The handbook of fixed income securities eighth edition

Mann General Features of Floaters and Major Product Types 354 Call and Put Provisions 356 Overview and Scope of International Bond Markets 385 The Instruments: Domestic, Euro, and Foreig

and Managing Fixed Income Instruments

PROFESSOR OF FINANCE EDHEC BUSINESS SCHOOL

WITH STEVEN V MANN

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Residential Mortgage-Backed Securities 16

Commercial Mortgage-Backed Securities 17

Event Risk 30

Sector Risk 30

Other Risks 30

Statistical Measures of Portfolio Risk:

Standard Deviation, Skewness, and Kurtosis 30

Tracking Error Risk 31

Key Points 32

Chapter 3

Bond Market Indexes 33

Frank K Reilly and David J Wright

Uses of Bond Indexes 33

Building and Maintaining a Bond Index 35

Description of Alternative Bond Indexes 36

Overall Bond Market Growth 51

The Rise of Electronic Trading 52

The Impact of Regulatory Requirements 55

Shift to a Fee-Based Broker-Dealer Revenue Model 56

Universe of Electronic Trading Platforms 57

Current Technologies 59

Market Data and the Aggregation of Fixed Income ECNs 61

Retail-Fixed Income Market Participation 62

Retail Access to Individual Bonds 63

Fixed Income Pricing 66

The Yield Curve 77

The Spread Curve 80

Cyclicality of Credit Spreads 81

Conventional Yield Measures 102

Total Return Analysis 113

Key Points 120

Chapter 7

Measuring Interest-Rate Risk 123

Frank J Fabozzi, Gerald W Buetow, Jr., Robert R Johnson, and

Brian J Henderson

The Full-Valuation Approach 124

Price Volatility Characteristics of Bonds 128

Duration 137

Modified Duration versus Effective Duration 143

Convexity 149

Price Value of a Basis Point 164

The Importance of Yield Volatility 165

U.S Treasury Securities 193

Michael J Fleming and Frank J Fabozzi

Types of Securities 194

The Primary Market 195

The Secondary Market 199

Zero-Coupon Treasury Securities 204

Acknowledgments 205

Key Points 205

Chapter 10

Agency Debt Securities 207

Mark O Cabana and Frank J Fabozzi

Agency Debt Market Overview 208

Types of Agency Debt Securities 211

The Primary Market 214

The Secondary Market 215

Agency Debt Issuance 215

Issuing Agencies 217

Large, Active Issuers 218

Smaller, Active Issuers 220

Nonactive Issuers and Recently Retired GSEs 221

Acknowledgments 223

Key Points 223

Chapter 11

Municipal Bonds 225

Sylvan G Feldstein, Frank J Fabozzi, Alexander Grant, and David Ratner

Features of Municipal Securities 227

Types of Municipal Obligations 229

The Commercial Credit Rating of Municipal Bonds 238

Municipal Bond Insurance 244

Valuation Methods 245

Tax Provisions Affecting Municipals 246

Yield Relationships within the Municipal Bond Market 249

Primary and Secondary Markets 251

Frank J Fabozzi, Steven V Mann, and Adam B Cohen

The Corporate Trustee 260

Some Bond Fundamentals 261

Security for Bonds 264

Alternative Mechanisms to Retire Debt before Maturity 270

Stephen J Antczak, Frank J Fahozzi, and Jung Lee

Syndicated Bank Loans 290

Convertible Securities and Their Investment Application 299

Jonathan L Home and Chris P Dialynas

Basic Characteristics of Convertible Securities and Key Terms 299

Overview of Convertible Bond Valuation and Risk Metrics 304

Primary Investors in Convertible Bonds 309

Motivations behind the Issuance of Convertible Securities 312

Key Points 314

Chapter 15

Structured Notes and Credit-Linked Notes 315

John D Finnerty and Rachael W Park

Structured Notes 316

Credit-Linked Notes 329

Key Points 336

Chapter 16

Private Money Market Instruments 337

Frank J Fahozzi and Steven V Mann

Chapter 17

Floating-Rate Securities 353

Frank J Fabozzi and Steven V Mann

General Features of Floaters and Major Product Types 354

Call and Put Provisions 356

Overview and Scope of International Bond Markets 385

The Instruments: Domestic, Euro, and Foreign 387

Dollar-Denominated International Bonds 389

Non-Dollar-Denominated Debt International Bonds 397

International Fixed Income and Understanding Currency Risk 401

Key Points 406

Chapter 20

Emerging Markets Debt 409

Jane Sachar Braiier

The Debt Universe 409

Emerging Markets Debt Performance History 413

Collateralized Brady Bonds 437

Noncollateralized Brady Bonds 438

Chapter 21

Fixed Income Exchange Traded Funds 439

Matthew Tucker and Stephen Laipply

Investment Characteristics 440

Fixed Income ETF Management 447

Fixed Income ETF Characteristics and Mechanics 448

Trading Behavior: A Closer Look at Premiums and Discounts 453

Key Points 456

Chapter 22

Covered Bonds 459

Vinod Kothari

Covered Bonds: From Europe to the Rest of the World 460

Understanding Covered Bonds 460

Structure of Covered Bonds 461

Cover Assets and Credit Enhancements 466

Asset/Liability Mismatches and Liquidity Risk 467

Ratings of Covered Bonds 469

Covered Bonds and Securitization 469

Accounting for Covered Bonds 472

Preferred Stock Ratings 478

Tax Treatment of Dividends 479

Key Points 480

PART THREE

SECURITIZED PRODUCTS

Chapter 24

An Overview of Mortgages and the Mortgage Market 483

Anand K Bhattacharya and William S Berliner

Product Definition and Terms 484

Mechanics of Mortgage Loans 488

The Mortgage Industry 492

Generation of Mortgage Lending Rates 496

Component Risks of Mortgage Products 502

Key Points 507

Chapter 25

Agency Mortgage-Backed Securities 509

Andrew Davidson, Anne Ching, and Eknath Belbase

Mortgage Loans 509

History of Secondary Mortgage Market 513

Agency Pool Programs 515

The CMO Market 537

The Reasons Why CMOs Exist 538

CMO Tranche Types 539

Agency versus Nonagency CMOs 558

Agency CMO Analysis 559

Key Points 566

Chapter 27

The Effect of Agency CMO PAC Bond Features on Performance 569

Linda Lowell

The Term Structure of CMO Yields 570

Collars and Collateral 572

Interaction of Collars and Collateral 574

PAC Collar Drift 577

When the PAC Breaks 578

Windows 578

Lockout 580

Is There a Z in the Deal? 581

Effect of Jump-Z and VADM Structures on PAC Bonds 584

Priority to Receive Excess Cash Flows 585

The Option Costs of PAC Features 585

Key Points 592

Chapter 28

Agency CMO Z-Bonds 593

Linda Lowell

The Basic Accrual Structure 594

How the Z Interacts with Other Bonds in the Structure 597

CMOs with PACs and a Z-Bond 600

Support Bond Basics 614

Support TAC Bonds 618

Reverse TACs 621

Layered PAC Bonds 624

Summary of Average Life Volatilities 627

Key Points 628

Chapter 30

Stripped Mortgage-Backed Securities 629

Cyrus Mohebhi, Gary Li, Todd White, and David Kwun 629

Overview of the SMBS Market 630

Investment Characteristics 633

Key Points 642

Chapter 31

Nonagency Residential Mortgage-Backed Securities 645

Dapeng Hu and Robert Goldstein

Chapter 32

Commercial Mortgage-Backed Securities 681

Wayne M Fitzgerald II and Mark D Paltrowitz

The Collateral Pool 683

Securitization of Credit Card Receivables 707

The Credit Card ABS Life Cycle 712

Cash-Flow Allocations 716

Credit and Investment Considerations 718

Key Points 725

Chapter 34

Securities Backed by Auto Loans and Leases, Equipment Loans and

Leases, and Student Loans 727

John McElravey

Securitization in Brief 727

Auto Loans and Leases 730

Equipment Loans and Leases 732

Computation of Par, Spot, and Forward Rates 746

Main Influences on the Yield-Curve Shape 749

Using Forward Rate Analysis in Yield-Curve Trades 757

Key Points 767

Chapter 37

A Framework for Analyzing Yield-Curve Trades 769

Antti Ilmanen

Forward Rates and Their Determinants 770

Decomposing Expected Returns of Bond Positions 777

Key Points 795

Chapter 38

Empirical Yield-Curve Dynamics and Yield-Curve Exposure 797

Wesley Phoa

Fundamental Determinants of Yield-Curve Dynamics 797

Empirical Analysis of Yield-Curve Dynamics 805

Beyond Level and Slope Risk 816

Key Points 823

Chapter 39

Term Structure Modeling with No-Arbitrage Interest Rate Models 825 Gerald W Buetow, Jr., and Brian J Henderson

Introduction to Models of the Short Rate 826

Binomial Interest Rate Lattices 831

Trinomial Lattice 851

Key Points 854

PART FIVE

VALUATION MODELING

Chapter 40

Valuation of Bonds with Embedded Options 857

Frank J Fabozzi, Andrew Kalotay, and Michael Dorigan

The Interest Rate Lattice 858

Calibrating the Lattice 862

Using the Lattice for Valuation 866

Fixed-Coupon Bonds with Embedded Options 866

Valuation of Two More Exotic Structures 871

Extensions 875

Key Points 878

Chapter 41

Valuation of Agency Mortgage-Backed Securities 881

Frank J Fabozzi, Scott F Richard, and Peter Ru

Evolution in the Convertible Markets 903

Basic Characteristics of Convertible Securities 920

Approaches to Valuation of Convertibles 925

Exercising the Embedded Options 939

Credit Analysis for Corporate Bonds 949

Martin Fridson, Frank J Fabozzi, and Adam B Cohen

Approaches to Credit Analysis 949

Industry Considerations 952

The Analysis of High-Yield Corporate Bonds 986

Credit Scoring Models 992

Key Points 994

Chapter 44

The Credit Analysis of Municipal General Obligation and

Revenue Bonds 995

Sylvan G Feldstein, Alexander Grant, and David Ratner

The Legal Opinion 996

The Need to Know Who Really Is the Issuer 1001

On the Financial Advisor and Underwriter 1003

General Credit Indicators and Economic Factors in the Credit Analysis 1004

Red Flags for the Investor 1020

Information Sources for the Analyst 1021

Key Points 1022

Chapter 45

Credit-Risk Modeling 1025

Tim Backshall, Kay Giesecke, and Lisa Goldberg

Structural Credit Models 1026

Reduced-Form Credit Models 1036

Incomplete-Information Credit Models 1040

Key Points 1044

PART SEVEN

MULTIFACTOR RISK MODELS

Chapter 46

Introduction to Multifactor Risk Models in Fixed Income

and Their Applications 1049

Anthony Lazanas, Antonio Baldaque da Silva, Radii Gdbudean, and Arne D Staal

Motivation and Structure Underlying Fixed Income Multifactor Risk Models 1050 Fixed Income Risk Models 1052

Applications of Risk Modeling 1058

Key Points 1066

Chapter 47

Analyzing Risk from Multifactor Fixed Income Models 1069

Anthony Lazcinas, Antonio Bed claque da Silva, Radu C Gdbudean, and A me D Staal

Approaches Used to Analyze Risk 1070

Key Points 1099

Chapter 48

Hedging Interest-Rate Risk with Term-Structure Factor Models 1101

Lionel Martellini, Philippe Priaulet, and Frank J Fahozzi

Defining Interest-Rate Risk(s) 1102

Hedging with Duration 1103

Relaxing the Assumption of a Small Shift 1106

Relaxing the Assumption of a Parallel Shift 1108

Comparative Analysis of Various Hedging Techniques 1114

Overview of Traditional Bond Management 1123

Overview of the Core/Satellite Approach 1126

Why Choose Indexing? 1127

Which Index Should Be Used? 1130

Primary Bond Indexing Risk Factors 1133

Enhancing Bond Indexing 1138

Measuring Success 1145

Key Points 1149

Chapter 50

Quantitative Management of Benchmarked Portfolios 1151

Lev Dynkin, Jay Hyman, Vadim Konstantinovsky, and Bruce D Phelps

Selection and Customization of Benchmarks 1152

Diversification Issues in Benchmarks 1157

Portfolio Analysis Relative to a Benchmark 1162

Quantitative Approaches to Benchmark Replication 1168

Replication with Cash Instruments: Stratified Sampling 1169

Controlling Issuer-Specific Risk in the Portfolio 1174

Quantitative Methods for Portfolio Optimization 1178

Tools for Quantitative Portfolio Management 1180

Primary Market Analysis 1191

Liquidity and Trading Analysis 1193

Secondary Trade Rationales 1194

Elements of Managing a High-Yield Bond Portfolio 1213

Mark R Shenkman and Nicholas R Sarchese

International Bond Portfolio Management 1247

Karthik Ramanathan, James M Gerard, and Frank J Fabozzi

Overview of International Bond Market Investing 1248

Investment Objectives and Policy Statements 1249

Developing a Portfolio Strategy 1255

Sources of Excess Return 1257

The Fundamental-Based Investment Approach 1260

Portfolio Construction 1263

Key Points 1275

Chapter 54

Fixed Income Transition Management 1277

Ananth Madhavan and Daniel Gal legos

Basics of Fixed Income Transitions 1278

Transition Metrics and Objectives 1281

Case Study of Risk Management 1288

Key Points 1289

Chapter 55

Managing the Spread Risk of Credit Portfolios Using the Duration Times Spread Measure 1291

Arik Ben Dor, Lev Dynkin, and Jay Hyman

The Need for a New Measure of Credit Spread Exposure 1292

Spread Volatility and DTS 1295

Risk Projection: Predicting Spread Volatility 1298

Hedging: Predicting Sensitivities to Market Spread Changes 1302

Replication: Creating index Tracking Portfolios 1306

Expressing Macro Views in Active Portfolios 1310

Portfolio Construction: Optimal Diversification of Issuer Risk 1311

Modeling: Calibrating Credit-Risk Factors 1314

Economic (Credit) Risk versus Financial (Leverage) Risk 1321

Analysis of Nonagency Mortgage-Backed Securities 1322

Key Points 1330

Chapter 57

Hedge Fund Fixed Income Strategies 1331

Ellen Rachlin, Chris P Dialynas, and Vineer Bhansali

Macro Investing 1332

Asset-Backed Credit Strategy 1342

Capital Structure Arbitrage 1344

Long/Short Credit Strategy 1345

Chapter 58

Financing Positions in the Bond Market 1355

Frank J Fahozzi and Steven V Mann

Introduction to Interest-Rate Futures and Options Contracts 1369

Frank J Fabozzi, Steven V Mann, Mark Pitts, and Robin Grieves

Basic Characteristics of Derivative Contracts 1370

Representative Exchange-Traded Interest-Rate Futures Contracts 1373

Mechanics of Futures Trading 1380

Representative Exchange-Traded Futures Options Contracts 1383

OTC Contracts 1387

Key Points 1393

Chapter 60

Pricing Futures and Portfolio Applications 1395

Frank J Fabozzi, Mark Pitts, and Bruce M Collins

Pricing of Futures Contracts 1395

Applications to Portfolio Management 1403

Portable Alpha 1406

Key Points 1408

Chapter 61

Controlling Interest-Rate Risk with Futures and Options 1409

Frank J Fabozzi, Shrikant Ramamurthy, and Mark Pitts

Controlling Interest-Rate Risk with Futures 1409

Hedging with Options 1428

Key Points 1442

Chapter 62

Interest-Rate Swaps and Swaptions 1445

Frank J Fahozzi, Steven V Mann, and Moorad Choudhry

Description of an Interest-Rate Swap 1445

Interpreting a Swap Position 1447

Terminology, Conventions, and Market Quotes 1449

Valuing Interest-Rate Swaps 1451

Primary Determinants of Swap Spreads 1468

Nongeneric Interest-Rate Swaps 1470

The Valuation of Interest-Rate Swaps and Swaptions 1479

Gerald W Bnetow and Brian J Henderson

Swap Valuation Using the Lattice Approach 1480

Forward-Start Swaps 1486

Valuing Swaptions 1490

Valuing Basis Swaps and Non-LIBOR-Based Swaps 1495

Factors Affecting Swap Valuation 1498

Key Points 1500

Chapter 64

The Basics of Interest-Rate Options 1501

William J Gartland and Nicholas C Letica

How Options Work 1501

Options Strategies—Reorganizing the Profit/Loss Graph 1514

Classic Option Strategies 1515

Practical Portfolio Strategies 1518

Volatility 1521

Key Points 1523

Chapter 65

Interest-Rate Caps and Floors 1525

George L Alhota and Radu S Tunaru

Caps and Floors Defined 1525

Collars and Corridors 1526

Hybrid Type Instruments 1527

Potential Applications of Caps and Floors 1528 Caplets and Flooiiets 1528

Insights on Trading Caps and Floors 1530

Caps and Floors versus Swaptions Wedge 1535 Key Points 1538

Step-by-Step Guide to Hedging 1595

The Need to Hedge 1596

Overview of Select Tail Risks 1600

Generic Challenges Facing Hedgers 1605

Unfunded Hedges (Insurance) 1613

Funded Hedges (Alpha Trades) 1618

Key Points 1631

PART TEN

PERFORMANCE EVALUATION AND

RETURN ATTRIBUTION ANALYSIS

Chapter 69

Principles of Performance Attribution 1635

Anthony Lazanas, Antonio Baldaque da Silva, Chris Sturhahn, Eric P Wilson, and Pam Zhong

Principles of Performance Attribution 1636

Mathematics of Performance Attribution 1639

Applications of Performance Attribution 1647

Key Points 1670

Chapter 70

Performance Attribution for Portfolios of

Fixed Income Securities 1671

Anthony Lazanas, Antonio Baldaque da Silva, Chris Sturhahn, Eric P Wilson, and Pam Zhong

Return Splitting 1672

Outperformance Breakdown 1681

Total Return Model 1682

Excess Return Model 1688

Fully Analytical Model 1697

Selecting an Appropriate Attribution Model 1709

Key Points 1710

Chapter 71

Advanced Topics in Performance Attribution 1711

Anthony Lazanas, Antonio Baldaque da Silva, Chris Sturhahn, Eric P Wilson, and Pam Zhong

Multicurrency Attribution 1712

Derivatives and Leverage 1728

From Theory to Practice 1735

Key Points 1739

APPENDIX

Methodology for Calculating Currency Exposures in

Bond Portfolios and Indexes 1741

Curt Hollingsworth

Main Formula for Bond Portfolios 1742

Main Formula for Citigroup Indexes 1753

Main Formula for Barclays Capital Indices 1757

Index 1763

©

Xhis book is designed to provide extensive coverage of the wide range of fixed income products and fixed income portfolio management strategies Each chapter

is written by an authority on the subject

The eighth edition of the Handbook is divided into ten parts Part One pro- vides general information about the investment features of fixed income securities, the risks associated with investing in fixed income securities, and background information about fixed income primary and secondary markets The basics of fixed income analytics—bond pricing, yield measures, spot rates, forward rates, total return, and price volatility measures (duration and convexity)—are also described in Part One

Parts Two and Three cover the basic characteristics of the instruments traded

in the market Government securities and corporate debt obligations (both bonds and loans) are covered in Part Two An important addition to the eighth edition is more extensive coverage of leveraged loans and covered bonds, as well as cover- age of fixed income exchange traded funds Part Three focuses on securitized products—mortgage-backed securities and asset-backed securities The coverage

of the nonagency residential mortgage-backed securities and commercial mort- gage-backed securities reflects market developments that followed the subprime mortgage crisis in 2007 Unlike the seventh edition, this edition includes separate chapters on planned amortization class bonds, support bonds, accrual (Z) bonds, and stripped mortgage-backed securities

The focus in Part Four is on the term structure of interest rates, both the use

of the information contained in those rates and the modeling of the term structure

Part Five builds on the analytical framework explained in Part One In this part, two methodologies for valuing fixed income securities are discussed: the lat- tice model and the Monte Carlo model A by-product of these models is the option- adjusted spread The valuation of convertible bonds is also covered in this part

xxiii

The topic of credit risk and its analysis is the subject of Part Six Traditional methods of credit analysis for corporate bonds and municipal bonds are explained and illustrated There is also coverage of the various approaches to credit risk modeling

Multifactor risk models and their applications are explained in Part Seven The more popular fixed income portfolio management strategies are covered in Part Eight A framework for classifying the types of bond portfolio strategies is provided in the first chapter in Part Eight, Chapter 49 There is then coverage of quantitative management strategies versus a benchmark, global credit bond port- folio management, high-yield bond portfolio management, international bond portfolio management, and investing in distressed structured credit securities In addition, there are several specialized chapters related to bond portfolios strate- gies, such as transition management and financing positions in the bond market, and hedge fund strategies

Part Nine covers derivative instruments: interest-rate derivatives (futures/for- ward contracts, options, interest-rate swaps, and caps and floors) and credit deriva- tives (primarily credit default swaps) The basic feature of each instrument is described as well as how it is valued and used to control the risk of a fixed income portfolio The basics of credit derivatives are also explained

Performance evaluation and return attribution analysis are covered in the last three chapters of the Handbook in Part Ten Coverage includes how these models are built and used, as well as the underlying principles in building these models

There is one appendix that covers the various methodologies for calculating currency exposures in bond portfolios and the major international bond indexes

Revisions to the Seventh Edition

The eighth edition is a substantial revision over the seventh edition The seventh edition had 60 chapters and an appendix The eighth edition has 71 chapters and one appendix The following 31 chapters (as well as the appendix) are new:

4 Electronic Trading for the Fixed Income Market

5 Macro-Economic Dynamics and the Corporate Bond Market

10 Agency Debt Securities

13 Leveraged Loans

15 Structured Notes and Credit-Linked Notes

21 Fixed Income Exchange Traded Funds

22 Covered Bonds

27 The Effect of Agency CMO PAC Bond Features on Performance

28 Agency CMO Z-Bonds

29 Support Bonds with Schedules in Agency CMO Deals

30 Stripped Mortgage-Backed Securities

31 Nonagency Residential Mortgage-Backed Securities

32 Commercial Mortgage-Backed Securities

34 Securities Backed by Auto Loans and Leases, Equipment Loans and Leases, and Student Loans

35 Collateralized Loan Obligations

38 Empirical Yield-Curve Dynamics and Yield-Curve Exposure

39 Term Structure Modeling with No-Arbitrage Interest Rate Models

46 Introduction to Multifactor Risk Models in Fixed Income and Their Applications

47 Analyzing Risk from Multifactor Fixed Income Models

52 Elements of Managing a High-Yield Bond Portfolio

55 Managing the Spread Risk of Credit Portfolios Using the Duration

Times Spread Measure

56 Investing in Distressed Structured Credit Securities

57 Hedge Fund Fixed Income Strategies

63 The Valuation of Interest-Rate Swaps and Swaptions

65 Interest-Rate Caps and Floors

66 Credit Derivatives

67 Credit Derivative Valuation and Risk

68 Hedging Tail Risk

69 Principles of Performance Attribution

70 Performance Attribution for Portfolios of Fixed Income Securities

71 Advanced Topics in Performance Attribution

Moreover, the following seven chapters have been substantially revised:

14 Convertible Securities and Their Investment Application

19 International Bond Markets and Instruments

25 Agency Mortgage-Backed Securities

42 Convertible Securities: Their Structures, Valuation, and Trading

43 Credit Analysis for Corporate Bonds

53 International Bond Portfolio Management

54 Fixed Income Transition Management

When a comprehensive book of this type must be expanded to accommo- date the introduction of new products, analytical tools and methodologies, and strategies, some chapters in the prior edition had to be removed due to real "bind- ing" constraints—there are physical limitations on the number of pages that can

be bound Deleted from the revised handbook are chapters on dedicated portfolio strategies (immunization and cash-flow matching) and collateralized debt obliga- tions (cash and synthetic) The former topic, although an important one, involves bond portfolio strategies wherein a manager seeks to lock in prevailing interest rates In the low interest-rate environment as of this writing, few institutions appear to be pursuing such strategies As for collateral debt obligations, although there are securities of this type outstanding, there is basically no new issuance except for collateralized loan obligations (a chapter on this product is included in the eighth edition)

Frank J Fahozzi, Ph.D., CFA, CPA

Editor

©

The first edition of The Handbook of Fixed Income Securities was published three decades ago Over the years and eight editions of the book, I have benehted from the guidance of many participants in the various sectors of the bond market

I would like to extend my deep personal appreciation to the contributing authors

in all editions of the book Steven Mann, in particular, contributed eight of the chapters in the current edition

There are two individuals whom I would like to single out who contributed

to the first six editions and are now retired from the industry: Jane Tripp Howe and Richard Wilson Jane was widely recognized as one of the top corporate credit analysts She contributed not only to the Handbook but also to several other books that I edited She was my "go to" person when I needed a chapter on any aspect of corporate credit analysis In the eighth edition, Martin Fridson, Adam Cohen, and I revised the chapter by Jane on corporate bond credit analysis and

we thank her for granting us permission to use the core of her chapter that appeared in the sixth edition

Richard Wilson contributed several chapters to earlier editions of the Handbook When I began my study of the fixed income market in the late 1970s, he served as my mentor At that time, there were so many nuances about the institu- tional aspects of the market that were not in print His historical perspective and his insights helped me form my view of the market In addition, from his many contacts

in the industry, he identified for me potential contributors to the first edition

Frank J Fabozzi, Ph.D., CFA, CPA

©

George L Albota

Director

Capital Markets/Market Risk Manager

Bank of America Merrill Lynch, London

Stephen J Antczak, CFA

Consultant

Tim Backshall

Chief Credit Derivatives Strategist

Credit Derivatives Research Ltd

Eknath Belbase, Ph.D

Senior Consultant

Andrew Davidson & Co., Inc

William S Berliner

Executive Vice President

Manhattan Capital Markets

Arizona State University

Jane Sachar Brauer

Director

Merrill Lynch

John B Brynjolfsson, CFA

Managing Director and CIO

Armored Wolf, LLC

Gerald W Buetow, Jr., Ph.D., CFA

Chief Investment Officer

Innealta Capital

Mark O Cabana Senior Trader/Analyst Federal Reserve Bank of New York Anne Ching, CFA

Senior Analyst Andrew Davidson & Co., Inc

Moorad Choudhry, Ph.D

MD, Head of Business Treasury, Global Banking & Markets Royal Bank of Scotland Adam B Cohen, J.D

Founder Covenant Review Bruce M Collins, Ph.D

Professor of Finance Western Connecticut State University Alexander Crawford

Linda Lowell Principal OffStreet Research LLC Ravi F Dattatreya, Ph.D

Managing Director Exellex Financial Engineering Andrew Davidson

President Andrew Davidson & Co., Inc

Chris P Dialynas Managing Director Pacific Investment Management Company Arik Ben Dor, Ph.D

Director Barclays Capital Michael Dorigan, Ph.D

Director & Senior Quantitative Analyst PNC Capital Advisors LLC

xxvii

EDHEC Business School

Martin Fridson, CFA

Global Credit Strategist

BNP Paribas Asset Management

Quantitative Research Analyst

Fidelity Management and Research

Company/Pyramis Global Advisors

Kay Giesecke, Ph.D

Assistant Professor of Management Science and Engineering

Stanford University Lisa Goldberg, Ph.D

Executive Director of Research MSCI

Adjunct Professor of Statistics University of California at Berkeley Robert Goldstein

Managing Director BlackRock Solutions Alexander Grant

Portfolio Manager Fidelity Investments Jonathan L Horne Executive Vice President Pacific Investment Management Company Dapeng Hu, Ph.D., CFA

Managing Director BlackRock Solutions Jay Hyman, Ph.D

Managing Director Barclays Capital Antti Ilmanen, Ph.D

Managing Director AQR Capital Management (Europe) LLP Robert R Johnson, Ph.D., CFA

Senior Managing Director CFA Institute

Andrew Kalotay, Ph.D

President Andrew Kalotay Associates Vadim Konstantinovsky, CFA Director

Barclays Capital

Vinod Kothari

Financial Consultant and Visiting Faculty

Indian Institute of Management

Jack Malvey, CFA

Chief Global Markets Strategist

BNY Mellon Asset Management

Steven V Mann, Ph.D

Professor of Finance

The Moore School of Business

University of South Carolina

Lionel Martellini, Ph.D

Professor of Finance

EDHEC Business School

Scientific Director, EDHEC Risk Institute

John McElravey, CFA

Director, Head of Consumer ABS Research

Wells Fargo Securities, LLC

Executive Vice President

Pacific Investment Management Company

Marshall Nicholson Managing Director Knight BondPoint Dominic O'Kane, D.Phil (OXON) Affiliated Professor of Finance EDHEC Business School Mark D Paltrowitz

Managing Director BlackRock

Rachael W Park Senior Associate Finnerty Economic Consulting, LLC Bruce D Phelps, Ph.D., CFA

Managing Director Barclays Capital Wesley Phoa, Ph.D

Senior Vice President Capital International Research, Inc

Mark Pitts, Ph.D

Mark R Shenkman President, Chief Investment Officer Shenkman Capital Management, Inc

Philippe Priaulet, Ph.D

Head of Fixed Income Sales for Shareholders Networks Natixis Associate Professor

Mathematics Department University of Evry Val d'Essonne Ellen Rachlin

Managing Director Mariner Investment Group, LLC Shrikant Ramamurthy

Consultant Karthik Ramanathan Senior Vice President and Director of Bonds Fidelity Management and Research

Company/Pyramis Global Advisors David Ratner, CFA

Industry Consultant Frank K Reilly, Ph.D., CFA Bernard J Hank Professor of Finance University of Notre Dame

Scott F Richard, DBA Practice Professor of Finance Wharton

University of Pennsylvania

Nicholas R Sarchese, CFA

Senior Vice President

Shenkman Capital Management, Inc

Antonio Baldaqne da Silva, Ph.D

Todd White Managing Director Columbia Management Investment Advisors, LLC

Eric P Wilson Vice President Barclays Capital David J Wright, Ph.D

Professor of Finance University of Wisconsin-Parkside Pam Zhong, CFA

Vice President Barclays Capital

BACKGROUND

OVERVIEW OF THE TYPES AND

FEATURES OF FIXED INCOME

SECURITIES

Frank J Fabozzi, Ph.D., CFA, CPA

Professor of Finance EDHEC Business School

Michael G Ferri, Ph.D Professor of Finance George Mason University

Steven V Mann, Ph.D Professor of Finance The Moore School of Business University of South Carolina

This chapter will explore some of the most important features of bonds, preferred stock, and structured products and provide the reader with a taxonomy of terms and concepts that will be useful in the reading of the specialized chapters to follow

BONDS

Type of Issuer

One important characteristic of a bond is the nature of its issuer Although non- U.S governments and firms raise capital in U.S financial markets, the three largest issuers of debt are domestic corporations, municipal governments, and the federal government and its agencies Each class of issuer, however, features additional and significant differences

Domestic corporations, for example, include regulated utilities as well as less regulated manufacturers Furthermore, each firm may sell different kinds of bonds: Some debt may be publicly placed, whereas other bonds may be sold directly to one or only a few buyers (referred to as a private placement)-, some debt

is collateralized by specific assets of the company, whereas other debt may be unsecured Municipal debt is also varied: "General obligation" bonds (GOs) are backed by the full faith, credit, and taxing power of the governmental unit issuing

3

them; "revenue bonds," on the other hand, have a safety, or creditworthiness, that depends on the vitality and success of the particular entity (such as toll roads, hospitals, or water systems) within the municipal government issuing the bond

The U.S Treasury has the most voracious appetite for debt, but the bond market often receives calls from its agencies Federal government agencies include federally related institutions and government-sponsored enterprises (GSEs)

It is important for the investor to realize that, by law or practice or both, these different borrowers have developed different ways of raising debt capital over the years As a result, the distinctions among the various types of issuers correspond closely to differences among bonds in yield, denomination, safety of principal, maturity, tax status, and such important provisions as the call privilege, put features, and sinking fund As we discuss the key features of fixed income securities, we will point out how the characteristics of the bonds vary with the obligor or issuing authority A more extensive discussion is provided in later chapters in this book that explain the various instruments

Maturity

A key feature of any bond is its term-to-maturity, the number of years during which the borrower has promised to meet the conditions of the debt (which are contained in the bond's indenture) A bond's term-to-maturity is the date on which the debt will cease and the borrower will redeem the issue by paying the face value, or principal One indication of the importance of the maturity is that the code word or name for every bond contains its maturity (and coupon) Thus the title of the Anheuser Busch Company bond due, or maturing, in 2016 is given

as "Anheuser Busch S-Vbs of 2016." In practice, the words maturity, term, and term-to-maturity are used interchangeably to refer to the number of years remain- ing in the life of a bond Technically, however, maturity denotes the date the bond will be redeemed, and either term or term-to-maturity denotes the remaining number of years until that date

A bond's maturity is crucial for several reasons First, maturity indicates the expected life of the instrument, or the number of periods during which the holder

of the bond can expect to receive the coupon interest and the number of years before the principal will be paid Second, the yield on a bond depends substan- tially on its maturity More specifically, at any given point in time, the yield offered on a long-term bond may be greater than, less than, or equal to the yield offered on a short-term bond As will be explained in Chapter 8, the effect of maturity on the yield depends on the shape of the yield-curve Third, the volatil- ity of a bond's price is closely associated with maturity: Changes in the market level of rates will wrest much larger changes in price from bonds of long matu- rity than from otherwise similar debt of shorter life.1 Finally, as explained in Chapter 2, there are other risks associated with the maturity of a bond

1 Chapter 7 discusses this point in detail

When considering a bond's maturity, the investor should be aware of any provisions that modify, or permit the issuer to modify, the maturity of a bond Although corporate bonds (referred to as "corporates") are typically term bonds (issues that have a single maturity), they often contain arrangements by which the issuing firm either can or must retire the debt early, in full or in part Some corporates, for example, give the issuer a call privilege, which permits the issu- ing firm to redeem the bond before the scheduled maturity under certain condi- tions (these conditions are discussed below) Municipal bonds may have the same provision The U.S government no longer issues bonds that have a call privilege The last callable bond was called in November 2009 Many industrials and some utilities have sinking-fund provisions, which mandate that the firm retire a substantial portion of the debt, according to a prearranged schedule, dur- ing its life and before the stated maturity Municipal bonds may be serial bonds

or, in essence, bundles of bonds with differing maturities (Some corporates are

of this type, too.)

Usually, the maturity of a corporate bond is between 1 and 30 years This

is not to say that there are not outliers In fact, financially sound firms have begun

to issue longer-term debt in order to lock in long-term attractive financing For example, in the late 1990s, there were approximately 90 corporate bonds issued with maturities of 100 years

Although classifying bonds as "short term," "intermediate term," and

"long term" is not universally accepted, the following classification is typically used Bonds with a maturity of 1 to 5 years are generally considered short term; bonds with a maturity between 5 and 12 years are viewed as intermediate term (and are often called notes) Long-term bonds are those with a maturity greater than 12 years

Coupon and Principal

A bond's coupon is the periodic interest payment made to owners during the life

of the bond The coupon is always cited, along with maturity, in any quotation of

a bond's price Thus one might hear about the "IBM 6.5 due in 2028" or the

"Campbell's Soup 8.875 due in 2021" in discussions of current bond trading In these examples, the coupon cited is in fact the coupon rate, that is, the rate of interest that, when multiplied by the principal, par value, or face value of the bond, provides the dollar value of the coupon payment Typically, but not univer- sally, for bonds issued in the United States, the coupon payment is made in semi- annual installments An important exception is mortgage-backed and asset-backed securities that usually deliver monthly cash-flows In contrast, for bonds issued in some European bond markets and all bonds issued in the Eurobond market, the coupon payment is made annually Bonds may be bearer bonds or registered bonds With bearer bonds, investors clip coupons and send them to the obligor for payment In the case of registered issues, bond owners receive the payment auto- matically at the appropriate time All new bond issues must be registered

Zero-coupon bonds have been issued by corporations and municipalities since the early 1980s For example, Barclay's Bank PLC has a zero-coupon bond outstanding due in August 2036 that was issued on August 15, 2006 Although the U.S Treasury does not issue zero-coupon debt with a maturity greater than one year, such securities are created by government securities dealers Merrill Lynch was the first to do this with its creation of Treasury Investment Growth Receipts (TIGRs) in August 1982 The most popular zero-coupon Treasury securities today are those created by government dealer firms under the Treasury's Separate Trading

of Registered Interest and Principal Securities (STRIPS) Program Just how these securities—commonly referred to as Treasury strips—are created will be explained

in Chapter 9 The investor in a zero-coupon security typically receives interest by buying the security at a price below its principal, or maturity value, and holding it

to the maturity date The reason for the issuance of zero-coupon securities is explained in Chapter 9 However, some zeros are issued at par and accrue interest during the bond's life, with the accrued interest and principal payable at maturity

Sovereign governments and corporations issue securities with a coupon rate tied to the rate of inflation These debt instruments, referred to as inflation-linked bonds, or simply "linkers," have been issued since 1945 The earlier issuers of linkers were the governments of Argentina, Brazil, and Israel The modern linker

is attributed to the U.K government's index-linked gilt issued in 1981 followed by Australia, Canada, and Sweden The United States introduced an inflation-linked security in January 1997, calling those securities Treasury Inflation Protected Securities, or TIPS These securities, which carry the full faith and credit of the U.S government, comprised approximately 10% of the outstanding U.S Treasury market as of mid-2009 Shortly after the introduction of TIPS in 1997, U.S gov- ernment-related entities such as the Federal Farm Credit, Federal Home Loan Bank, Fannie Mae, and the Tennessee Valley Authority began issuing linkers

Different designs can be employed for linkers The reference rate that is a proxy for the inflation rate is changes in the consumer price index (CPI) In the United Kingdom, for example, the index used is the Retail Prices Index (All Items), or RPI In France, there are two linkers with two different indexes: the French CPI (excluding tobacco) and the Eurozone's Harmonised Index of Consumer Prices (HICP) (excluding tobacco) In the United States, the Consumer Price Index-Urban, Non-Seasonally Adjusted (denoted by CPI-U), is calculated

by the U.S Bureau of Labor Statistics.2

2 The CPI-U is the most widely followed and perhaps the most understood inflation index among

alternative choices, such as the Gross Domestic Product (GDP) deflator and the Personal Consumption Expenditure (PCE) deflator Monthly changes in the CPI-U represent the average changes in prices facing urban consumers with regard to a fixed basket of goods and services This group of urban consumers represents about 87% of the total U.S population The Treasury reserves the right to substitute an alternative price index under the following circumstances: (1) the CPI-U is discontinued, (2) the CPI-U is altered materially to the detri- ment of the investor and/or the security, or (3) the CPI-U is altered by legislation or executive order in a manner harmful to the investor and/or the security

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 six-year step-up note might have a coupon rate that

is 5% for the first two years, 5.8% for the next two years, and 6% for the last two years Consider a stairway note issued by Barclays Bank PLC in July 2009 The initial coupon was 2.8% until January 2010 and thereafter the coupon rate reset every six months to the maximum of the previous coupon rate or six- month LIB OR

In contrast to a coupon rate that is fixed for the bond's entire life, the term floating-rate security or floater encompasses several different types of securities with one common feature: The coupon rate will vary over the instrument's life The coupon rate is reset at designated dates based on the value of some reference rate adjusted for a spread For example, consider a floating-rate note issued in September

2007 by Bank of America that matured in September 2011 This floater delivered cash flows quarterly and had a coupon formula equal to three-month LIB OR plus

50 points

Typically, floaters have coupon rates that reset more than once a year (e.g., semiannually, quarterly, or monthly) Conversely, the term adjustable-rate or variable-rate security refers to those issues whose coupon rates reset not more frequently than annually

There are several features about floaters that deserve mention First, a floater may have a restriction on the maximum (minimum) coupon rate that will be paid at any reset date called a cap (floor) Second, while the reference rate for most floaters

is a benchmark interest rate or an interest rate index, a wide variety of reference rates appear in the coupon formulas A floater's coupon could be indexed to movements

in foreign exchange-rates, the price of a commodity (e.g., crude oil), movements in

an equity index (e.g., the S&P 500), or movements in a bond index (e.g., the Merrill Lynch Corporate Bond Index) Third, while a floater's coupon rate normally moves

in the same direction as the reference rate, there are floaters whose coupon rate moves in the opposite direction from the reference rate These securities are called inverse floaters or reverse floaters Consider a hypothetical inverse floater that makes coupon payments according to the following formula:

18% - 2.5 x (three-month LIB OR)

This inverse floater had a floor of 3% and a cap of 15.5% Finally, range notes are floaters whose coupon rate is equal to the reference rate (adjusted for a spread) as long as the reference rate is within a certain range on the reset date

If the reference rate is outside the range, the coupon rate is zero for that period For instance, Barclay's Bank issued a range note in November 2006 (due in November 2016) This issue makes coupon payments quarterly The investor earns three-month LIBOR +113 basis points for every day during this quarter that three-month LIBOR is between 0% and 7.5% Interest accrues at 0% for each day that three-month LIBOR is outside this range As a result, this range note has a floor of 0%

Structures in the high-yield (junk bond) sector of the corporate bond market have introduced variations in the way coupon payments are made For example,

in a leveraged buyout or recapitalization financed with high-yield bonds, the heavy interest payment burden the corporation must bear places severe cash-flow constraints on the firm To reduce this burden, firms involved in leveraged buy- outs (LBOs) and recapitalizations have issued deferred-coupon structures that permit the issuer to defer making cash interest payments for a period of three to seven years There are three types of deferred-coupon structures: (1) deferred- interest bonds, (2) step-up bonds, and (3) payment-in-kind bonds These struc- tures are described in Chapter 12

Another high-yield bond structure allows the issuer to reset the coupon rate

so that the bond will trade at a predetermined price The coupon rate may reset annually or reset only once over the life of the bond Generally, the coupon rate will be the average of rates suggested by two investment banking firms The new rate will then reflect the level of interest rates at the reset date and the credit- spread the market wants on the issue at the reset date This structure is called an extendihle reset bond Notice the difference between this bond structure and the floating-rate issue described earlier With a floating-rate issue, the coupon rate resets based on a fixed spread to some benchmark, where the spread is specified

in the indenture and the amount of the spread reflects market conditions at the time the issue is first offered In contrast, the coupon rate on an extendible reset bond is reset based on market conditions suggested by several investment banking firms at the time of the reset date Moreover, the new coupon rate reflects the new level of interest rates and the new spread that investors seek

One reason that debt financing is popular with corporations is that the inter- est payments are tax-deductible expenses As a result, the true after-tax cost of debt to a profitable firm is usually much less than the stated coupon interest rate The level of the coupon on any bond is typically close to the level of yields for issues of its class at the time the bond is first sold to the public Some bonds are issued initially at a price substantially below par value (called original-issue dis- count bonds, or OIDs), and their coupon rate is deliberately set below the current market rate However, firms usually try to set the coupon at a level that will make the market price close to par value This goal can be accomplished by placing the coupon rate near the prevailing market rate

To many investors, the coupon is simply the amount of interest they will receive each year However, the coupon has another major impact on an investor's experience with a bond The coupon's size influences the volatility of the bond's price: The larger the coupon, the less the price will change in response to a change

in market interest rates Thus the coupon and the maturity have opposite effects

on the price volatility of a bond This will be illustrated in Chapter 7

The principal, par value, or face value of a bond is the amount to be repaid

to the investor either at maturity or at those times when the bond is called or retired according to a repayment schedule or sinking-fund provisions But the

principal plays another role, too: It is the basis on which the coupon or periodic interest rests The coupon is the product of the principal and the coupon rate

Participants in the bond market use several measures to describe the poten- tial return from investing in a bond: current yield, yield-to-maturity, yield-to-call for a callable bond, and yield-to-put for a putable bond A yield-to-worst is often quoted for bonds This is the lowest yield of the following: yield-to-maturity, yields to all possible call dates, and yields to all put dates The calculation and limitations of these yield measures are explained and illustrated in Chapter 6

The prices of most bonds are quoted as percentages of par or face value To convert the price quote into a dollar figure, one simply divides the price by 100 (converting it to decimal) and then multiplies by the par value The following table illustrates this

Par Value Price Quote

Price as a Percentage of Par Price in Dollars

Call and Refunding Provisions

If a bond's indenture contains a call feature or call provision, the issuer retains the right to retire the debt, fully or partially, before the scheduled maturity date The chief benefit of such a feature is that it permits the borrower, should market rates fall, to replace the bond issue with a lower-interest-cost issue The call fea- ture has added value for corporations and municipalities It may in the future help them to escape the restrictions that frequently characterize their bonds (about the disposition of assets or collateral) The call feature provides an additional benefit

to corporations, which might want to use unexpectedly high levels of cash to retire outstanding bonds or might wish to restructure their balance sheets

The call provision is detrimental to investors, who run the risk of losing a high-coupon bond when rates begin to decline When the borrower calls the issue, the investor must find other outlets, which presumably would have lower yields than the bond just withdrawn through the call privilege Another problem for the investor is that the prospect of a call limits the appreciation in a bond's price that could be expected when interest rates decline