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					         Chapter 1

An Overview of Fixed-Income Securities

   This purpose of this chapter is to provide you with an
    introduction to the fixed-income market in their
    entirety. In particular we try to answer:
       What is meant by “fixed income”
       Why they exist.
       What are the major fixed-income markets
       Who the major players are in each market.
       What are the distinguishing features of instruments in each
   We also try to begin developing a general framework
    for pricing fixed income instruments, given that we
    have interest rate uncertainty.

                “Fixed” Income
   When we say “fixed” income, we really mean the market
    for debt, and debt-related instruments.
   In the old days of course, most debt truly had fixed
   Obviously many bonds today have floating rates.
   Many “fixed” income derivatives have highly uncertain
    cash flows associated with them.
   The defining characteristic of (most) of these
    instruments is that there are well-defined rules
    governing when there will be a payout to the holder of
    the instrument.

                   Fixed Income
   Fixed income instruments are issued by Governments,
    government agencies, quasi-governmental agencies,
    corporations, municipalities, banks, and even by
   In general holders of fixed-income obligations take
    priority over equity holder with respect to a firm‟s cash
    flows (does not apply to government in general!)
   If a firm defaults on a bond, the bondholder generally
    have the right to take over the firm, literally wresting
    ownership from the equity holders.
   Shareholders can sometimes take actions that reduce
    the value of a bond, without triggering default, such as
    taking on additional risk after issuing a bond.

                   Fixed Income
   A bullet-security is generally any instrument that has a
    fixed coupon, fixed maturity, and no call provisions.
   Note that a bond-holder always has the “option” to
   Most fixed-income securities trade in markets that are
    not centrally organized, that is, there is no NYSE for
    bonds (although a very few bonds do trade on the
   Instead they trade via an OTC (over the counter)
    system, which is essentially a series of computer and
    phone networks among dealers and brokers.

                Market Participants
   There are three major participants in the fixed income
       Issuers of fixed income securities – i.e. users of the proceeds of
        fixed income issuances.
       Financial intermediaries – They make money by providing
        information to the market.
       Investors – i.e. those that supply funds to the market.
   There is a fourth category of entity that affects the
    market – the regulatory entity.
   Many large investors may take on any (or all) of these
    rolls at various times.

                Market Participants
   Issuers:                             Objectives
       Governments                          To raise funds.
       Corporations                         The hope to sell securities at a
       Banks                                 “fair” market price.
       States, municipalities               To provide a liquid
       Quasi-governmental entities           marketplace for their investors
                                              and shareholders.
       Foreign institutions.
                                             To design and issue debt
                                              securities that best suits the
                                              needs of the firm and any
                                             “Agency” costs/games
                                              sometimes come into play

                 Market Participants
   Financial Intermediaries:               Objectives
       Primary dealers                         To make money by facilitating
       Other dealers/brokers                    trades.
       Investment banks                        To provide information to the
       Credit rating agencies                   market.
       Credit and liquidity enhancers          To reduce transaction costs to
       Data providers
                                                To provide a primary market
       Servicing companies                      mechanism for issuers of
                                                To provide orderly market
                                                 making in secondary markets.
                                                To provide risk-management
                                                To provide trading operations.

                Market Participants
   Investors                     Objectives
       Government(s)                 To earn a rate of return for a
       Pension funds                  given level of risk.
       Mutual funds                  Diversification
       Insurance companies           To speculate on interest rate
       Commercial banks               movements.
       Hedge funds                   To modify their interest rate
                                       risk exposure.
       Foreign governments
       Foreign institutions
       Individuals

                   Regulatory Bodies
   There is not a single regulatory       These regulators may have
    body for all fixed income               very different objectives such
    markets, but a mix of them              as:
    including:                                  Insuring a fair, orderly, and
        SEC                                     open marketplace.
        Federal Reserve                        Implementing
        Office of Comptroller of the            monetary/economic policy
         Currency                               Assuring the safety and
        Office of Federal Housing               soundness of the banking
         Enterprise Oversight/HUD                system.
        State regulatory agencies              Assuring access to mortgages
                                                 and housing for all citizens

               Risks in Fixed Income
   Obviously there are a number of risks that can be
    embedded in any fixed-income instrument. These
       Interest rate risk
            Inflation Risk
       Credit Event risk
            Default risk
       Liquidity risk
       Timing/Cash Flow risk
       Foreign Exchange risk
       Taxation Risk

       Fixed Income Terminology
   The coupon rate (c) on a fixed income security is used
    solely to determine the periodic cash flows (coupon
    payments) made to the holder of the bond.
   The yield (y) on a fixed income security is the rate of
    return earned on a bond given the cash flows it will
    generate and the price at which the holder purchased it.
   The par amount is the “face” value of the bond – i.e. the
    principal amount of the bond.
   Bonds trade in an active secondary market, so normally
    a bond is purchased at a price that is different from the
    par amount. The yield and the coupon rate are only the
    same if the bond is purchased for par.

       Fixed Income Terminology
   Most bonds pay interest on an annual, semi-annual or
    quarterly basis. Many mortgage-related bonds, however,
    pay interest on a monthly basis.
   To calculate the cash due the holder of the bond at a
    coupon payment date, simply multiply the periodic
    coupon rate (usually the annual coupon rate divided by
    the number of coupon payments per year)
   Recall that a basis point is 1/100th of a percentage point,
    i.e. 1 basis point (1 bp) = .0001.

       Fixed Income Terminology
   Most bonds (although not all) have a specified maturity
    date, or time to maturity.
   A number of bonds, especially those that are securitized
    by other assets, will have multiple classes of investors.
    These investor classes will have differing priority of cash
    flows. Typically the “A” investor will have first priority,
    the “B” investor second priority, etc.
   The Bond Covenants will specify the exact contractual
    rules that will govern when and how cash will be
    distributed to the investors.
   Frequently a third-part trustee will have the
    responsibility for interpreting and applying the bond

       Fixed Income Terminology
   Absolute priority rules – the contractual rules under
    which the bondholders are paid in the event of a
   It is very common for the bondholders to agree to
    deviations from this in order to negotiate a better deal
    with the managers/equity owners of the firm.
   Debt with a call provision will specify a price, and a time
    or time frame, when the issuer can redeem the debt.
   A puttable bond is one in which the holder has the right
    to force the issuer to purchase the debt back at a given
    price. (Good example is a bank CD.)
   A convertible bond is one in which the bondholder can
    covert their debt to a fixed number of shares.
       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
   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.
   Some bonds will come with third-party guarantees that
    insure that the bondholders will receive the principal

        Fixed Income Terminology
   Municipal bonds have a number of interesting features.
    There are two basic types:
       General Obligation Bonds – The government‟s taxation authority
        backs the bond.
       Revenue bonds – revenue from a specific project is used to pay
        the bonds down. Very common for Dorms, hospitals, industrial
        parks to be paid for this way.

        Classification of Securities
   Sovereign Debt – Debt issued by a national government.
       US Treasury, U.K. Gilts, etc.
   Agency Securities – Debt issued by quasi-governmental
       TVA, FHLMC, FNMA, Corp. For Pub. Broadcasting, Farm Credit
   Corporate Securities – Debt issued by corporation.
   Mortgage-backed Securities – Debt that is backed solely
    by a pool of underlying mortgages.
   Asset-backed Securities – Debt that is backed by other
    (usually riskier) securities, such as credit cards, car
    loans, student loans, etc.
   Municipals.

            Size of Debt Markets
   A really good source for this type of data is the Federal
    Reserve‟s Statistical Release Z.1 (Flow of Fund‟s
    Account). It is available at the link below.

   Check out the “Levels” tables, especially L.2 and L.3, on
    page 59 of the report.

                     Treasury Market
   This is probably the best known of the debt markets, but
    it is not the largest.
   Backed by the full faith and credit of US government.
   Has been the world benchmark for liquidity and safety
    for decades.
   Debt buyback programs were starting to impinge upon
    liquidity, especially in some of the smaller issuances.
       Increase in government debt is taking care of that!
       Typically issues:
            13 week, 26 week, and 52 week Treasury Bills
            2, 3, 4, 5, 7 and 10 year Treasury Notes
            15, 20 and 30 year Treasury Bonds

                Treasury Market
   Most Treasury bonds are purchased and held in
    portfolio, so that only the most recently issued bonds are
    really traded actively. These are called “on the run”
    bonds. (Off the run bonds are still liquid, but they may
    not actually trade each day.)
   Treasury Bills and Notes pay interest on a semi-annual
    basis (and so their rates are quoted in a semi-annual
   If you purchase one between coupon payments, you will
    have to pay to the original owner the accrued interest
    they are owed. You will then receive the full coupon on
    the next payment date.

                Treasury Market
   The “flat price” (sometimes called the clean price) is the
    quoted price, and does not include the additional
    accrued interest you will have to pay.
   The “invoice price” (sometimes called the cash price or
    the dirty price) includes the accrued interest.
   Normally the treasury yield curve is upward sloping.
    Note this is not the same as the zero coupon yield curve.
   Occasionally the longer bonds will have lower coupons
    than the shorter bonds. This is an inverted yield curve.

             Treasury Market






       0         100          200           300          400

Yield curve as of 1/14/03: 3 Month 1.17, 6 month 1.21, 2 year 1.74
5 year 3.04, 10 year 4.08, 30 year 5.00. Source Bloomberg

             Treasury Market






       0         100          200           300          400

Yield curve as of 1/15/03: 3 Month 0.87, 6 month 0.95, 2 year 1.65
5 year 2.98, 10 year 3.99, 30 year 4.88. Source Bloomberg

                Treasury Market
   The yield curve moves around a lot over time. There are
    several sites on the internet that present this in an
    animated manner – which is actually pretty cool.
   Here is one (but there are a lot of others out there.)

                  Other Sovereigns
   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.)
        Essentially they pay interest forever.
       Coupon payments typically referred to as dividends.
   Japan
       Large market, quoted on simple yield basis, typically issues
        bullet bonds. Callable at any time. Maximum maturity is 20

               Agency Securities
   Government Sponsored Enterprises are private
    companies that the Federal government implicitly
   Most well-known are Fannie Mae and Freddie Mac.
   There is a small credit spread associated with them. For
    Fannie Mae/Freddie Mac it is about 25 bp. For some of
    the smaller (less politically covered) GSE‟s its 50-75 bp.
   Note that the agencies themselves issue debt, and they
    also issue Securities backed by mortgages (or other
    assets). These are actually different instruments.
   Fannie/Freddie are trying to start an agency „reference‟
    bond, and they also create bonds that are eligible for
                  Corporate Bonds
   The market for corporate debt is much more complex
    than the market for government and near-government
   Each individual issue tends to be smaller, and liquidity
    can be a problem.
   Bid-ask spreads tend to be wider.
   Default risk is real – hence rating agencies.
   Three primary categories of debt:
       Money market – less than 1 year maturity.
       Medium Term notes – 1-5 year maturity.
       Corporate bonds – longer than 5 years maturity.

                     Corporate Bonds
   A few key terms/ideas:
       Commercial Paper – Short term discount notes, that if under 270
        days term require no SEC registration, even if sold to the public.
       Shelf-registration – SEC allows a firm to file a 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, that really went a
        long way to restructuring corporate America, and led to the
        economic boom of the 1980‟s and 1990‟s.
            Deferred interest bonds (sometimes called accrual or z bonds.)
            Payment-in-kind bonds – allows issuer the option to pay cash or
             another bond for coupon or principal repayment.

         Mortgage Backed Securities
   Most MBS are issued by Fannie Mae, Freddie Mac, or
    Ginnie Mae.
   Fannie/Freddie MBS are largely the same, Ginnie Mae is
    quite different.
   The basic steps for Fannie/Freddie MBS are:
    1.   Banks/Brokers/Mortgage Companies originate mortgages.
    2.   Originators sell loans to Fannie/Freddie.
    3.   Fannie/Freddie pay originators to “service” loans on their
    4.   Fannie/Freddie pools many 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.

      Mortgage Backed Securities
   Fannie Mae and Freddie Mac guarantee that if the
    borrowers default, the investors will receive all interest
    and principal that they are owed.
   The receive a fee for this guarantee.
   Fannie Mae and Freddie Mac set minimum underwriting
    standards for loans they will purchase and put into
   MBS are traded in an extremely active secondary
   Securities Dealers, Brokers, etc., use basic pass-throughs
    to create highly structured products known as
    Collateralized Mortgage Obligations.

        Mortgage Backed Securities
   Because of the right of the borrower to prepay the loan,
    there is timing/cash flow risk associated with mortgage
    backed securities.
       Prepayment risk is a huge issue in a falling interest rate
       MBS can actually lose value as interest rates drop (negative
       Investors assume that prepayments cause a 30 year mortgage
        pool to only last for about 10 years or less. If rates rise, then
        borrowers will likely slow down prepayments (when investors
        would really like them to prepay), thus creating what is called
        “extension risk”.

           Asset Backed Securities
   The success of the MBS market has spurred the rapid
    development of many other securitized markets,
       Car loans
       Credit cards
       Home equity loans
       Student loans
       Equipment leases
       Royalties to David Bowie‟s older songs (I‟m not kidding.)
       Junk bonds
   Generally these ABS allow one to pool a bunch of risky-
    loans, and, via structuring, reduce their risk, to at least
    one class of investors.
   How to turn “BBB” debt into “AAA”.
                  Municipal Bonds
   As stated earlier, municipal bonds can be either:
       General Obligation Bonds
       Revenue Bonds

   Although it is somewhat more restricted now, most Gen.
    Obligation bonds are free of federal taxes, and taxes in
    the state that issued them.

   Because of this, they have yields that are lower than
    Treasuries and debts of comparable credit companies.
   Credit/default risk does exist in muncipals.

         A Framework for Pricing
   Most pricing of fixed income is done relative to a
    benchmark or referent rate, frequently Treasury, but
    also LIBOR.
   Typically what one does is find a referent bond with the
    same (or similar) maturity as the one being priced, and
    use the yield on the referent as starting point.
   A spread is then added to take into account the risk
    associated with the target bond. These risks would
    include credit, liquidity, timing, foreign exchange, etc.
   This rate would then be used for pricing (discounting)
    the bond.


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