The Financial Institute of Israel

1
Fixed Income 2

• Zvi Wiener
• 02-588-3049
• http//pluto.mscc.huji.ac.il/mswiener/zvi.html

2
Plan FI-2

• Example of Duration and Convexity
• Treasuries
• Agencies
• Corporate
• Municipals
• The Treasury Securities Markets Overview and
  Recent Developments, by D. Dupont and B. Sack,
  Federal Reserve Bulletin, Dec-99.

3
Example

• Portfolio consists of 1M of a bond with duration
  of 1 year and 1M worth of a bond with duration
  of 20 years.
• What is the duration of the portfolio?

4
Rough calculation

• Duration of the first bond is 1 year, of the
  second bond is 20 years.
• This means that when IR go 1 up we will lose 1
  of the first bond and 20 of the second.
• All together we will lose 10.5 of the portfolio.
• The duration is (roughly) 10.5 years.

5
Value
value
Parallel shift
6
Duration
7
Convexity

• For a simple bond portfolio it does not help
  much!
• It is much more important to consider 2 risk
  factors!

8
Portfolio 2
Time 0 1 5 20
Money 1 -2 2 Term Structure 5 6 7

• value

Assets duration 7.19 Liabilities duration
4.7169
9
8 Coupon Bond
10
Macaulay Duration
11
Understanding of Duration/Convexity

• What happens with duration when a coupon is paid?
• How does convexity of a callable bond depend on
  interest rate?
• How does convexity of a puttable bond depend on
  interest rate?

12
Callable bond

• The buyer of a callable bond has written an
  option to the issuer to call the bond back.
• Rationally this should be done when
• Interest rate fall and the debt issuer can
  refinance at a lower rate.

13
Puttable bond

• The buyer of a such a bond can request the loan
  to be returned.
• The rational strategy is to exercise this option
  when interest rates are high enough to provide an
  interesting alternative.

14
Imbedded Call Option
r
15
Imbedded Put Option
regular bond
r
16
Convertible Bond
Payoff
Stock
17
Timing of exercise

• European
• American
• Bermudian
• Lock up time

18
Passive Bond Management

• Passive management takes bond prices as fairly
  set and seeks to control only the risk of the
  fixed-income portfolio.
• Indexing strategy
• attempts to replicate a bond index
• Immunization
• used to tailor the risk to specific needs
  (insurance companies, pension funds)

19
Bond-Index Funds

• Similar to stock indexing.
• Major indices Lehman Brothers, Merill Lynch,
  Salomon Brothers.
• Include government, corporate, mortgage-backed,
  Yankee bonds (dollar denominated, SEC registered
  bonds of foreign issuers, sold in the US).

20
Bond-Index Funds

• Properties
• many issues
• not all are liquid
• replacement of maturing issues
• Tracking error is a good measurement of
  performance. According to Salomon Bros. With
  100M one can track the index within 4bp.
  tracking error per month.

21
Cellular approach
22
Immunization

• Immunization techniques refer to strategies used
  by investors to shield their overall financial
  status from exposure to interest rate
  fluctuations.

23
Net Worth Immunization

• Banks and thrifts have a natural mismatch between
  assets and liabilities. Liabilities are primarily
  short-term deposits (low duration), assets are
  typically loans or mortgages (higher duration).
• When will banks lose money, when IR increase or
  decline?

24
Gap Management

• ARM are used to reduce duration of bank
  portfolios.
• Other derivative securities can be used.
• Capital requirement on duration (exposure).
• Basic idea
• to match duration of assets and liabilities.

25
Target Date Immunization

• Important for pension funds and insurances.
• Price risk and reinvestment risk.
• What is the correlation between them?

26
Target Date Immunization
Accumulated value
Original plan
0 t t
27
Target Date Immunization
Accumulated value
IR increased at t
0 t t
28
Target Date Immunization
Accumulated value
0 t D t
29
Target Date Immunization
Accumulated value
Continuous rebalancing can keep the terminal
value unchanged
0 t D t
30
Good Versus Bad Immunization
value
10,000
Single payment obligation
0 8 r
31
Good Versus Bad Immunization
value
Good immunizing strategy
10,000
Single payment obligation
0 8 r
32
Good Versus Bad Immunization
value
Good immunizing strategy
10,000
Single payment obligation
0 8 r
33
Good Versus Bad Immunization
Bad immunizing strategy
value
Good immunizing strategy
10,000
Single payment obligation
0 8 r
34
Standard Immunization

• Is very useful but is based on the assumption of
  the flat term structure. Often a higher order
  immunization is used (convexity, etc.).
• Another reason for goal oriented mutual funds
• (retirement, education, housing, medical
  expenses).

35
Cash Flow Matching and Dedication

• Is a very reasonable strategy, but not always
  realizable.
• Uncertainty of payments.
• Lack of perfect match
• Saving on transaction fees.

36
Active Bond Management

• Mainly speculative approach based on ability to
  predict IR or credit enhancement or market
  imperfections (identifying mispriced loans).

37
Substitution Swap

• Exchange of one bond for a very similar bond.
• Motivation belief that one of them is mispriced.
• Example 20-yr, 9 coupon Ford Motor bond
  callable after 5 years at 1,050 versus a 9
  coupon Chrysler bond with 20 yr to maturity.

38
Contingent Immunization
value
12,000
10,000
0 5 yr t
39
Contingent Immunization
value
12,000
10,000
Stop boundary
0 5 yr t
40
Contingent Immunization
41
Contingent Immunization
42
Interest Rate Swap

• One of the major fixed-income tools.
• Example 6m LIBOR versus 7 fixed.
• Exchange of net cash flows.
• Risk involved IR risk, default risk (small).
• Why the default risk on IR swaps is small?

43
Interest Rate Swap
7.05
6.95
Company B
Swap dealer
Company A
No need in an actual loan. Can be used as a
speculative tool or for hedging.
44
Currency Swap

• A similar exchange of two loans in different
  currencies.
• Subject to a higher default risk, because of the
  principal.
• Is useful for international companies to hedge
  currency risk.

45
The Treasuries Securities Market

• US Treasury debt 3.6Trillion
• daily transactions 190B
• yields are viewed as benchmarks
• 1776, first US issue (Revolutionary War)
• Increase during the Civil war, WW1,
• tripled during the great depression
• exploded during WW2.

46
Types of Treasuries securities

• 3.2T - marketable
• Bills - up to one year
• Notes 1-10 years when issued
• Bonds longer then 10 years
• 57 are notes, 20 bills and 20 bonds.
• Some are callable (by the Treasury)
• 97 are nominal

47
Nonmarketable securities

• Government account series (83)
• State and Local Government Series (7)
• saving bonds (7)
• held by off-budget government programs, like
  social security, local governments, etc.
• yield is at least 5bp below marketable Treasuries.

48
Issuance of Treasuries

• regularly scheduled auctions primary market.
• 2,000 brokers and dealers are registered
• Prime dealers are selected by NY Fed -
  counterparites for open market operations.

49
Auctions

• The process begins several days before.
• when issued market after the announcement but
  before it takes place.
• On the day of the auctions bids may be submitted
  to FED.
• Competitive bids - quantity and yield
• Noncompetitive bids - small orders

50
Auctions

• Uniform price method for 2, 5 year notes, TIPS
• Other issues have multiple price auction
• Bidders get securities at their bid price.
• Non-competitive get at the average price of
  competitive bids.

51
Auctions

• 6.5B of 13-week bills and 7.5B of 26 week
  bills - weekly
• 10B of 52 week bills - every four weeks
• 15B of 2-year notes, every 4 weeks
• 12B of ten -year notes and 10B of 30 years
  bonds - semiannually.
• Sometimes an old issue may be reopen.

52
Cancellations

• 1986 20 year bond
• 1990 4 year note
• 1993 7 year note
• 1998 3 year note

53
Market

• Primarily OTC (over the counter) market.
• Officially registered at NYSE, but volume is
  negligible.
• Market makers in Treasuries - bid-offer spread.
• Six primary dealers - 50 of trades (22 hr/day).
• 94 - NY, 4 - London, 2 Tokyo.

54
Quoting conventions

• Coupon securities are quoted in terms of price
  expressed in dollars.
• Clean price excludes accrued interest.
• Accrued interest
• next couponfraction of time that passed.
• Bills are quoted in terms of discount rate as
  of face value. Assuming 360 days in a year, i.e.
  multiplied by 360 and divided by the actual
  number of days remaining to maturity.

55
Price quotes for T-Bills

• Bank discount basis

Yd - annualized yield on a bank discount basis D
- dollar discount face - price F - face value t
- number of actual days to maturity
56
Price quotes for T-Bills
57
Price quotes for T-Bills
100 days to maturity price 97,569 will be
quoted at 8.75
58
Price quotes for T-Bills
The quoted yield is based on the face value and
not on the actual amount invested. The yield is
annualized on 360 days basis. Bond equivalent
yield CD equivalent yield
59
Price quotes for Notes and Bonds
Actual/actual day count convention. Example 50
days have passed, 183 days in the period and
yearly coupon per 100 is 8, then AI 8/2
50/183 1.0929
60
Recordkeeping

• National Book-Entry System (NBES) maintains
  records for depository institutions.
• Most trades are delivery versus payment.
• Federal Reserve grants finality and provides an
  intraday credit to financially healthy depository
  institutions.

61
Ownership

• FED 12
• Depository institutions 7
• Institutional investors 27
• State and local governm. 7
• Foreign and international 33
• Others 14

62
STRIPS

• Separate Trading of Registered Interest and
  Principal of Securities.
• Stripping and reconstitution.
• About 33 of all outstanding T-bonds are
  stripped.
• Creates zero-coupon securities.
• US company must pay tax on accrued interest is
  taxed every year, so strips create a negative CF.

63
Determinants of the Yield Curve

• Federal Reserve sets a target level for the fed
  funds rate - the rate at which depository
  institutions make uncollaterized overnight loans
  to one another.
• Long-term rates reflect expectations of future
  rates and can be influenced by the outlook for
  monetary policy.

64
Liquidity

• Bid-offer spread 1-2 cents per 100 face
• Corporate bonds for example 13 cents
• High yield bonds 19 cents
• on-the-run - recently issued in a particular
  maturity class. With time became off-the-run.
• Flight to Quality (fall 98) bid-ask 16-25 cents.

65
Repurchase Agreements

• Borrowing and lending using Treasuries and other
  debt as collateral.
• Repo (loan). You sell a security to counterparty
  and agree to repurchase the same security at a
  specified price at a later date (often next day).
• Reverse Repo - you agree to purchase a security
  and sell it back at a specified price later.

66
Repurchase Agreements

• Most repos are general-collateral repo rate.
• Some securities are special (for example
  on-the-run).
• Specialness peaks around next auction, then
  declines sharply.
• NY FED operates a securities lending for primary
  dealers using FEDs portfolio while posting other
  Treasury security as collateral.

67
Treasury Based Derivatives

• Futures and options for 2, 5, 10 year notes and
  bonds are listed by CBOT and CFFE. CNE offers
  futures and options on bills and other short term
  interest rate products.
• End of October 99 open interest for CBOT
  long-bond futures was 635,000 (each one based on
  100,000 face value).
• Daily volume 300,000 contracts.

68
Treasury Based Derivatives

• CBOT also offers options on Treasury futures -
  contract that allows the holder to buy/sell a
  future contract at a specified price.
• Cheapest-to-deliver option and conversion factor
  (compare to commodities).

69
TIIS TIPS

• Treasury Inflation Indexed (Protected)
  Securities.
• Since 97, 92B were issued, based on the
  non-seasonally adjusted CPI lagged 2.5 months.
• The quoted price do not reflect the accumulated
  inflation compensation.
• Real price quotedindex ratio accrued
  interest
• I-bonds saving bonds that are also CPI indexed.

70
TIIS TIPS

• 5, 10, 30 years notes and bonds.
• Less liquid 2-6 cents per 100 face.
• CBOT offers options and futures on TIPS
• Canada, France, England, Israel have similar
  types of debt.

71
T-bills markets

• Issuance of T-bills was cut sharply.
• Between Dec-96 and Sep-99 the total outstanding
  amount of coupon securities declined 7 while
  bills declined 16.
• Treasury Debt buybacks. Reverse auctions trying
  to remove small issues.

72
Government-Sponsored Enterprises

• Fannie Mae benchmark and Freddie Mac
  reference notes and bond.
• Can be electronically transferred through
  clearing houses as Euroclear and Cedel and NBES.
• Outstanding amount 150B with 2-30 years to
  maturity.

73
Government-Sponsored Enterprises

• GNMA - Government National Mortgage Association
• FHLBS - Federal Home Loan Bank System
• Sallie Mar - Student Loan Marketing Association

74
Corporate Debt Instruments

• corporate bonds
• medium-term notes
• CP commercial papers
• ABS asset backed securities
• They have priority over common stocks in the case
  of bankruptcy.

75
Corporate Bonds

• Main types of issuers
• utilities
• transportation
• industrial
• banks and financial companies

76
Bond Indentures

• trustee
• term bonds, serial bonds
• collateral
• debenture bond - not secured
• guaranteed bonds

77
Bond Provisions

• Call and refund provisions - the issuer has the
  right to redeem the entire amount before
  maturity. Sometimes there is a premium to be
  paid in such a case (redemption schedule).
• Special redemption prices for debt redeemed
  through the sinking fund
• Refunding means replacing by another debt.

78
Bond Provisions

• Sinking fund provision sometimes the issuer is
  required to retire a portion of an issue each
  year.
• either by cash payment to bondholders (lottery)
• or by buyback bonds

79
Bond Rating

• Duff and Phelps Credit Rating Co.
• Fitch Investors Service
• Moodys Investors Service
• Standard Poors Corporation

80
Rating

• Moodys SP Fitch DP
• Aaa AAA AAA AAA
• Aa1 AA AA AA
• Aa2 AA AA AA
• Aa3 AA- AA- AA-
• A1 A A A
• A2 A A A
• A3 A- A- A-

81
Rating

• BBB- or better investment grade
• BB and below - speculative grade
• D to DDD default
• transition matrix

82
One year transition matrix

• Aaa Aa A Baa Ba B CD
• Aaa 91.9 7.38 0.72 0 0 0 0
• Aa 1.1 91.3 7.1 0.3 0.2 0 0
• A 0.1 2.6 91.2 5.3 0.6 0.2 0
• Baa 0 0.2 5.4 87.9 5.5 0.8 0.2

83
High Yield Bonds

• LBO, downgrading, refinancing
• fallen angels
• deferred interest bonds
• Step-up bonds pay initially low interest which
  increases with time

84
SEC rule 144A

• Allows to trade private placements among
  qualified institutions.

85
Medium Term Notes (MTN)

• Notes are registered with the SEC under Rule 415
  (the shelf registration) and are offered
  continuously to investors by an agent of the
  issuer.
• Maturities vary from 9 months to 30 years.
• Can be either fixed or floating.
• Very flexible way to raise debt!

86
Primary Market (MTN)

• Issuer posts spreads over Treasuries for a
  variety of maturities.
• Then an agent tries to find an investor. Minimal
  size is between 1M and 25M.
• The schedule can be changes at any time!
• Often structured MTNs are used (caps, floors,
  etc.) structured notes.

87
Structured Notes

• Many institutional investors can use swaps and
  structured notes to participate in markets that
  were prohibited.
• Another use of structured notes is in risk
  management.
• Financial Engineering is used to create
  securities satisfying the needs of investors.

88
Commercial Papers

• Short term unsecured promissory note
• An alternative to short term bank borrowing
• A typical round-lot transaction is 100,000
• In the USA maturity is up to 270 days
• Requires less paperwork
• Those with maturity up to 90 days can be used as
  collateral for FED discount window.

89
Commercial Papers

• Typically rolled over
• Rollover risk is backed by an unused bank credit
  line
• In order to issue CP one need either a high
  rating or good collateral
• Sometimes credit enhancement is used (LOC)
• CP issued in the USA by foreigners are called
  Yankee CP

90
Commercial Papers

• Between 71 an 89 there was one default on CP.
• 3 defaults occurred in 89 and 4 in 90
• Direct paper is sold without an agent
• Secondary market is thin
• There is a special rating for CP, P-1,3, A-1,3
• discount instruments, used by money market

91
Bankruptcy and Credit Rights

• liquidation - all assets will be distributed
• reorganization - a new corporate entity will
  result
• a company that files for protection becomes a
  debtor in possession and continues to operate
  under the supervision of the court

92
Bankruptcy and Credit Rights

• Absolute priority rule - senior creditors are
  paid in full before junior creditors are paid
  anything.
• Works in liquidation but often does not work in
  reorganization.

93
Municipal Securities

• Exemption of interest income from federal
  taxation.
• Issued by states, counties, special districts,
  cities, towns, school districts.

94
Municipal Securities

• Exemption of interest income from federal
  taxation.
• General obligation bonds - backed by tax power
• Limited tax general obligation bonds
• Revenue bonds - based on specific projects

95
Municipal Securities

• Airport Revenue Bonds
• College and University Revenue Bonds
• Hospital Revenue Bonds
• Industrial Revenue Bonds
• Single-Family Revenue Bonds (mortgages)
• Multifamily Revenue Bonds (housing projects)
• Water Revenue Bonds

96
Hybrid and Special Bond Securities

• Insured bonds - typically by an insurance firm
• Bank-backed municipal bonds (letter of credit)
• Refunded Bonds - a portfolio of safe securities
  is placed in trust and they will cover the
  payments.
• Troubled city bailout bonds

97
Municipal Money Market Products

• TAN tax anticipation notes
• RAN revenue anticipation notes
• GAN grant anticipation notes
• BAN bond anticipation notes
• Tax exempt commercial paper

98
Municipal Derivatives

• floaters floating rate spread
• inverse floaters interest - floating rate
• strips
• partial strip are zeros till a call date and
  then become coupon type

99
Yield on Municipal Bonds

• tax-exempt yield
• equivalent taxable yield
• 1-marginal tax rate
• for example bond offers 6.5 and marginal tax
  rate 40
• 0.065
• 0.1083
• 1-0.40

100
Non-US Bonds

• national bond markets
• domestic market
• Foreign market
• Yankee USA
• Samurai Japan
• bulldog UK
• Rembrandt Holland
• matador Spain

101
International bond market

• Eurobond and Euroyen markets
• Global bond - simultaneous offering
• Typically registered in Luxembourg, London or
  Zurich, but traded OTC.
• Supranationals - IBRD, World Bank, etc.

102
Eurobond market

• Dual currency bonds (coupon in one currency,
  principal in another).
• Option currency bond one side can choose the
  currency.
• Convertible bonds with warrants - can be
  converted into another asset. Equity, debt, gold
  or currency warrant.

103
Eurobond market

• Floating Rate Notes FRN based on LIBOR or
  LIBID
• many are collared
• some are perpetual

104
Comparing Yields

• bond equivalent yield of Eurodollar bond
• 2(1yield to maturity)0.5-1
• for example A Eurodollar bond with 10 yield has
  the bond equivalent yield of
• 21.100.5-1 9.762

105
Japanese Government Bonds JGB

• short term Treasury bills
• medium term bonds
• long term bonds
• super long term bonds (20 years)

106
German Government Bonds

• U-Schatze discount paper up to 2 years
• Kassens federal government notes (2-6 y.)
• OBLEs 5 year federal government notes
• Bunds federal government bonds (6-30 y.)
• all coupon payments are annual

107
UK Government Bonds Gilts

• straights bullet bonds (some callable)
• convertibles (option to holder to convert to
  longer gilts)
• index linked low coupon 2-2.5
• irredeemable (perpetual)

108
Brady Bonds

• Argentina, Brazil, Costa Rica, Dominican
  Republic, Ecuador, Mexico, Uruguay, Venezuela,
  Bulgaria, Jordan, Nigeria, Philippines, Poland.
• Partially collateralized by US government
  securities