Fixed Income Analysis 6th

As illustrated in Chapter 2, all other factors constant, the higher the coupon rate, theless the price will change in response to a change in market interest rates.. Floating-Rate Securi

FIXED INCOME

ANALYSIS

Second Edition

Frank J Fabozzi, PhD, CFA, CPA

with contributions from

Mark J.P Anson, PhD, CFA, CPA, Esq.

Kenneth B Dunn, PhD

J Hank Lynch, CFA Jack Malvey, CFA Mark Pitts, PhD Shrikant Ramamurthy Roberto M Sella Christopher B Steward, CFA

John Wiley & Sons, Inc.

FIXED INCOME

ANALYSIS

and administered the renowned Chartered Financial Analyst Program With a rich history

of leading the investment profession, CFA Institute has set the highest standards in ethics,education, and professional excellence within the global investment community, and is theforemost authority on investment profession conduct and practice

Each book in the CFA Institute Investment Series is geared toward industry practitionersalong with graduate-level finance students and covers the most important topics in theindustry The authors of these cutting-edge books are themselves industry professionals andacademics and bring their wealth of knowledge and expertise to this series

FIXED INCOME

ANALYSIS

Second Edition

Frank J Fabozzi, PhD, CFA, CPA

with contributions from

Mark J.P Anson, PhD, CFA, CPA, Esq.

Kenneth B Dunn, PhD

J Hank Lynch, CFA Jack Malvey, CFA Mark Pitts, PhD Shrikant Ramamurthy Roberto M Sella Christopher B Steward, CFA

John Wiley & Sons, Inc.

Published simultaneously in Canada.

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Library of Congress Cataloging-in-Publication Data:

Fabozzi, Frank J.

Fixed income analysis / Frank J Fabozzi.—2nd ed.

p cm.—(CFA Institute investment series)

Originally published as: Fixed income analysis for the chartered financial

analyst program New Hope, Pa : F J Fabozzi Associates, c2000.

Includes index.

ISBN-13: 978-0-470-05221-1 (cloth)

ISBN-10: 0-470-05221-X (cloth)

1 Fixed-income securities I Fabozzi, Frank J Fixed income analysis for

the chartered financial analyst program 2006 II Title.

HG4650.F329 2006

332.63’23—dc22

2006052818 Printed in the United States of America.

10 9 8 7 6 5 4 3 2 1

v

XI Event Risk 35

CHAPTER 3

CHAPTER 4

CHAPTER 5

CHAPTER 6

III Price Volatility Characteristics of Bonds 160

CHAPTER 8

III Treasury Returns Resulting from Yield Curve Movements 189

IV Constructing the Theoretical Spot Rate Curve for Treasuries 190

VI Expectations Theories of the Term Structure of Interest Rates 196

CHAPTER 9

V Valuing a Bond with an Embedded Option Using the Binomial Model 226

CHAPTER 10

VI Nonagency Residential Mortgage-Backed Securities 296

III Home Equity Loans 313

CHAPTER 12

CHAPTER 13

CHAPTER 14

CHAPTER 17

II Review of Standard Deviation and Downside Risk Measures 476

IX Risks of Investing in Mortgage-Backed Securities 495

IV Scenario Analysis for Assessing Potential Performance 513

V Using Multi-Factor Risk Models in Portfolio Construction 525

CHAPTER 19

CHAPTER 20

Relative-Value Methodologies for Global Credit Bond

III Total Return Analysis 565

CHAPTER 21

CHAPTER 22

CHAPTER 23

Hedging Mortgage Securities to Capture Relative Value

CHAPTER 24

IV Total Return Swap 677

There is an argument that an understanding of any financial market must incorporate anappreciation of the functioning of the bond market as a vital source of liquidity This argument

is true in today’s financial markets more than ever before, because of the central role that debtplays in virtually every facet of our modern financial markets Thus, anyone who wants to be

a serious student or practitioner in finance should at least become familiar with the currentspectrum of fixed income securities and their associated derivatives and structural products.This book is a fully revised and updated edition of two volumes used earlier in preparationfor the Chartered Financial Analysts (CFA) program However, in its current form, it goesbeyond the original CFA role and provides an extraordinarily comprehensive, and yet quitereadable, treatment of the key topics in fixed income analysis This breadth and quality of itscontents has been recognized by its inclusion as a basic text in the finance curriculum of majoruniversities Anyone who reads this book, either thoroughly or by dipping into the portionsthat are relevant at the moment, will surely reach new planes of knowledgeability about debtinstruments and the liquidity they provide throughout the global financial markets

I first began studying the bond market back in the 1960s At that time, bonds werethought to be dull and uninteresting I often encountered expressions of sympathy abouthaving been misguided into one of the more moribund backwaters in finance Indeed, adesigner of one of the early bond market indexes (not me) gave a talk that started with adeclaration that bonds were ‘‘dull, dull, dull!’’

In those early days, the bond market consisted of debt issued by US Treasury, agencies,municipalities, or high grade corporations The structure of these securities was generally quite

‘‘plain vanilla’’: fixed coupons, specified maturities, straightforward call features, and somesinking funds There was very little trading in the secondary market New issues of tax exemptbonds were purchased by banks and individuals, while the taxable offerings were taken down

by insurance companies and pension funds And even though the total outstanding footingswere quite sizeable relative to the equity market, the secondary market trading in bonds wasminiscule relative to stocks

Bonds were, for the most part, locked away in frozen portfolios The coupons werestill—literally—‘‘clipped,’’ and submitted to receive interest payments (at that time, scissorswere one of the key tools of bond portfolio management) This state of affairs reflected theenvironment of the day—the bond-buying institutions were quite traditional in their culture(the term ‘‘crusty’’ may be only slightly too harsh), bonds were viewed basically as a source ofincome rather than an opportunity for short-term return generation, and the high transactioncosts in the corporate and municipal sectors dampened any prospective benefit from trading.However, times change, and there is no area of finance that has witnessed a more rapidevolution—perhaps revolution would be more apt—than the fixed income markets Interestrates have swept up and down across a range of values that was previously thought to beunimaginable New instruments were introduced, shaped into standard formats, and then

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exploded to huge markets in their own right, both in terms of outstanding footings and themagnitude of daily trading Structuring, swaps, and a variety of options have become integralcomponents of the many forms of risk transfer that make today’s vibrant debt market possible.

In stark contrast to the plodding pace of bonds in the 1960s, this book takes the reader

on an exciting tour of today’s modern debt market The book begins with descriptions ofthe current tableau of debt securities After this broad overview, which I recommend toeveryone, the second chapter delves immediately into the fundamental question associatedwith any investment vehicle: What are the risks? Bonds have historically been viewed as alower risk instrument relative to other markets such as equities and real estate However, intoday’s fixed income world, the derivative and structuring processes have spawned a veritablesmorgasbord of investment opportunities, with returns and risks that range across an extremelywide spectrum

The completion of the Treasury yield curve has given a new clarity to term structure andmaturity risk In turn, this has sharpened the identification of minimum risk investments forspecific time periods The Treasury curve’s more precisely defined term structure can then help

in analyzing the spread behavior of non-Treasury securities The non-Treasury market consists

of corporate, agency, mortgage, municipal, and international credits Its total now far exceedsthe total supply of Treasury debt To understand the credit/liquidity relationships across thevarious market segments, one must come to grips with the constellation of yield spreads thataffects their pricing Only then can then one begin to understand how a given debt security isvalued and to appreciate the many-dimensional determinants of debt return and risk

As one delves deeper into the multiple layers of fixed income valuation, it becomes evidentthat these same factors form the basis for analyzing all forms of investments, not just bonds Inevery market, there are spot rates, forward rates, as well as the more aggregated yield measures

In the past, this structural approach may have been relegated to the domain of the arcane orthe academic In the current market, these more sophisticated approaches to capital structureand term effects are applied daily in the valuation process

Whole new forms of securitized fixed income instruments have come into existence andgrown to enormous size in the past few decades, for example, the mortgage backed, assetbacked, and structured-loan sectors These sectors have become critical to the flow of liquidity

to households and to the global economy at large To trace how liquidity and credit availabilityfind their way through various channels to the ultimate demanders, it is critical to understandhow these assets are structured, how they behave, and why various sources of funds are attracted

to them

Credit analysis is another area that has undergone radical evolution in the past fewyears The simplistic standard ratio measures of yesteryear have been supplemented by marketoriented analyses based upon option theory as well as new approaches to capital structure.The active management of bond portfolios has become a huge business where sizeablefunds are invested in an effort to garner returns in excess of standard benchmark indices Thefixed income markets are comprised of far more individual securities than the equity market.However, these securities are embedded in term structure/spread matrix that leads to muchtighter and more reliable correlations The fixed income manager can take advantage of thesetighter correlations to construct compact portfolios to control the overall benchmark risk andstill have ample room to pursue opportunistic positive alphas in terms of sector selection, yieldcurve placement, or credit spreads There is a widespread belief that exploitable inefficienciespersist within the fixed income market because of the regulatory and/or functional constraints

placed upon many of the major market participants In more and more instances, these called alpha returns from active bond management are being ‘‘ported’’ via derivative overlays,possibly in a leveraged fashion, to any position in a fund’s asset allocation structure.

so-In terms of managing credit spreads and credit exposure, the development of credit defaultswaps (CDS) and other types of credit derivatives has grown at such an incredible pace that itnow constitutes an important market in its own right By facilitating the redistribution anddiversification of credit risk, the CDS explosion has played a critical role in providing ongoingliquidity throughout the economy These structure products and derivatives may have evolvedfrom the fixed income market, but their role now reaches far afield, e.g., credit default swapsare being used by some equity managers as efficient alternative vehicles for hedging certaintypes of equity risks

The worldwide maturing of pension funds in conjunction with a more stringentaccounting/regulatory environment has created new management approaches such as surplusmanagement, asset/liability management (ALM), or liability driven investment (LDI) Thesetechniques incorporate the use of very long duration portfolios, various types of swaps andderivatives, as well as older forms of cash matching and immunization to reduce the fund’sexposure to fluctuations in nominal and/or real interest rates With pension fund assets ofboth defined benefit and defined contribution variety amounting to over $14 trillion in theUnited States alone, it is imperative for any student of finance to understand these liabilitiesand their relationship to various fixed income vehicles

With its long history as the primary organization in educating and credentialing financeprofessionals, CFA Institute is the ideal sponsor to provide a balanced and objective overview

of this subject Drawing upon its unique professional network, CFA Institute has been able

to call upon the most authoritative sources in the field to develop, review, and updateeach chapter The primary author and editor, Frank Fabozzi, is recognized as one of themost knowledgeable and prolific scholars across the entire spectrum of fixed income topics

Dr Fabozzi has held positions at MIT, Yale, and the University of Pennsylvania, and haswritten articles in collaboration with Franco Modigliani, Harry Markowitz, Gifford Fong,Jack Malvey, Mark Anson, and many other noted authorities in fixed income One could nothope for a better combination of editor/author and sponsor It is no wonder that they havemanaged to produce such a valuable guide into the modern world of fixed income

Over the past three decades, the changes in the debt market have been arguably far morerevolutionary than that seen in equities or perhaps in any other financial market Unfortunately,the broader development of this market and its extension into so many different arenas andforms has made it more difficult to achieve a reasonable level of knowledgeability However,this highly readable, authoritative and comprehensive volume goes a long way towards thisgoal by enabling individuals to learn about this most fundamental of all markets The morespecialized sections will also prove to be a resource that practitioners will repeatedly dip into

as the need arises in the course of their careers

Martin L LeibowitzManaging DirectorMorgan Stanley

I would like to acknowledge the following individuals for their assistance.

First Edition (Reprinted from First Edition)

Dr Robert R Johnson, CFA, Senior Vice President of AIMR, reviewed more than a dozen ofthe books published by Frank J Fabozzi Associates Based on his review, he provided me with

an extensive list of chapters for the first edition that contained material that would be useful

to CFA candidates for all three levels Rather than simply put these chapters together into abook, he suggested that I use the material in them to author a book based on explicit contentguidelines His influence on the substance and organization of this book was substantial

My day-to-day correspondence with AIMR regarding the development of the materialand related issues was with Dr Donald L Tuttle, CFA, Vice President It would seem fittingthat he would serve as one of my mentors in this project because the book he co-edited,

Managing Investment Portfolios: A Dynamic Process (first published in 1983), has played an

important role in shaping my thoughts on the investment management process; it also hasbeen the cornerstone for portfolio management in the CFA curriculum for almost two decades.The contribution of his books and other publications to the advancement of the CFA body

of knowledge, coupled with his leadership role in several key educational projects, recentlyearned him AIMR’s highly prestigious C Stewart Sheppard Award

Before any chapters were sent to Don for his review, the first few drafts were sent toAmy F Lipton, CFA of Lipton Financial Analytics, who was a consultant to AIMR forthis project Amy is currently a member of the Executive Advisory Board of the CandidateCurriculum Committee (CCC) Prior to that she was a member of the Executive Committee

of the CCC, the Level I Coordinator for the CCC, and the Chair of the Fixed Income TopicArea of the CCC Consequently, she was familiar with the topics that should be included

in a fixed income analysis book for the CFA Program Moreover, given her experience inthe money management industry (Aetna, First Boston, Greenwich, and Bankers Trust), shewas familiar with the material Amy reviewed and made detailed comments on all aspects ofthe material She recommended the deletion or insertion of material, identified topics thatrequired further explanation, and noted material that was too detailed and showed how itshould be shortened Amy not only directed me on content, but she checked every calculation,provided me with spreadsheets of all calculations, and highlighted discrepancies between thesolutions in a chapter and those she obtained On a number of occasions, Amy added materialthat improved the exposition; she also contributed several end-of-chapter questions Amy hasbeen accepted into the doctoral program in finance at both Columbia University and LehighUniversity, and will begin her studies in Fall of 2000

xvii

After the chapters were approved by Amy and Don, they were then sent to reviewersselected by AIMR The reviewers provided comments that were the basis for further revisions.

I am especially appreciative of the extensive reviews provided by Richard O Applebach, Jr.,CFA and Dr George H Troughton, CFA I am also grateful to the following reviewers:

Dr Philip Fanara, Jr., CFA; Brian S Heimsoth, CFA; Michael J Karpik, CFA; Daniel E.Lenhard, CFA; Michael J Lombardi, CFA; James M Meeth, CFA; and C Ronald Sprecher,PhD, CFA

I engaged William McLellan to review all of the chapter drafts Bill has completed theLevel III examination and is now accumulating enough experience to be awarded the CFAdesignation Because he took the examinations recently, he reviewed the material as if he were

a CFA candidate He pointed out statements that might be confusing and suggested ways toeliminate ambiguities Bill checked all the calculations and provided me with his spreadsheetresults

Martin Fridson, CFA and Cecilia Fok provided invaluable insight and direction for thechapter on credit analysis (Chapter 9 of Level II) Dr Steven V Mann and Dr Michael Ferrireviewed several chapters in this book Dr Sylvan Feldstein reviewed the sections dealing withmunicipal bonds in Chapter 3 of Level I and Chapter 9 of Level II George Kelger reviewedthe discussion on agency debentures in Chapter 3 of Level I

Helen K Modiri of AIMR provided valuable administrative assistance in coordinatingbetween my office and AIMR

Megan Orem of Frank J Fabozzi Associates typeset the entire book and provided editorialassistance on various aspects of this project

Second Edition

Dennis McLeavey, CFA was my contact person at CFA Institute for the second edition Hesuggested how I could improve the contents of each chapter from the first edition and readseveral drafts of all the chapters The inclusion of new topics were discussed with him Dennis

is an experienced author, having written several books published by CFA Institute for the CFAprogram Dennis shared his insights with me and I credit him with the improvement in theexposition in the second edition

The following individuals reviewed chapters:

Stephen L Avard, CFA

Marcus A Ingram, CFA

Muhammad J Iqbal, CFA

William L Randolph, CFA

Gerald R Root, CFA

Richard J Skolnik, CFA

R Bruce Swensen, CFA

Lavone Whitmer, CFA

Larry D Guin, CFA consolidated the individual reviews, as well as reviewed chapters1–7 David M Smith, CFA did the same for Chapters 8–15

The final proofreaders were Richard O Applebach, CFA, Dorothy C Kelly, CFA, Louis

J James, CFA and Lavone Whitmer

Wanda Lauziere of CFA Institute coordinated the reviews Helen Weaver of CFA Instituteassembled, summarized, and coordinated the final reviewer comments

Jon Fougner, an economics major at Yale, provided helpful comments on Chapters 1and 2.

Finally, CFA Candidates provided helpful comments and identified errors in the firstedition

CFA Institute is pleased to provide you with this Investment Series covering major areas inthe field of investments These texts are thoroughly grounded in the highly regarded CFAProgram Candidate Body of Knowledge (CBOK) that draws upon hundreds of practicinginvestment professionals and serves as the anchor for the three levels of the CFA Examinations.

In the year this series is being launched, more than 120,000 aspiring investment professionalswill each devote over 250 hours of study to master this material as well as other elements ofthe Candidate Body of Knowledge in order to obtain the coveted CFA charter We providethese materials for the same reason we have been chartering investment professionals for over

40 years: to improve the competency and ethical character of those serving the capital markets

PARENTAGE

One of the valuable attributes of this series derives from its parentage In the 1940s, a handful

of societies had risen to form communities that revolved around common interests and work

in what we now think of as the investment industry

Understand that the idea of purchasing common stock as an investment—as opposed tocasino speculation—was only a couple of decades old at most We were only 10 years past thecreation of the U.S Securities and Exchange Commission and laws that attempted to level theplaying field after robber baron and stock market panic episodes

In January 1945, in what is today CFA Institute Financial Analysts Journal, a

funda-mentally driven professor and practitioner from Columbia University and Graham-NewmanCorporation wrote an article making the case that people who research and manage portfoliosshould have some sort of credential to demonstrate competence and ethical behavior Thisperson was none other than Benjamin Graham, the father of security analysis and futurementor to a well-known modern investor, Warren Buffett

The idea of creating a credential took a mere 16 years to drive to execution but by 1963,

284 brave souls, all over the age of 45, took an exam and launched the CFA credential Whatmany do not fully understand was that this effort had at its root a desire to create a professionwhere its practitioners were professionals who provided investing services to individuals inneed In so doing, a fairer and more productive capital market would result

A profession—whether it be medicine, law, or other—has certain hallmark characteristics.These characteristics are part of what attracts serious individuals to devote the energy of theirlife’s work to the investment endeavor First, and tightly connected to this Series, there must

be a body of knowledge Second, there needs to be some entry requirements such as thoserequired to achieve the CFA credential Third, there must be a commitment to continuingeducation Fourth, a profession must serve a purpose beyond one’s direct selfish interest Inthis case, by properly conducting one’s affairs and putting client interests first, the investment

xxi

professional can work as a fair-minded cog in the wheel of the incredibly productive globalcapital markets This encourages the citizenry to part with their hard-earned savings to beredeployed in fair and productive pursuit.

As C Stewart Sheppard, founding executive director of the Institute of Chartered FinancialAnalysts said, ‘‘Society demands more from a profession and its members than it does from aprofessional craftsman in trade, arts, or business In return for status, prestige, and autonomy,

a profession extends a public warranty that it has established and maintains conditions ofentry, standards of fair practice, disciplinary procedures, and continuing education for itsparticular constituency Much is expected from members of a profession, but over time, more

is given.’’

‘‘The Standards for Educational and Psychological Testing,’’ put forth by the AmericanPsychological Association, the American Educational Research Association, and the NationalCouncil on Measurement in Education, state that the validity of professional credentialingexaminations should be demonstrated primarily by verifying that the content of the examina-tion accurately represents professional practice In addition, a practice analysis study, whichconfirms the knowledge and skills required for the competent professional, should be the basisfor establishing content validity

For more than 40 years, hundreds upon hundreds of practitioners and academics haveserved on CFA Institute curriculum committees sifting through and winnowing all the manyinvestment concepts and ideas to create a body of knowledge and the CFA curriculum One ofthe hallmarks of curriculum development at CFA Institute is its extensive use of practitioners

in all phases of the process

CFA Institute has followed a formal practice analysis process since 1995 The effortinvolves special practice analysis forums held, most recently, at 20 locations around the world.Results of the forums were put forth to 70,000 CFA charterholders for verification andconfirmation of the body of knowledge so derived

What this means for the reader is that the concepts contained in these texts were driven

by practicing professionals in the field who understand the responsibilities and knowledge thatpractitioners in the industry need to be successful We are pleased to put this extensive effort

to work for the benefit of the readers of the Investment Series

BENEFITS

This series will prove useful both to the new student of capital markets, who is seriouslycontemplating entry into the extremely competitive field of investment management, and tothe more seasoned professional who is looking for a user-friendly way to keep one’s knowledgecurrent All chapters include extensive references for those who would like to dig deeper into

a given concept The workbooks provide a summary of each chapter’s key points to helporganize your thoughts, as well as sample questions and answers to test yourself on yourprogress

For the new student, the essential concepts that any investment professional needs tomaster are presented in a time-tested fashion This material, in addition to university studyand reading the financial press, will help you better understand the investment field I believethat the general public seriously underestimates the disciplined processes needed for thebest investment firms and individuals to prosper These texts lay the basic groundwork formany of the processes that successful firms use Without this base level of understandingand an appreciation for how the capital markets work to properly price securities, you may

not find competitive success Furthermore, the concepts herein give a genuine sense of thekind of work that is to be found day to day managing portfolios, doing research, or relatedendeavors.

The investment profession, despite its relatively lucrative compensation, is not foreveryone It takes a special kind of individual to fundamentally understand and absorb theteachings from this body of work and then convert that into application in the practitionerworld In fact, most individuals who enter the field do not survive in the longer run Theaspiring professional should think long and hard about whether this is the field for him- orherself There is no better way to make such a critical decision than to be prepared by readingand evaluating the gospel of the profession

The more experienced professional understands that the nature of the capital marketsrequires a commitment to continuous learning Markets evolve as quickly as smart minds canfind new ways to create an exposure, to attract capital, or to manage risk A number of theconcepts in these pages were not present a decade or two ago when many of us were startingout in the business Hedge funds, derivatives, alternative investment concepts, and behavioralfinance are examples of new applications and concepts that have altered the capital markets inrecent years As markets invent and reinvent themselves, a best-in-class foundation investmentseries is of great value

Those of us who have been at this business for a while know that we must continuouslyhone our skills and knowledge if we are to compete with the young talent that constantlyemerges In fact, as we talk to major employers about their training needs, we are oftentold that one of the biggest challenges they face is how to help the experienced professional,laboring under heavy time pressure, keep up with the state of the art and the more recentlyeducated associates This series can be part of that answer

CONVENTIONAL WISDOM

It doesn’t take long for the astute investment professional to realize two common characteristics

of markets First, prices are set by conventional wisdom, or a function of the many variables

in the market Truth in markets is, at its essence, what the market believes it is and how itassesses pricing credits or debits on those beliefs Second, as conventional wisdom is a product

of the evolution of general theory and learning, by definition conventional wisdom is oftenwrong or at the least subject to material change

When I first entered this industry in the mid-1970s, conventional wisdom held thatthe concepts examined in these texts were a bit too academic to be heavily employed in thecompetitive marketplace Many of those considered to be the best investment firms at thetime were led by men who had an eclectic style, an intuitive sense of markets, and a greattrack record In the rough-and-tumble world of the practitioner, some of these concepts wereconsidered to be of no use Could conventional wisdom have been more wrong? If so, I’m notsure when

During the years of my tenure in the profession, the practitioner investment managementfirms that evolved successfully were full of determined, intelligent, intellectually curiousinvestment professionals who endeavored to apply these concepts in a serious and disciplinedmanner Today, the best firms are run by those who carefully form investment hypothesesand test them rigorously in the marketplace, whether it be in a quant strategy, in comparativeshopping for stocks within an industry, or in many hedge fund strategies Their goal is tocreate investment processes that can be replicated with some statistical reliability I believe

those who embraced the so-called academic side of the learning equation have been muchmore successful as real-world investment managers.

THE TEXTS

Approximately 35 percent of the Candidate Body of Knowledge is represented in the initialfour texts of the series Additional texts on corporate finance and international financialstatement analysis are in development, and more topics may be forthcoming

One of the most prominent texts over the years in the investment management industry

has been Maginn and Tuttle’s Managing Investment Portfolios: A Dynamic Process The third

edition updates key concepts from the 1990 second edition Some of the more experiencedmembers of our community, like myself, own the prior two editions and will add this

to our library Not only does this tome take the concepts from the other readings andput them in a portfolio context, it also updates the concepts of alternative investments,performance presentation standards, portfolio execution and, very importantly, managingindividual investor portfolios To direct attention, long focused on institutional portfolios,toward the individual will make this edition an important improvement over the past

Quantitative Investment Analysis focuses on some key tools that are needed for today’s

professional investor In addition to classic time value of money, discounted cash flowapplications, and probability material, there are two aspects that can be of value overtraditional thinking

First are the chapters dealing with correlation and regression that ultimately figure intothe formation of hypotheses for purposes of testing This gets to a critical skill that manyprofessionals are challenged by: the ability to sift out the wheat from the chaff For mostinvestment researchers and managers, their analysis is not solely the result of newly createddata and tests that they perform Rather, they synthesize and analyze primary research done

by others Without a rigorous manner by which to understand quality research, not only canyou not understand good research, you really have no basis by which to evaluate less rigorousresearch What is often put forth in the applied world as good quantitative research lacks rigorand validity

Second, the last chapter on portfolio concepts moves the reader beyond the traditionalcapital asset pricing model (CAPM) type of tools and into the more practical world ofmultifactor models and to arbitrage pricing theory Many have felt that there has been aCAPM bias to the work put forth in the past, and this chapter helps move beyond that point

Equity Asset Valuation is a particularly cogent and important read for anyone involved

in estimating the value of securities and understanding security pricing A well-informedprofessional would know that the common forms of equity valuation—dividend discountmodeling, free cash flow modeling, price/earnings models, and residual income models (oftenknown by trade names)—can all be reconciled to one another under certain assumptions.With a deep understanding of the underlying assumptions, the professional investor can betterunderstand what other investors assume when calculating their valuation estimates In myprior life as the head of an equity investment team, this knowledge would give us an edge overother investors

Fixed Income Analysis has been at the frontier of new concepts in recent years, greatly

expanding horizons over the past This text is probably the one with the most new material forthe seasoned professional who is not a fixed-income specialist The application of option andderivative technology to the once staid province of fixed income has helped contribute to an

explosion of thought in this area And not only does that challenge the professional to stay up

to speed with credit derivatives, swaptions, collateralized mortgage securities, mortgage backs,and others, but it also puts a strain on the world’s central banks to provide oversight and therisk of a correlated event Armed with a thorough grasp of the new exposures, the professionalinvestor is much better able to anticipate and understand the challenges our central bankersand markets face

I hope you find this new series helpful in your efforts to grow your investment knowledge,whether you are a relatively new entrant or a grizzled veteran ethically bound to keep up

to date in the ever-changing market environment CFA Institute, as a long-term committedparticipant of the investment profession and a not-for-profit association, is pleased to give youthis opportunity

Jeff Diermeier, CFAPresident and Chief Executive OfficerCFA Institute

September 2006

It is important to recognize in working through the numerical examples and illustrations

in this book that because of rounding differences you may not be able to reproduce some

of the results precisely The two individuals who verified solutions and I used a spreadsheet

to compute the solution to all numerical illustrations and examples For some of the moreinvolved illustrations and examples, there were slight differences in our results

Moreover, numerical values produced in interim calculations may have been rounded offwhen produced in a table and as a result when an operation is performed on the values shown

in a table, the result may appear to be off Just be aware of this Here is an example of acommon situation that you may encounter when attempting to replicate results

Suppose that a portfolio has four securities and that the market value of these foursecurities are as shown below:

Let’s do this with our hypothetical portfolio We will assume that the duration for each

of the securities in the portfolio is as shown below:

There are instances in the book where it was necessary to save space when I cut and paste alarge spreadsheet For example, suppose that in the spreadsheet I specified that Column (3) beshown to only two decimal places rather than seven decimal places The following table wouldthen be shown:

Suppose instead that the computations were done with a hand-held calculator rather than

on a spreadsheet and that the percentage of each security in the portfolio, Column (3), andthe product of the percent and duration, Column (5), are computed to two decimal places.The following table would then be computed:

Suppose that you decided to make sure that the total in Column (3) actually totals to100% Which security’s percent would you round up to do so? If security 3 is rounded up to34%, then the results would be reported as follows:

in this book, the price of one or more bonds must be computed as an interim calculation toobtain a solution If you use a spreadsheet’s built-in feature for computing a bond’s price (ifthe feature is available to you), you might observe slightly different results

Please keep these rounding issues in mind You are not making computations for sending

a rocket to the moon, wherein slight differences could cause you to miss your target Rather,what is important is that you understand the procedure or methodology for computing thevalues requested

In addition, there are exhibits in the book that are reproduced from published research.Those exhibits were not corrected to reduce rounding error

‘‘alternative asset classes.’’ Our focus in this book is on one of the two major asset classes: fixedincome securities.

While many people are intrigued by the exciting stories sometimes found with ties—who has not heard of someone who invested in the common stock of a small companyand earned enough to retire at a young age?—we will find in our study of fixed incomesecurities that the multitude of possible structures opens a fascinating field of study While fre-quently overshadowed by the media prominence of the equity market, fixed income securitiesplay a critical role in the portfolios of individual and institutional investors

equi-In its simplest form, a fixed income security is a financial obligation of an entity thatpromises to pay a specified sum of money at specified future dates The entity that promises

to make the payment is called the issuer of the security Some examples of issuers are central

governments such as the U.S government and the French government, government-relatedagencies of a central government such as Fannie Mae and Freddie Mac in the United States,

a municipal government such as the state of New York in the United States and the city ofRio de Janeiro in Brazil, a corporation such as Coca-Cola in the United States and YorkshireWater in the United Kingdom, and supranational governments such as the World Bank.Fixed income securities fall into two general categories: debt obligations and preferred

stock In the case of a debt obligation, the issuer is called the borrower The investor who purchases such a fixed income security is said to be the lender or creditor The promised pay-

ments that the issuer agrees to make at the specified dates consist of two components: interestand principal (principal represents repayment of funds borrowed) payments Fixed income

securities that are debt obligations include bonds, mortgage-backed securities, asset-backed

securities, and bank loans.

In contrast to a fixed income security that represents a debt obligation, preferred stock

represents an ownership interest in a corporation Dividend payments are made to thepreferred stockholder and represent a distribution of the corporation’s profit Unlike investorswho own a corporation’s common stock, investors who own the preferred stock can onlyrealize a contractually fixed dividend payment Moreover, the payments that must be made

to preferred stockholders have priority over the payments that a corporation pays to common

1

stockholders In the case of the bankruptcy of a corporation, preferred stockholders are givenpreference over common stockholders Consequently, preferred stock is a form of equity thathas characteristics similar to bonds.

Prior to the 1980s, fixed income securities were simple investment products Holdingaside default by the issuer, the investor knew how long interest would be received and whenthe amount borrowed would be repaid Moreover, most investors purchased these securitieswith the intent of holding them to their maturity date Beginning in the 1980s, the fixedincome world changed First, fixed income securities became more complex There are features

in many fixed income securities that make it difficult to determine when the amount borrowedwill be repaid and for how long interest will be received For some securities it is difficult todetermine the amount of interest that will be received Second, the hold-to-maturity investorhas been replaced by institutional investors who actively trades fixed income securities

We will frequently use the terms ‘‘fixed income securities’’ and ‘‘bonds’’ interchangeably Inaddition, we will use the term bonds generically at times to refer collectively to mortgage-backedsecurities, asset-backed securities, and bank loans

In this chapter we will look at the various features of fixed income securities and in thenext chapter we explain how those features affect the risks associated with investing in fixedincome securities The majority of our illustrations throughout this book use fixed incomesecurities issued in the United States While the U.S fixed income market is the largest fixedincome market in the world with a diversity of issuers and features, in recent years there hasbeen significant growth in the fixed income markets of other countries as borrowers haveshifted from funding via bank loans to the issuance of fixed income securities This is a trendthat is expected to continue

II INDENTURE AND COVENANTS

The promises of the issuer and the rights of the bondholders are set forth in great detail in

a bond’s indenture Bondholders would have great difficulty in determining from time to

time whether the issuer was keeping all the promises made in the indenture This problem isresolved for the most part by bringing in a trustee as a third party to the bond or debt contract.The indenture identifies the trustee as a representative of the interests of the bondholders

As part of the indenture, there are affirmative covenants and negative covenants.

Affirmative covenants set forth activities that the borrower promises to do The most commonaffirmative covenants are (1) to pay interest and principal on a timely basis, (2) to pay all taxesand other claims when due, (3) to maintain all properties used and useful in the borrower’sbusiness in good condition and working order, and (4) to submit periodic reports to a trusteestating that the borrower is in compliance with the loan agreement Negative covenants setforth certain limitations and restrictions on the borrower’s activities The more commonrestrictive covenants are those that impose limitations on the borrower’s ability to incuradditional debt unless certain tests are satisfied

III MATURITY

The term to maturity of a bond is the number of years the debt is outstanding or the number

of years remaining prior to final principal payment The maturity date of a bond refers to the

date that the debt will cease to exist, at which time the issuer will redeem the bond by paying

the outstanding balance The maturity date of a bond is always identified when describing abond For example, a description of a bond might state ‘‘due 12/1/2020.’’

The practice in the bond market is to refer to the ‘‘term to maturity’’ of a bond as simplyits ‘‘maturity’’ or ‘‘term.’’ As we explain below, there may be provisions in the indenture thatallow either the issuer or bondholder to alter a bond’s term to maturity

Some market participants view bonds with a maturity between 1 and 5 years as term.’’ Bonds with a maturity between 5 and 12 years are viewed as ‘‘intermediate-term,’’ and

‘‘short-‘‘long-term’’ bonds are those with a maturity of more than 12 years

There are bonds of every maturity Typically, the longest maturity is 30 years However,Walt Disney Co issued bonds in July 1993 with a maturity date of 7/15/2093, making them100-year bonds at the time of issuance In December 1993, the Tennessee Valley Authorityissued bonds that mature on 12/15/2043, making them 50-year bonds at the time of issuance.There are three reasons why the term to maturity of a bond is important:

Reason 1: Term to maturity indicates the time period over which the bondholder can

expect to receive interest payments and the number of years before the principal will

be paid in full

Reason 2: The yield offered on a bond depends on the term to maturity The relationship

between the yield on a bond and maturity is called the yield curve and will be

discussed in Chapter 4

Reason 3: The price of a bond will fluctuate over its life as interest rates in the market

change The price volatility of a bond is a function of its maturity (among othervariables) More specifically, as explained in Chapter 7, all other factors constant, thelonger the maturity of a bond, the greater the price volatility resulting from a change

in interest rates

IV PAR VALUE

The par value of a bond is the amount that the issuer agrees to repay the bondholder at

or by the maturity date This amount is also referred to as the principal value, face value,

redemption value, and maturity value Bonds can have any par value.

Because bonds can have a different par value, the practice is to quote the price of a bond as apercentage of its par value A value of ‘‘100’’ means 100% of par value So, for example, if a bondhas a par value of $1,000 and the issue is selling for $900, this bond would be said to be selling at

90 If a bond with a par value of $5,000 is selling for $5,500, the bond is said to be selling for 110.When computing the dollar price of a bond in the United States, the bond must first beconverted into a price per US$1 of par value Then the price per $1 of par value is multiplied bythe par value to get the dollar price Here are examples of what the dollar price of a bond is, giventhe price quoted for the bond in the market, and the par amount involved in the transaction:1

Notice that a bond may trade below or above its par value When a bond trades below its

par value, it said to be trading at a discount When a bond trades above its par value, it said

to be trading at a premium The reason why a bond sells above or below its par value will be

explained in Chapter 2

V COUPON RATE

The coupon rate, also called the nominal rate, is the interest rate that the issuer agrees to pay

each year The annual amount of the interest payment made to bondholders during the term

of the bond is called the coupon The coupon is determined by multiplying the coupon rate

by the par value of the bond That is,

coupon= coupon rate × par valueFor example, a bond with an 8% coupon rate and a par value of $1,000 will pay annualinterest of $80 (= $1, 000 × 0.08)

When describing a bond of an issuer, the coupon rate is indicated along with the maturitydate For example, the expression ‘‘6s of 12/1/2020’’ means a bond with a 6% coupon ratematuring on 12/1/2020 The ‘‘s’’ after the coupon rate indicates ‘‘coupon series.’’ In ourexample, it means the ‘‘6% coupon series.’’

In the United States, the usual practice is for the issuer to pay the coupon in twosemiannual installments Mortgage-backed securities and asset-backed securities typically payinterest monthly For bonds issued in some markets outside the United States, couponpayments are made only once per year

The coupon rate also affects the bond’s price sensitivity to changes in market interestrates As illustrated in Chapter 2, all other factors constant, the higher the coupon rate, theless the price will change in response to a change in market interest rates

A Zero-Coupon Bonds

Not all bonds make periodic coupon payments Bonds that are not contracted to make periodic

coupon payments are called zero-coupon bonds The holder of a zero-coupon bond realizes

interest by buying the bond substantially below its par value (i.e., buying the bond at a discount).Interest is then paid at the maturity date, with the interest being the difference between the parvalue and the price paid for the bond So, for example, if an investor purchases a zero-couponbond for 70, the interest is 30 This is the difference between the par value (100) and the pricepaid (70) The reason behind the issuance of zero-coupon bonds is explained in Chapter 2

B Step-Up Notes

There are securities that have a coupon rate that increases over time These securities are called

step-up notes because the coupon rate ‘‘steps up’’ over time For example, a 5-year step-up

note might have a coupon rate that is 5% for the first two years and 6% for the last three years

Or, the step-up note could call for a 5% coupon rate for the first two years, 5.5% for the thirdand fourth years, and 6% for the fifth year When there is only one change (or step up), as in

our first example, the issue is referred to as a single step-up note When there is more than one change, as in our second example, the issue is referred to as a multiple step-up note.

An example of an actual multiple step-up note is a 5-year issue of the Student LoanMarketing Association (Sallie Mae) issued in May 1994 The coupon schedule is as follows:

C Deferred Coupon Bonds

There are bonds whose interest payments are deferred for a specified number of years That

is, there are no interest payments during for the deferred period At the end of the deferredperiod, the issuer makes periodic interest payments until the bond matures The interestpayments that are made after the deferred period are higher than the interest payments thatwould have been made if the issuer had paid interest from the time the bond was issued Thehigher interest payments after the deferred period are to compensate the bondholder for the

lack of interest payments during the deferred period These bonds are called deferred coupon

bonds.

D Floating-Rate Securities

The coupon rate on a bond need not be fixed over the bond’s life Floating-rate securities, sometimes called variable-rate securities, have coupon payments that reset periodically according to some reference rate The typical formula (called the coupon formula) on certain

determination dates when the coupon rate is reset is as follows:

coupon rate= reference rate + quoted margin

The quoted margin is the additional amount that the issuer agrees to pay above the

reference rate For example, suppose that the reference rate is the 1-month London interbankoffered rate (LIBOR).2Suppose that the quoted margin is 100 basis points.3Then the couponformula is:

coupon rate= 1-month LIBOR + 100 basis points

So, if 1-month LIBOR on the coupon reset date is 5%, the coupon rate is reset for that period

at 6% (5% plus 100 basis points)

The quoted margin need not be a positive value The quoted margin could be subtractedfrom the reference rate For example, the reference rate could be the yield on a 5-year Treasurysecurity and the coupon rate could reset every six months based on the following couponformula:

coupon rate= 5-year Treasury yield − 90 basis points

2LIBOR is the interest rate which major international banks offer each other on Eurodollar certificates

of deposit

3In the fixed income market, market participants refer to changes in interest rates or differences in interest

rates in terms of basis points A basis point is defined as 0.0001, or equivalently, 0.01% Consequently,

100 basis points are equal to 1% (In our example the coupon formula can be expressed as 1-monthLIBOR+ 1%.) A change in interest rates from, say, 5.0% to 6.2% means that there is a 1.2% change inrates or 120 basis points

So, if the 5-year Treasury yield is 7% on the coupon reset date, the coupon rate is 6.1% (7%minus 90 basis points).

It is important to understand the mechanics for the payment and the setting of thecoupon rate Suppose that a floater pays interest semiannually and further assume that thecoupon reset date is today Then, the coupon rate is determined via the coupon formula andthis is the interest rate that the issuer agrees to pay at the next interest payment date six monthsfrom now

A floater may have a restriction on the maximum coupon rate that will be paid at any

reset date The maximum coupon rate is called a cap For example, suppose for a floater whose

coupon formula is the 3-month Treasury bill rate plus 50 basis points, there is a cap of 9% Ifthe 3-month Treasury bill rate is 9% at a coupon reset date, then the coupon formula wouldgive a coupon rate of 9.5% However, the cap restricts the coupon rate to 9% Thus, for ourhypothetical floater, once the 3-month Treasury bill rate exceeds 8.5%, the coupon rate iscapped at 9% Because a cap restricts the coupon rate from increasing, a cap is an unattractivefeature for the investor In contrast, there could be a minimum coupon rate specified for a

floater The minimum coupon rate is called a floor If the coupon formula produces a coupon

rate that is below the floor, the floor rate is paid instead Thus, a floor is an attractive featurefor the investor As we explain in Section X, caps and floors are effectively embedded options.While the reference rate for most floaters is an interest rate or an interest rate index, awide variety of reference rates appear in coupon formulas The coupon for a floater could beindexed to movements in foreign exchange rates, the price of a commodity (e.g., crude oil),the return on an equity index (e.g., the S&P 500), or movements in a bond index In fact,through financial engineering, issuers have been able to structure floaters with almost anyreference rate In several countries, there are government bonds whose coupon formula is tied

to an inflation index

The U.S Department of the Treasury in January 1997 began issuing inflation-adjusted

securities These issues are referred to as Treasury Inflation Protection Securities (TIPS).

The reference rate for the coupon formula is the rate of inflation as measured by the ConsumerPrice Index for All Urban Consumers (i.e., CPI-U) (The mechanics of the payment of thecoupon will be explained in Chapter 3 where these securities are discussed.) Corporations

and agencies in the United States issue inflation-linked (or inflation-indexed) bonds For

example, in February 1997, J P Morgan & Company issued a 15-year bond that pays theCPI plus 400 basis points In the same month, the Federal Home Loan Bank issued a 5-yearbond with a coupon rate equal to the CPI plus 315 basis points and a 10-year bond with acoupon rate equal to the CPI plus 337 basis points

Typically, the coupon formula for a floater is such that the coupon rate increases whenthe reference rate increases, and decreases when the reference rate decreases There are issueswhose coupon rate moves in the opposite direction from the change in the reference rate

Such issues are called inverse floaters or reverse floaters.4It is not too difficult to understandwhy an investor would be interested in an inverse floater It gives an investor who believesinterest rates will decline the opportunity to obtain a higher coupon interest rate The issuerisn’t necessarily taking the opposite view because it can hedge the risk that interest rates willdecline.5

4In the agency, corporate, and municipal markets, inverse floaters are created as structured notes Wediscuss structured notes in Chapter 3 Inverse floaters in the mortgage-backed securities market arecommon and are created through a process that will be discussed in Chapter 10

5The issuer hedges by using financial instruments known as derivatives, which we cover in later chapters

The coupon formula for an inverse floater is:

coupon rate= K − L × (reference rate) where K and L are values specified in the prospectus for the issue.

For example, suppose that for a particular inverse floater, K is 20% and L is 2 Then the

coupon reset formula would be:

coupon rate= 20% − 2 × (reference rate)Suppose that the reference rate is the 3-month Treasury bill rate, then the coupon formulawould be

coupon rate= 20% − 2 × (3-month Treasury bill rate)

If at the coupon reset date the 3-month Treasury bill rate is 6%, the coupon rate for the nextperiod is:

There is a wide range of coupon formulas that we will encounter in our study of fixedincome securities.6These are discussed below The reason why issuers have been able to createfloating-rate securities with offbeat coupon formulas is due to derivative instruments It is tooearly in our study of fixed income analysis and portfolio management to appreciate why some

of these offbeat coupon formulas exist in the bond market Suffice it to say that some of theseoffbeat coupon formulas allow the investor to take a view on either the movement of someinterest rate (i.e., for speculating on an interest rate movement) or to reduce exposure to therisk of some interest rate movement (i.e., for interest rate risk management) The advantage

to the issuer is that it can lower its cost of borrowing by creating offbeat coupon formulas forinvestors.7While it may seem that the issuer is taking the opposite position to the investor,this is not the case What in fact happens is that the issuer can hedge its risk exposure by usingderivative instruments so as to obtain the type of financing it seeks (i.e., fixed rate borrowing

or floating rate borrowing) These offbeat coupon formulas are typically found in ‘‘structurednotes,’’ a form of medium-term note that will be discussed in Chapter 3

6In Chapter 3, we will describe other types of floating-rate securities

7These offbeat coupon bond formulas are actually created as a result of inquiries from clients of dealerfirms That is, a salesperson will be approached by fixed income portfolio managers requesting a structure

be created that provides the exposure sought The dealer firm will then notify the investment bankinggroup of the dealer firm to contact potential issuers