Notesale: Turn your study into money

Document Preview

Extracts from the notes are below, to see the PDF you'll receive please use the links above

---

Concepts

Description

Basic features of a fixed income
securities

Fixed income securities : Defining elements
1
...
Maturity date of the bond : Bond with original maturities ≤ 1 year → money market securi es ; Bond with original maturi es > 1 year → capital market securi es
3
...
Coupon rate and payment frequency
5
...
Bond indenture specifies :
- Bond's features
- Souce of funds for repayment
- Assets pledged as collateral
- Credit enhancements (if any)
- Covenants (if any)

Affirmative (positive) covenant /
Negative covenant

Covenant : provisions of bond indenture, to protect bonholders' interest
Affirmative covenant: actions that the issuers must perform (e
...
: comply with laws and regulations, make payment timely, etc
...
g
...
)

Legal, regulatory and tax
considerations of fixed income
securities

- Bond's legal and regulations are subjected to the place of issuance and trading:
+ Domestic bonds : traded in the issuer's home country and currency
+ Foreign bonds : from foreign issuers, but denominated in the currency of the country where they are traded
+ Eurobonds : issued outside the jurisdiction of any single country, denominated in a currency other than that of the countries in which they trade
- Issuing entities : might be government or agency; corporation, holding company, subsidiaries or special-purpose entities
- Source of repayment:
+ Sovereign bonds : Tax
+ Nonsovereign bonds : Tax or project's revenue
+ Corporate bonds : funds from firm's operation
+ Securitised bonds : CF from a pool of financial assets
- Secured bonds : being backed by specific collateral ; Unsecurd bonds : represent an overall claim against the issuer's CF and assets
- Credit enhancement :
+ Overcollateralisation - internal : Value of pledged collaterals > par value
+ Excess spread - internal : bond yield < yield of the assets supporting the asset-backed securities
+ tranches with different claim seniority - internal :
+ Surety bonds - external : issued by insurance company, promise to make up any shortfall in cash available to repay the debt
+ Bank guarantees - external : issued by bank, promise to make up any shortfall in cash available to repay the debt
+ Letter of credit - external: Promise to lend money o the issuer if it does not have enough cas to make the payment
- Taxation : Interest income is taxed at same rate as ordinary income ; gains / losses from selling bond are taxed at capital gain tax rate
**** Purely discount bond : increase in value toward par is considered interest income

Structure of cash flow - fixed
income securities

1
...
Bond with amortising structure : repay part of its principal at each payment date
- Fully amortising structure : make equal payments throughout the bond life
- Partially amortising structure : has balloon payment at maturity, which repay the remaining principal as a lump sum
3
...
g
...
Floating rate notes may have a cap (upper limit of the coupon rate) and/or floor (lower limit of the
coupon rate)
4
...
Credit-linked coupon bond : coupon rate will go up if the credit rating of issuer falls, and vice versa
6
...
Deferred coupon bond (split coupon bond) : regular coupon payments do not begin until a period of time after issuance
8
...
g
...

Bonds with no embedded option are Straight bond or Option-free bond
Most common embedded option bonds are:
- Callable bonds
- Putable bonds
- Convertible bonds
- Warrants : give warrants holders the right to buy firm's common share at a given price over a given period of time
- Contingent convertible bonds : Bonds that would be converted to common equity automatically if special events occurs
...
g
...
g
...
g
...
Public offering :
- Underwritten : Investment bank (or syndicate of investment banks) purchase the entire issue and sell the bonds to the dealers
- Best-effort : investment bank sells the bonds on commission
- Auction : commonly used to issue government debt
2
...
Bonds are traded via:
- exchanges : some government bonds and corporate bonds are traded on exchanges
- Dealers (or OTC) markets : most bonds are traded in secondary markets via dealers
...
Bank debt
- Typically varble rate loan, LIBOR based
- Could be bilateral loan (Loan from 1 bank) or syndicated loan (Loan from several banks)
2
...
Corporate bonds
- Both fixed rate and floating rate
- Might be unsecured or secured with collateral
- Might have call, put, or conversion option
Short-term funding alternatives for 1
...
Certificate of deposit : mature on a specific dates, offered in a range of ST maturities
- Non-negotiable CDs : can't be sold, withdrawal of funds incurs significant penalty
- Negotiable CDs : can be sold, are traded in domestic bond markets and Eurobond market
3
...
Interbank funds : unsecured loan from 1 bank to another bank, for a period of 1 day up to 1 year
Repurchase agreements and
related risks

Repurchase agreement (Repo) : arrangement by which a party sells a securities to a couterparty, with a commitment to buy it back at a specified date in the future, at a specified price
...
Bond's YTM ↑ → bond price ↓ ; Bond's YTM ↓ → bond price ↑
2
...
% ↑ in value when ↓ YTM by a X% > % ↓ in value when ↑ YTM by a X%
4
...
Bonds with longer maturity → more sensi ve to change in YTM

Relationship between price and
maturity

Price will converge to par value as maturity approach

Spot rate

Spot rate : Market discount rates for a single payment to be received in the future (aka
...
Method 1:
- Use average of YTMs for bonds with same maturity
- Use linear interpolation to adjust for difference in maturities
2
...
Loan portfolio is securitised → bank receives the proceeds → could make more loans
- Allow investors to invest in securities that better match their preferred risk, maturity, return characteristics
- Provide diversification and risk reduction compared to purchasing individual loans

Parties to a securitisation:
- Seller : Firm that is raising fund through the securitisation
- SPE : entity independent of the sellers
...

Sellers
(Servicers)
$1m

$1m mortgage, car loan, etc
...

Investors
Structure of securitisation

Structure of securitisation
1
...
Multiple tranches of scurities, each tranch has a different claim to the cash flows of the underlying assets
- Credit tranching (senior / subordinated structure) : subordinated tranches absorb credit losses up to their principal values
...
After the first tranche principal repayments finish, the
Second tranche receive all principal repayments from the underlying assets until the principal value of this tranche is paid off

Prepayment of principal

Prepayment : a partial or full repayment of principal in excess of the scheduled principal repayments required by the mortgage, due to :
- Homeowner sells the home during mortgage term
- Refinance the mortgage → prepay the remaining principal amount using the proceeds of a new, lower interest rate loan
- Paying more than scheduled payment → ↓ principal outstanding, ↓ interest charge, pay off the loan prior to maturity

Prepayment risk

Prepayment makes timing and amount of CF from mortage loans and MBS to be uncertain
Contraction risk : risk of more rapid prepayment than expected → ↓ amount of principal outstanding → ↓ total interest paid in the life of MBS
Extension risk : Risk of slower prepayments than expected

Residential mortgage loan

Residential mortgage loan : Loan, with residential real estate as underlying collateral
Characteristics of residential mortgage loan:
1
...
Interest rate
- Fixed-rate mortgage : interest rate is unchanged over the life of the mortgage
- Adjustable-rate mortgage (variable-rate mortgage) : interest rate that can change over the life of the mortgage
- Index-referenced mortgage : interest rate changes based on a market determined reference rate (LIBOR, 1-year T-bill rate)
- Hybrid mortgage : Loan becomes adjustable-rate mortgage after the initial fixed-rate period
- Rollover (Negotiable) mortgage : Interest rate changes to a different fixed-rate after the initial fixed-rate period
3
...
Prepayment provisions
- Some loans have no penalty for prepayment of principal
- Some loans have prepayment penalty
5
...
Each mortgage past-through security is a claim on CF from the pool mortgage
Securitised mortgage : Mortgage included in the pool
Weighted average maturity (WAM) : weighted average (based on outstanding principal balance) of the final maturities of all mortgage in the pool
Weighted average coupon (WAC) : weighted average of interest rates of all mortgages in the pool

Non-agency RMBS

Definition :
- Not issued by GNMA, Freddie Mac or Fannie Mae
- Credit quality depends on credit quality of the borrower, characteristics of the loans (LTV ratio)
- Could have credit enhancement (overcollaterised, credit tranching, etc
...
Primary CMO structures are :
1
...
But all principal payments are paid to Tranche 1 (short tranche) until Tranche 1's principal is fully
paid off
...
Planned amortization class tranches : has 1 or more planned amortisation class (PAC) tranches and support tranches
...
Support tranches
4
...
CMBS are nonrecourse loan
Structure : CMBS is divided into tranches, with losses due to default are first absorbed by lowest-priority tranche
Call protection : prepayment protection
...
Loan-level call protection - provide by the terms of individual mortgages :
- Prepayment lockout : Borrowers are prohibited from prepaying the mortgage loan for a specific period of time
- Defeasance : Using the prepaid principal to purchase a portfolio of government securities that is sufficient to make the remaining required payments on the CMBS → ↑ credit quality of
the CMBS loan pool
- Prepayment penalty point : penalty charged the borrowers for principal prepayment
- Yield maintenance charges : Borrowers are charged the amount of interest lost in case of principal prepayment
2
...
Debt-to-service-coverage ratio (DSC) - CMBS only

𝐷𝑒𝑏𝑡 − 𝑡𝑜 − 𝑠𝑒𝑟𝑣𝑖𝑐𝑒 𝑟𝑎𝑡𝑖𝑜 =

𝑁𝑒𝑡 𝑜𝑝𝑒𝑟𝑎𝑡𝑖𝑛𝑔 𝑖𝑛𝑐𝑜𝑚𝑒
𝐷𝑒𝑏𝑡 𝑠𝑒𝑟𝑣𝑖𝑐𝑒

Net operating income : after deduction for real estate taxes, but prior any relevant income taxes
Higher DSC ratio → be er
DSC ratio < 1 → borrower is not genera ng sufficient CF to make debt payments
2
...
Coupon + prinipal payment
2
...
Capital gain / loss (if sell the bond prior to maturity)

Reinvestment risk / market price
risk of fixed-rate bond
(example : p 95)

Assumption : Interest rate earned on reinvested coupon payments = YTM on the bond
Summary :
- Short-term investment horizon : market price risk > reinvestment risk
- Long-term investment horizon : market price risk < reinvestment risk
Specifically :
- Hold fixed-rate bond to maturity → annualised rate of return = YTM of the bond when purchase
- Sell a bond prior to maturity → rate of return = YTM @ purchase, if YTM did not change since the purchase
- ↑ YTM (meaning ↑ reinvestment rate) a er the bond is purchased but before the first coupon payment → ↑ return of buy & hold investor (>YTM @ purchase) ; and vice versa
- ↑ YTM (meaning ↑ reinvestment rate) a er the bond is purchased but before the first coupon payment → ↓ return if bond is held for a short period (< than YTM @ purchase); and vice
versa
- ↑ YTM (meaning ↑ reinvestment rate) a er the bond is purchased but before the first coupon payment → ↑ return if bond is held for a long period (> YTM @ purchase); and vice
versa
Annualised holding period rate of return : compound annual return earned from the bond over the holding period

Impact of maturity, coupon, yield,
option on interest rate risk

Macaulay Duration (MacDur)

- ↑ maturity → ↑ interest rate risk (PV of payments made further in the future are more sensi ve to changes in YTM used to calculate PV)
- ↑ coupon rate → ↓ interest rate risk (↑ bond value received sooner → ↓ sensi ve to change in YTM)
- ↑ bond's YTM → ↓ interest rate risk (lower YTM → steeper slope , which mean more sensi ve to change in YTM)
- Put / Call option → ↓ interest rate risk (↓ effec ve dura on)
Duration : measure of bond interest rate risk, measure sensitivity of a bond's full price to a change in its yield

𝑀𝑎𝑐𝑎𝑢𝑙𝑎𝑦 𝐷𝑢𝑟𝑎𝑡𝑖𝑜𝑛 = 𝑊 × 1 + 𝑊 × 2 + 𝑊 × 3 + ⋯ + 𝑊 × 𝑁
In which :
𝑃𝑎𝑦𝑚𝑒𝑛𝑡 @ 𝑦𝑒𝑎𝑟 𝑁 𝑃𝑟𝑛𝑐𝑖𝑝𝑎𝑙 @ 𝑦𝑒𝑎𝑟 𝑁 + 𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 @ 𝑦𝑒𝑎𝑟 𝑁
𝑊 =
=
𝐵𝑜𝑛𝑑 𝑓𝑎𝑐𝑒 𝑣𝑎𝑙𝑢𝑒
𝐵𝑜𝑛𝑑 𝑓𝑎𝑐𝑒 𝑣𝑎𝑙𝑢𝑒
𝑁 = ℎ𝑜𝑙𝑑𝑖𝑛𝑔 𝑝𝑒𝑟𝑖𝑜𝑑 (𝑦𝑒𝑎𝑟𝑠)

Modified Duration (ModDur)

𝑀𝑜𝑑𝑖𝑓𝑖𝑒𝑑 𝐷𝑢𝑟𝑎𝑡𝑖𝑜𝑛 =

𝑀𝑎𝑐𝐷𝑢𝑟
𝑌𝑇𝑀
𝑁

1+

In which :
N = number of payment period in a year
Modified Duration provides an approximate % change in bond's PV for 1% change in YTM

𝐴𝑝𝑝𝑟𝑜𝑥𝑖𝑚𝑎𝑡𝑒 % 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝐵𝑜𝑛𝑑 𝑝𝑟𝑖𝑐𝑒 =
Approximate Modified Duration

Approximate Modified Duration : to approximate modified duration directly using bond values for a same size increase and decrease in YTM

𝐴𝑝𝑝𝑟𝑜𝑥𝑖𝑚𝑎𝑡𝑒𝑙𝑦 𝑚𝑜𝑑𝑖𝑓𝑖𝑒𝑑 𝑑𝑢𝑟𝑎𝑡𝑖𝑜𝑛 =

Effective Duration

−𝑀𝑜𝑑𝐷𝑢𝑟
∆𝑌𝑇𝑀

𝑉 −𝑉
2 × 𝑉 × ∆𝑌𝑇𝑀

In which :
𝑉 = 𝑃𝑉 𝑜𝑓 𝑏𝑜𝑛𝑑 𝑖𝑓 𝑌𝑇𝑀 𝑑𝑒𝑐𝑟𝑒𝑎𝑠𝑒𝑠 𝑏𝑦 ∆𝑌𝑇𝑀
𝑉 = 𝑃𝑉 𝑜𝑓 𝑏𝑜𝑛𝑑 𝑖𝑓 𝑌𝑇𝑀 𝑖𝑛𝑐𝑟𝑒𝑎𝑠𝑒𝑠 𝑏𝑦 ∆𝑌𝑇𝑀
𝑉 = 𝑐𝑢𝑟𝑟𝑒𝑛𝑡 𝑃𝑉 𝑜𝑓 𝑏𝑜𝑛𝑑
2 = average change in ↑ and ↓ in bond PV
Effective Duration : measure interest rate sensitivity og bonds with embedded put, call or prepayment options
𝐴𝑝𝑝𝑟𝑜𝑥𝑖𝑚𝑎𝑡𝑒𝑙𝑦 𝑚𝑜𝑑𝑖𝑓𝑖𝑒𝑑 𝑑𝑢𝑟𝑎𝑡𝑖𝑜𝑛 =

𝑉 −𝑉
2 × 𝑉 × ∆𝐶𝑢𝑟𝑣𝑒

Key rate duration (partial duration) Key rate duration : Measure of the price sensitivity of a bond / bond portfolio to a change in the spot rate for a specific maturity (different maturity → different sensi vity level)

Duration of portfolio

𝑃𝑜𝑟𝑡𝑓𝑜𝑙𝑖𝑜 𝑑𝑢𝑟𝑎𝑡𝑖𝑜𝑛 = 𝑊 × 𝐷 + 𝑊 × 𝐷 + ⋯ + 𝑊 × 𝐷
in which:
𝐹𝑢𝑙𝑙 𝑝𝑟𝑖𝑒 𝑜𝑓 𝑏𝑜𝑛𝑑 𝑖
𝑊 =
𝑇𝑜𝑡𝑎𝑙 𝑣𝑎𝑙𝑢𝑒 𝑜𝑓 𝑝𝑜𝑟𝑡𝑓𝑜𝑙𝑖𝑜
𝐷 = 𝐷𝑢𝑟𝑎𝑡𝑖𝑜𝑛 𝑜𝑓 𝑏𝑜𝑛𝑑 𝑖
𝑁 − 𝑛𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝑏𝑜𝑛𝑑𝑠 𝑖𝑛 𝑡ℎ𝑒 𝑝𝑜𝑟𝑡𝑓𝑜𝑙𝑖𝑜

Money duration /
Price value per basis point

Money duration : duration expressed in currency units
Money duration = Annual modified duration × PV of bond position
Price value per basis point (PVBP) : Money change in the PV of bond when YTM changes by 0
...
Sensitivity of bond price to a given change in yield
2
...

2 components of credit risk:
1
...
Loss severity (loss given default) : the amount of losses of bondholders if the issuer default
Expected loss = Default risk × Loss severity
Recovery rate = 1 - % Loss severity
Yield spread = Credit risky bond's yield - Credit risk free bond's yield
Spread risk : possibility that a bond losses its value due to widen in credit spread, relative to its benchmark
Spread risk includes:
1
...
Market liquidity risk : Risk of receiving less than market value when selling the bond

General seniority rankings for debt 1
...
Unsecured debt:
- Senior unsecured debt
- Senior subordinated debt
- Subordinated debt
- Junior subordinated debt
Corporate issuer credit rating /
Notching

Corporate family ratings (CFR) : credit rating for issuer
Corporate credit ratings (CCR) : credit rating for issue specific (for each bond)
Investment grade : Bonds with rating ≥ Baa3/BBBNon-investment grade (high yield bonds or junk bonds) : Bond with credit rating ≤ Ba1/BB+
Cross default provision : when a compan defaults on 1 of its several outstanding bonds → might trigger default on the remaining issues
Notching : assigning different ratings to bonds of same issuer, based on : seniority of the bond,impact on potential loss severity, etc
...
Credit rating are dynamic : credit ratings change over time
2
...
Event risk is dufficult to assess : Risks specific to a company / industry are difficult to predict and incorporate into credit ratings
4
...
Capacity : Borrower's ability to repay debt obligations on time
...
Industry Structure : using Porter's 5 forces
b
...
More volatile earnings, revenues, CF → More risky
- Industry growth prospects
- Industry published statistics
c
...
Collateral : Issues to be considered when assess colateral values:
- Intangible assets : Patents are considered high-quality intangible assets → can be sold to generate CF
...
Covenants
- Overly restrictive covenants → retrict borrower's opera on → ↓ borrower's ability to repay
- Covenant for repayment of debt obligation → ↓ uncertainty for debtholders
4
...
Profit and CF
- EBITDA
- Funds from operations (FFO) = Net income + depreciation + amortisation + deferred taxes + non-cash items = CFO - ∆ in Working Capital
- FCF before dividends = net income + depreciation + amortisation - CAPEX - increase in Working Capital
- FCF after dividends = FCF before dividends - Dividends
...
Leverage ratios
- Debt / Capital = Debt / (Debt + Equity)
- Debt / EBITDA
- FFO / Debt
- FCF after dividends / debt
3
...
Credit cycle : Credit cycle improve → Credit spreads narrow ; Credit cycle deteriorate → Credit spreads widen
2
...
Financial market performance : Strong-performing market → Credit spreads narrow ; Steady-performing market with low vola lity of returns → Credit spreads narrow
4
...
General market demand & supply : High demand for bond → Credit spreads narrow ; Excess supply for bond → Credit spreads widen

Special consideration when
evaluating the credit of high yield
debt

1
...
Many high yield issuers are privately owned → cannot access public equity market for needed funds
- High yield issuers with few / unrealiable sources of income ; or significant amount of debt coming due in a short time frame → poten al default
2
...
Debt structure : High yield companies with high proportion of secured bank debt → less capacity to borrow from banks → more ikely to default in financially stressful situa on + lower
recovery rates for unsecured debt issuers
4
...
Covenants
- Change of control put : give debtholders the right to require to buy back debt in the event of an acquisition
- Restricted payments : limit the cash dividend payment to equity holders
- Limitations on liens : limit the amount of secured debt a borrower could carry
- Restricted vs
...
Institutional effectiveness : successful policymaking, absence of corruption, commitment to honor debts
2
...
International investment position : country's foreign reserves, external debt, status of its currency in international markets
4
...
Monetary flexibility : ability to use monetary policy for domestic economic objectives, credibility and effectiveness of monetary policy
2 ratings for each national government :
- Local currency debt rating (higher rating)
- Foreign currency debt rating (lower rating)
Sovereign default in the event of : war, political instability, severe devaluation of currency, large decline in prices of the country's export commodities

Special consideration when
evaluating the credit of nonsovereign government debt

Municipal bonds are classified into 2 types :
- General obligation bonds : unsecured bonds, backed by the full faith and credit of the issuing govermental entities, supporting by its taxing power → lower credit risk
- Revenue obligation bonds : issued to finance a project → higher credit risk
Considerations in evaluating GO bonds:
- Employment
- Trend in per capita income and per capita debt
- Tax base dimension
- Demographics
- Ability to attract new jobs
- Economic cycle of revenue
Cosiderations in evaluating revenue bonds : similar to analysing corporate bonds



---