FINN 6211

Objectives of Investors

• Diversification

• Buy securities

with

a risk

‐return

profile

that

best fits their needs

• Get in ormation on cre it rating

10

11Source: Fixed Income Securities: Tools for Today’s Markets , Tuckman 3e, 2011, Wiley.




FINN 6211

What is a “Fixed Income” Security?

• When we say “fixed” income, we mean the market

for debt, and debt‐related instruments.

• Due to

financial

innovation,

it

is

not

always

clear

if

a given security should be classified as a fixed

income security.

• The defining characteristic of these instruments is

that there are well‐defined rules for the schedule

of payout to the holder and these payouts are

contractual (i.e., legally binding) obligations of the

issuer.13


• In particular, a debt instrument requiring the issuer (debtor or borrower) to repay the lender (investor or holder) the amount borrowed and interest over a specified period of time.

• In the corporate context, holders of fixed‐income obligations take priority over equity holders with respect to a firm’ s cash

flows.

• If a firm defaults on a bond, the bondholders generally have

the right to take over the firm, gaining ownership from the

equity holders.

• Agency conflicts arise when equity holders take actions that reduce the value of a bond, without triggering default, such as

taking on additional risk after issuing a bond.

14


• A bullet‐security is generally any instrument

that has a fixed coupon, fixed maturity, and no

call provisions or other options.

• Most fixed

‐income

securities

trade

in

dealers

market via an OTC (over the counter) system,

which is essentially a series of computer and

phone networks among dealers and brokers.

• Few are traded on exchanges such as the NYSE.

15



FINN 6211

Fixed Income Terminology• Main elements on a debt instrument:

– Maturity (short, intermediate, and long)

– Principal or

face

value

or

par

value

– Issuer

–

• zeros

• floaters and inverse floaters

• deferred‐coupon bonds (LBO and recapitalization): deferred‐interest; step‐up, payment‐in‐kind, coupon

reset.

• Amortizing versus non‐amortizing instruments

• frequency of coupon payments

16

Fixed Income Terminology

• Main elements of a bond (continued)

– Covenants (e.g., dividend restriction)

– Provisions (e.g., sinking fund)

–

• Call

• Put

• Conversion

• Exchangeable option

• coupons and principal paid in different currencies

17

Fixed Income Terminology• Most bonds (although not all) have a specified

maturity date, or time to maturity.

• The par amount is the “face” value of the bond – i.e.

the principal amount of the bond.

•

solely to determine the periodic cash flows (coupon

payments) made to the bondholder.

• Most bonds pay interest on an annual, semi‐annual

or quarterly basis. Many mortgage‐related bonds,

however, pay interest on a monthly basis.

18



FINN 6211

Typical Cash Flow PatternTypical Cash Flow Patterncoupon rate 2.125%, face value $1,000,000coupon rate 2.125%, face value $1,000,000



• The yield on a fixed income security is the rate of return on a bond given the periodic cash flows and

the current price.

• Bonds usually trade at a price that is different from

the ar amount at a remium if hi her than ar at

a discount if lower than par). The yield and the

coupon rate are the same only if the bond is purchased at par.

• One basis point is 1/100th of a percentage point, i.e. 1 basis point (1 bp) = .0001.

20

Selected Treasury Bond PricesSelected Treasury Bond Prices

21

Source: Bloomberg, May 19, 2012



FINN 6211

Selected Treasury Bond PricesSelected Treasury Bond Prices

•• Prices are presented as a percent of face value; Prices are presented as a percent of face value;

number after hyphen is in 32nd, or called number after hyphen is in 32nd, or called ticksticks..

•• For example:For example:

– – 1.75% coupon, 5/15/22 maturity bond, price is1.75% coupon, 5/15/22 maturity bond, price is

– – 3.00% coupon, 5/15/42 maturity bond, price is (+ means 3.00% coupon, 5/15/42 maturity bond, price is (+ means

half a tick)half a tick)

%25.100%32

810008100

22

%890625.103%32

5.2810328103

Fixed Income Terminology• The indenture is the contract (a written

agreement between the issuer and

bondholder) that set forth the promises of a

corporate bond issuer and the rights of the

investors, usually specifying the coupon rate, , , , ,

and other terms.

• The bond covenants specify the exact contractual rules and restrictions.

• Often a third‐part trustee will have the

responsibility for interpreting and applying the

bond covenants.

23

Fixed Income Terminology• Absolute priority rules (APR) – the contractual

rules under which the bondholders are paid in

the event of a bankruptcy.

• In case of reorganization/bankruptcy, it is very

deviations from this in order to negotiate a

better deal with the managers/equity owners of the firm or to abide by the court’ s decisions.

24



FINN 6211

Fixed Income Terminology• Many corporate bonds will have a sinking fund

provision. This is an agreement which requires

that

the

bond

issuer

periodically

retire

a

specified portion of the bond issuance.

• Some bonds, especially those of lower‐credit quality issuers, will require a reserve fund, which requires that the firm begin gradually

placing funds into an account to guarantee the

ultimate repayment of the principal.

25


• Some bonds will come with third‐party

guarantees that insure that the bondholders

will receive the principal sum.

• A call option enables the issuer to redeem the

on s prior to maturity. T e provision

specifies the call schedule (a step‐down

schedule) containing the prices and times of the redemption if the issuer choose to

exercise the call.

26


• A putable bond is one in which the holder has

the right to sell the bond back to the issuer usually at par.

• A convertible bond is

one in

which

the

bondholder can covert their debt to a fixed

number of common equity shares.

27



FINN 6211

Fixed Income Terminology• A exchangeable bond is one in which the

bondholder can covert their debt to a fixed

number of

common

equity

shares

of

the

company other than the issuer.

•

structured to be paid in different currencies (dual‐currency bonds). For example, coupon

payments are paid in Japanese yen and

principal in U.S. dollars.

28


• Municipal bonds have a number of interesting

features. There are two basic types of municipal bonds:

– General Obligation Bonds (GOBs) – The

’

bond.

– Revenue bonds – revenue from a specific project is used to pay the bonds down. It is very common

for highways, bridges, hospitals, industrial parks to

be paid for this way.

29

Major Fixed Income Market Sectors• Sovereign Debt – Debt issued by a national government.

– US Treasury, U.K. Gilts, etc.

• Agency Securities – Debt issued by quasi‐governmental

entities.

• Corporate Securities

– Debt

issued

by

corporations.

• Municipals – debt issued by cities, local governments.

• Mortgage‐backed Securities (MBS) – Debt backed solely

by a pool of underlying mortgages.

• Asset‐backed Securities – Debt that is backed by assets,

such as credit cards, car loans, student loans, etc.

30



FINN 6211

Treasury Market

• Securities are backed by the full faith and credit of

US government.

• Securities are

often

viewed

as

the

world

benchmark

for liquidity and quality (default‐free!)

• os recen y ssue reasury secur es are ca e

“on the run” securities, which are the most liquid.

“On the run” issues become “off the run” once the

Treasury announces a new issue. “Off the run”

issues are still liquid, but they may not actually trade

each day.

31

Treasury MarketTreasury Market

Source: The Bureau of the Public Debt, April 30, 2012

32

Treasury Market

• Treasury Bills and Notes pay interest on a

semi‐annual basis.

• The “flat price” (or the clean price) is the

uoted

rice, and

does

not

include

the

accrued interest.

• The “invoice price” (or the cash price or the

dirty price) is the sum of the flat price and the

accrued interest.

33



FINN 6211

Treasury Yield CurveTreasury Yield Curve

*Bloomberg, as of January 9, 2012

34

Source: Bloomberg, May 19, 2012

Other Sovereign Markets• Canada

– Typically bullet loans, 2‐30 years.

• Britain

– Standard Gilts: bullet loans.

– Index‐linked: inflation linked bonds.

– Irredeemable gilts: perpetual bonds (that may be called

at par.)

• Japan

– Large market, quoted on simple yield basis, typically

issues bullet bonds. Callable at any time.

35

36

Source: Fixed Income Securities: Tools for Today’s Markets , Tuckman 3e, 2011, Wiley.



FINN 6211

Agency Market

• Government Sponsored Enterprises (GSEs) are

private companies that the Federal government

implicitly

guarantees.

• Most well‐known are Fannie Mae and Freddie

Mac.

• These agencies issue regular debt as well as

securities backed by mortgages (or assets).

37

Agency Market

• Major Agencies

– Federal Home Loan Bank (FHLB)

– Federal National Mortgage Association (FNMA)

– Federal Home Loan Mortgage Corporation

(FHLMC)

– Tennessee Valley Authority (TVA)

– Student Loan Marketing Association (SLMA)

– Farm Credit System (FCS)

38

Corporate Market

• Corporate debt is much more complex in

structure and design than Treasury and

agency securities.

• Individual issues

tend

to

be

smaller,

li uidit

and default are serious concerns.

• Bid‐ask spreads are wider and depth narrower due to liquidity concerns.

• Default risk is non‐trivial, therefore the role of rating agencies are important.

39



FINN 6211

Corporate Market

• Three primary categories of debt:

– Money market

instruments

– less

than

1 year

maturity, such as commercial papers.

– –

year to 30 years, flexible issuance schedule as they

are shelf ‐registered.

– Corporate bonds/notes – usually longer than 5

years maturity.

40

Corporate Market

• Some key terms:

– Commercial Paper – Short term discount notes, that if under 270 days term require no SEC

registration.

– ‐ –

single registration that is good for 3 years, allowing them to then issue multiple bonds under that registration.

– High‐yield bonds – The so‐called junk bonds, quite

popular in the buyout activities.

41

Mortgage Backed Market• The basic steps for Fannie/Freddie to create a

MBS :1. Banks/Brokers/Mortgage Companies originate

mortgages.

2. Originators sell loans to Fannie/Freddie.

“ ” . ann e re e pay or g na ors o serv ce oans on

their behalf.

4. Fannie/Freddie pools loans to form a mortgage pool.

5. Fannie/Freddie sells bonds backed by this pool.

6. All cash flows generated by pool of loans is “passed

through” proportionately to the owners of the MBS.

42



FINN 6211

Mortgage Backed Market

• Fannie Mae and Freddie Mac guarantee that if the borrowers default, the MBS investors will

receive all

interest

and

principal.

• Fannie Mae and Freddie Mac have minimum

purchase and put into pools.

• MBS are traded in an active secondary market.

43

Asset Backed Market

• The success of the MBS market has spurred

the rapid development of other securitized

markets, including:

– Car loans

– Credit cards receivables

– Home equity loans

– Student loans

– Equipment leases

– Hospital bill receivables

44

Risks in Bonds• Interest rate risk

• Reinvestment risk

• Default risk

• Inflation risk

• Exchan e rate

risk

• Liquidity risk

• Volatility risk

• Call risk

• Yield‐curve risk

• Event risk

• Risk Risk45

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