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CFA1: Fixed Income

  • Bond indentures: specifies all the obligations of the issuer of a fixed income security
    • negative covenants: prohibitions on the borrower
    • affirmative covenants: promises by the borrower
  • Debt securities 2 semiannual installments
    • zero-coupon bonds: no periodic payments
    • step-up notes: coupon rate increases
    • deferred coupon bonds: compounded coupon payments
    • floating rate securities: interest-sensitive variable rate
    • coupon formula: Reference rate + margin (e.g. LIBOR + 1.5%)
    • caps & floors: upper/lower limit on formula rate

<math> Accrued interest = T \times P \times R </math> where <math>T</math> is the fraction of the year, <math>P</math> is the principal, and <math>R</math> is the annualized interest rate.

  • Amortization
    • non-amortizing: pay only interests, returned at par value
    • amortizing~: equal payments which consist of interest and principal (mortgage)
  • Embedded options
    • prepayment: early retirement/repayment
    • call provision: right to prepayment
    • call protection: restriction of prepayment over period
    • Conversion options

Investment risks

  • Interest risk

Duration measure of interest rate risk

price sensitivity, Δ% bond price in response to Δ%I/y

Effective duration.png

  1. longer maturity
  2. lower coupon
  3. lower yield
  4. without embedded option
  • Reinvestment risk
  1. higher coupon: more returns
  2. call feature: subject to early retirement
  3. amortizing security
  4. prepayment option
  • Credit risk
    • downgrade risk: probability of ratings decrease
    • default risk
    • credit spread risk: higher market yield for lower rating
  • Liquidity risk
    • bid-ask spread: indicates liquidity of the market for a security
    • decrease in liquidity -> increase bid-ask spread -> lower sale price -> decrease in returns
  • Exchange rate risk
    • actual cash flows from investment may be worth more or less than expected
    • depreciation of the foreign currency

Bond Sectors

  • Treasury securities
    • Treasury Inflation Protected Securities(TIPS): coupon rate fixed, par value adjusted for inflation

Monetary policy tools

  • Debt securities valuation
    • clean price = quoted price

Yield measures

  • Zero-volatility (ZV) spread: (parallel) spread to Treasury spot-rate curve to get PV = market price
  • Option-adjusted spreads(OAS): that take out the effect of embedded options on yield, reflect yield differences for differences in risk and liquidity
    • Option cost in yield% = ZV spread% –OAS%
    • Option cost > 0 for callable, < 0 for putable

Interest rate risk