Cfa Level II Fixed Income Readings Outline

FIXED INCOME

SECTION I: GENERAL PRINCIPLES OF CREDIT ANALYSIS

1. Credit Risk

1. There are three distinct types of risks associated with credit risk

1. Default Risk – Borrow wont repay obligation
2. Credit Spread Risk – Risk that credit spread will increase which causes the issue’s value to decrease or underperform compared to benchmark
3. Downgrade Risk – Issue will be downgraded by rating agency, which causes the price of the bond to fall

1. Rating agencies release 3 sources of information that help assess the likelihood of downgrade risk

1. Credit Rating – Reflects probability of default
2. Rating Watch – Agencies typically announce that they are reviewing a particular issue in advance of ST up/down grade
3. Rating Outlook – LT projection

1. Moody’s Scale for assessing default risk of an issue:

1. Downgrade Watch: 2 notch reduction
2. Negative Outlook: 1 notch reduction
3. Stable Outlook: Maintain Current Rating
4. Positive Outlook: 1 notch increase
5. Upgrade Watch: 2 notch increase

1. Key Components of Credit Analysis – The 4 C’s

1. Character: Management Integrity & Commitment to Repay

1. Focuses on Firm’s corporate governance structure/best practices

1. Large board, separate committees (audit, comp, etc.), majority are independent, committees entirely ind., nominating committee should be the onces identifying new board members, CEO is NOT the chairman

1. Covenants: terms/conditions of borrowing

1. Affirmative require a company to do something
2. Negative prohibit company from doing something

1. Collateral: Quality of underlying if debt is an ABS
2. Capacity to Pay: There are 3 specific aspects that should be analyzed

1. Sources of Liquidity: Must assess Industry Trends (5-forces), Regulatory Environment, Operating & Competitive Position, Financial Position, & Sources of Liquidity

1. Financial Position & Liquidity Sources looks at a variety of things:

1. Firm’s Working Capital
2. Dependable Cash Flows (Annuity)
3. Can the firm Securitize Assets
4. Does the firm have access to 3rd party guarantees (e.g. parent)

1. Ratio Analysis: There are 4 types of Financial Ratios applicable to assessing a firm’s capacity to pay

1. Profitability Ratios can the firm generate funds to pay int. & princ.

1. ROE = [pic 1]

1. ST Solvency Ratios can the firm pay it ST obligations

1. Current, Acid-Test (Quick) = [pic 2]

1. Capitalization (Fin Leverage) Ratios firms ability to take on additional risk  →  with these the LOWER the better

1. LT Debt-to-Cap = [pic 3]
2. Total Debt-to-Cap = [pic 4]

1. Coverage Ratios ability to pay debt & lease obligations using their CFO

1. Int Coverage = TIE =    also there’s   [pic 5][pic 6]

*When you analyze these ratios for a firm compared to industry averages, you can make a good assessment of whether or not the firm is likely to be upgraded/downgraded

1. Cash Flow Analysis: How CFO is used to assess issuers ability to service debt

1. Rating agencies use CF measures slightly difference than that of the CF Statement, which then affects the ratios they incorporate

1. SEE PAGE 115 for the rundown

1. High Yield Corporate Bonds

1. Analysis is required of BOTH the Debt Structure & Corporate Structure

1. Debt Structure of a HY Issuers →Typically have MORE BANK DEBT than a corporation that is investment grade

1. Senior Bank Debt – has special characteristics that set it apart from regular debt

1. It is floating rate → CF analysis must be a scenario analysis
2. Its ST debt → Analyze ability to pay off immediate obligation
3. It has seniority → over other issued debt

1. Reset Notes – have a specific premium to the par val because the coupon rate on the note is reset periodically

1. The effect of changing credit spreads must be incorporated into scenario analysis, and the firm may sell assets to avoid higher interest costs in the future

1. Zero Coupon Bonds – Held by subordinated debtholders

1. The interest accruing over time can be negatively impacted by the increased amounts of senior debt

1. Corporate Structure of HY Issuers → Typically structured as a holding company

1. This means that the parent borrows and passes $ to subordinate
2. Therefore analysis must be of BOTH parent and subordinates
3. Should Consider if debt covenants restrict:

1. Dividend payments to the parent
2. Restrictions on asset sales
3. Intercompany loans

1. Municipal Bond Credit Analysis – 2 general types

1. Tax Backed Debt: secured by tax revenues

1. Must consider the debt per capita? Is the municipality’s budget balanced? What is the State’s ability to help the municipality? What are the employment trends

1. Revenue Bonds: revenue from a specific project

1. Analyze the Cash Inflows (amount & reliability), also whether the debt repayment will be the primary use of the CFs of the project, also analyze any covenants that may be in place

1. Sovereign Bond Analysis – This is broken into two types of risk

1. Economic Risk – Ability to Pay

1. Points that must be considered are:

1. Living Standards
2. Economic Growth
3. Fiscal & Monetary Policy → BOP Flexability

1. BOP = 0 = Current Acct + Fin Acct – Δ Reserves Acct

1. Public Debt Burden
2. Amount of composition of external debt & liquidity

1. Political Risk – Willingness to Pay

1. Points that must be considered are:

1. Subject gov’ts participation in the global economy
2. The political stability
3. Form of gov’t
4. Internal & external security risks

1. Rating the currency risk of sovereign debt – Each country has 2 ratings

1. Local Currency – (debt service depr.) Subject gov’t has more control of this

1. Looking at the political stability, income base/growth, country’s economic infrastructure, tax & budgetary discipline, monetary policy

1. Foreign Currency – The main concern here is economic & fiscal policies

1. Looking at its BOP along with the external Balance Sheet compared to its debt (foreign currency) obligations

1. ABS vs Corporates

1. With an ABS, there is no business or operating risks
2. The ABS servicer plays an important role

SECTION II: TERM STRUCTURE VOLATILITY OF INTEREST RATES

1. Yield Curve Shifts

1. Parallel Shift – the yield on all maturities change by the same amount in the same direction
2. NonParallel Shift – refers to anyrtime the slope of the yield curve changes. There are 2 kinds of nonparallel shifts

1. Twists

[pic 7]

1. With the steepened curve, spreads between LT & ST rates have widened
2. With the flattened curve, spreads between LT & ST rates have narrowed

1. Butterfly shifts

[pic 8]

1. Positive Butterfly Shift becomes less curved
2. Negative Butterfly Shift becomes more curved

1. The 3 factors that drive Treasury security returns

1. Δ in level of interest rates – 90% of variation →
2. Δ in slope of the Yield Curve – 8.5% of variation → Twists
3. Δ in curvature of Yield Curve – 1.5% or variation → Butterfly Shifts

1. Bootstrapping & the Treasury Spot Rate curve

1. Bootstrapping – sequentially calculating the spot rates from securities with different maturities → using the yields on T-bonds from the yield curve

1. Price = [pic 9]
2. There are 4 combinations of securities that can be used to construct the Treasury spot rate curve:

1. On-the-run treasuries only
2. On-the-run treasuries and some off the run
3. ALL treasury bonds, notes, and bills
4. Treasury strips

1. The appeal is that you want to use securities with high trade volumes, which are always the on the run issues, BUT since there are large gaps in the issuance timeline of bonds & notes, using off the run securities are often added

1. Issue is that off the run can have stale prices (low vol)

1. Treasury Strips – BIG PICTURE, we are trying to determine the accurate spot rate for all maturities. Treasury coupon strips are zero-coupon securities  created by “stripping out” the coupons from normal T-bonds → i.e. since they are zero-coupon, their rates are expressed as spot rates

1. Unfortunately, this does not necessarily work because the strips market is not very liquid, causing a liquidity premium to be priced into their rate. Also, they reflect a tax disadvantage bc accrued interest on strips are taxed even though there are no CFs realized

1. Swap Rate Curve – LIBOR Curve

1. This is an alternative to creating the treasury spot rate curve
2. Uses a series of swap rates quoted by swap dealers over a period of 2 – 30 years
3. Hold preference over Treasury Spot Rate curve for multiple reasons:

1. Swap Market is not regulated by any government

1. Makes swap rates in different countries more comparable

1. Swaps pricing are purely results of supply and demand

1. Not affected by technical factors that affect gov’t bonds

1. Do not contain sovereign risk
2. Has many more maturities

1. Pure (Unbiased) Expectations Theory, Liquidity Preference Theory, & Preferred Habitat Theory

1. Pure (Unbiased) Expectations Theory

1. Forward rates are purely a function of expected future spot rates

1. Everything is in equilibrium, so the forward rate can be implied

1. Liquidity Preference Theory

1. Investors demand a rate premium to compensate for their exposure to interest rate risk → higher premium for longer the maturity

1. Preferred Habitat Theory

1. Investors and borrowers trade bonds that match their future CF obligations

1. e.g. Banks ST security demand. Endowment LT security demand

1. Key Rate Duration – Assessing nonparallel shifts

1. This is the %Δ in the value of a bond portfolio in response to a 100bps Δ in the corresponding key rate (holding all else constant)

1. Key Rate Duration Matrix & Calculation

[pic 10]        [pic 11]

        [pic 12][pic 13]

*NOTE that a bond KR Duration = the bond portfolio’s effective duration

1. Key Rate Duration is typically applied to 3 kinds of bond portfolios:

1. Barbell – Large % & LT & ST maturity bonds
2. Ladder – Even distribution among all maturities
3. Bullet – Large % in Intermediate maturity bonds

1. Yield Volatility – useful for valuing callable bonds and IR derivatives, or measuring IR risk

1. Yield Volatility Measure – Std. Dev. Of yield changes

1. σ2 = [pic 14]

1. Xt = 100 * ln)[pic 15]
2. yt = yield on day t
3.  = avg yield change over period t = 1 to t = T[pic 16]

1. Commonly the std. dev. is annualized:

1. σannual = σdaily * (# of trading days in the year)0.5

1. Yield Volatility Forecast – Estimated using int. rate derivatives & option pricing models

1. σ2 =    ……but needs to be done for each observation in port.[pic 17]
2. σ2 =    [pic 18]

SECTION III: VALUING BONDS WITH EMBEDDED OPTIONS

1. Relative Value Analysis – Comparing the bond’s spread over the same benchmark, to the required spread

1. This determines if a bond is over/under valued compared to benchmark

1. Undervalued → Bond Spread > Required Spread → “Cheap”
2. Overvalued → Bond Spread < Required Spread → “Rich”

1. Constructing an Arbitrage-Free Interest Rate Tree – Binomial Tree

1. NOT LIKELY TO SHOW UP on pages 164-165
2. Builds to constructing a Binomial Tree

1. Backward Induction Valuation Methodology

1. Process of valuing using a binomial interest rate tree, but going from period n (maturity) to node 0, and compounding at each possible value

1. Spread Masures → REFRESHER

1. 3 common measures

1. Nominal Spread: YTMbond - YTMTreasury

1. The Bond and Treasury security must have the same maturity

1. Z-Spread: Spread over the ENTIRE spot rate curve[pic 19]

1. This is versus the Benchmark spot rate curve

1. OAS: z-spread – option cost

1. Calc using the binomial interest rate mode

1. Common benchmark interest rates used to calculate spreads

1. Treasury securities
2. Specific sector of the bond market with a credit rating higher than the issue being valued
3. A specific issuer

1. Value of callable/putable bonds

1. Calculation

1. Vcall = Vnoncallable - Vcallable
2. Vput = Vputable - Vnonputable

1. Effect of volatility on the arbitrage-free value of an option

1. As interest rate volatility increases, the value of a callable bond decreases, this is because the upside price a callable bond can rise to is basically capped at its call price

1. Effective Duration & Effective Convexity

1. DE =         AND        CE = [pic 20][pic 21]

1. Convertible Bonds

1. Keep in mind that the fact that its convertible means that the bond has an embedded call option
2. Conversion Ratio – The number of common shares for which a convertible bond can be exchanged

1. Calculation

1. Conversion Ratio = [pic 22]

1. Conversion Value – the value of the common stock into which the bond is converted into

1. Conversion Val. = Market$ * Conversion Ratio
2. The minimum value of the convertible bond must be GREATER than the conversion value or straight value

1. If not, then arbitrage opportunities would exist

1. Market Conversion Price (and price per share)

1. Aka the conversion parity price – the price the convertible bondholder would pay for the stock if they bought the bond and immediately converted it

1.  = [pic 23]

1. Per Share:

1. Market conversion premium per share

1. should = the market conversion price - the market price
2. Ratio:

1.  = [pic 24]

1. Premium Payback Period

1. time it takes to recoup the per-share premium (Breakeven point)
2. Ratio:

1. =[pic 25]

1. Favorable Income Difference Per Share:

1. = [pic 26]

1. Premium Over Straight Value

1. Downside risk is limited for investor, because its convertible means that the bond will not fall below the bond’s underlying straight-value
2. Ratio:

1. =) – 1[pic 27]

SECTION IV: MORTGAGE-BACKED SECTOR OF THE BOND MARKET