Course Content
FIXED-INCOME SECURITIES: DEFINING ELEMENTS
This chapter is covered under study session 14, reading 42 of the study materials provided by the Institute. After reading this chapter, a student should be able to: a. describe basic features of a fixed-income security; b. describe the content of a bond indenture; c. compare affirmative and negative covenants and identify examples of each; d. describe how legal, regulatory, and tax considerations affect the issuance and trading of fixed-income securities; e. describe how cash flows of fixed-income securities are structured; f. describe contingency provisions affecting the timing and/or nature of cash flows of fixed-income securities and identify whether such provisions benefit the borrower or the lender.
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FIXED-INCOME MARKETS: ISSUANCE, TRADING, AND FUNDING
This chapter is covered under study session 14, reading 43 of the study material provided by the Institute. After reading this chapter, a student should be able to: describe classifications of global fixed-income markets; b describe the use of interbank offered rates as reference rates in floating-rate debt; c describe mechanisms available for issuing bonds in primary markets; d describe secondary markets for bonds; e describe securities issued by sovereign governments; f describe securities issued by non-sovereign governments, quasi-government entities, and supranational agencies; g describe types of debt issued by corporations; h describe structured financial instruments; i describe short-term funding alternatives available to banks; j describe repurchase agreements (repos) and the risks associated with them.
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INTRODUCTION TO FIXED-INCOME VALUATION
This chapter is covered under study session 14, reading 44 of the study material provided by the Institute. After reading this chapter, a student should be able to: a calculate a bond’s price given a market discount rate; b identify the relationships among a bond’s price, coupon rate, maturity, and market discount rate (yield-to-maturity); c define spot rates and calculate the price of a bond using spot rates; d describe and calculate the flat price, accrued interest, and the full price of a bond; e describe matrix pricing; f calculate annual yield on a bond for varying compounding periods in a year; g calculate and interpret yield measures for fixed-rate bonds and floating-rate notes; h calculate and interpret yield measures for money market instruments; i define and compare the spot curve, yield curve on coupon bonds, par curve, and forward curve; j define forward rates and calculate spot rates from forward rates, forward rates from spot rates, and the price of a bond using forward rates; k compare, calculate, and interpret yield spread measures.
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INTRODUCTION TO ASSET-BACKED SECURITIES
This chapter is covered under study session 14, reading 45 of the study material provided by the Institute. After reading this chapter, a student should be able to: a. explain benefits of securitization for economies and financial markets; b. describe securitization, including the parties involved in the process and the roles they play; c. describe typical structures of securitizations, including credit tranching and time tranching; d. describe types and characteristics of residential mortgage loans that are typically securitized; e. describe types and characteristics of residential mortgage-backed securities, including mortgage pass-through securities and collateralized mortgage obligations, and explain the cash flows and risks for each type; f. define prepayment risk and describe the prepayment risk of mortgage-backed securities; g. describe characteristics and risks of commercial mortgage-backed securities; h. describe types and characteristics of non-mortgage asset-backed securities, including the cash flows and risks of each type; i. describe collateralized debt obligations, including their cash flows and risks.
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UNDERSTANDING FIXED-INCOME RISK AND RETURN
This chapter is covered under study session 15, reading 46 of the study materials provided by the Institute. After reading this chapter, a student should be able to: a. calculate and interpret the sources of return from investing in a fixed-rate bond; b. define, calculate, and interpret Macaulay, modified, and effective durations; c. explain why effective duration is the most appropriate measure of interest rate risk for bonds with embedded options; d. define key rate duration and describe the use of key rate durations in measuring the sensitivity of bonds to changes in the shape of the benchmark yield curve; e. explain how a bond’s maturity, coupon, and yield level affect its interest rate risk; f. calculate the duration of a portfolio and explain the limitations of portfolio duration; g. calculate and interpret the money duration of a bond and price value of a basis point (PVBP); h. calculate and interpret approximate convexity and distinguish between approximate and effective convexity; i. estimate the percentage price change of a bond for a specified change in yield, given the bond’s approximate duration and convexity; j. describe how the term structure of yield volatility affects the interest rate risk of a bond; k. describe the relationships among a bond’s holding period return, its duration, and the investment horizon; l. explain how changes in credit spread and liquidity affect the yield-to-maturity of a bond and how duration and convexity can be used to estimate the price effect of the changes.
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FUNDAMENTALS OF CREDIT ANALYSIS
This chapter is covered under study session 15, reading 47 of the study material provided by the Institute. After reading this chapter, a student should be able to: a. a describe credit risk and credit-related risks affecting corporate bonds; b. describe default probability and loss severity as components of credit risk; c. describe seniority rankings of corporate debt and explain the potential violation of the priority of claims in a bankruptcy proceeding; d. distinguish between corporate issuer credit ratings and issue credit ratings and describe the rating agency practice of “notching”; e. explain risks in relying on ratings from credit rating agencies; f. explain the four Cs (Capacity, Collateral, Covenants, and Character) of traditional credit analysis; g. calculate and interpret financial ratios used in credit analysis; h. evaluate the credit quality of a corporate bond issuer and a bond of that issuer, given key financial ratios of the issuer and the industry; i. describe factors that influence the level and volatility of yield spreads; j. explain special considerations when evaluating the credit of high yield, sovereign, and non-sovereign government debt issuers and issues.
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Fixed Income
About Lesson

a.  Under the CDO structure, the securities are issued, generally under different tranches, to generate funds that are managed by a fund manager and are invested in an asset pool consisting of different debt instruments.

Collateralized Debt Obligations (CDOs) Fixed Income CFA Level 1 Study Notes

b.  Unlike the other asset-backed securities, under CDOs, first, the securities are issued, and then it is managed by an asset manager, who then decides where and how to invest.
If the funds are invested completely in the bonds instrument, they are called the collateralized bond obligations. However, if they are invested only in the loans, they are called collateralized loan obligations.

c.  An asset manager is a person or an agency that buys and sells the assets to generate cash flows, in the form of capital gains, interests, etc.
There are certain restrictive covenants associated with the securities issued that guide the manager for their conduct and in their investment decision. The covenants may include the restrictions, such as, where the investments cannot be made (like on the basis of geography, or type of investments, etc.).
The ability to pay interest payments to the tranches depends on the performance of the assets and the asset manager.

d.  The cash flow for the asset pool comes from three different sources:

     i.  interest payments,

    ii.  maturing assets, and

   iii.  sale of assets.

e.  In a CDO structure, an SPV is floated which issues the bonds with floating rates and holds assets in the form of bonds having both fixed and floating rates. Thus, there is an interest rates swap (i.e. fixed for floating in this case).

f.  The CDOs can be classified into two major categories, i.e. Cash CDOs and Synthetic CDOs.

Collateralized Debt Obligations (CDOs) Fixed Income CFA Level 1 Study Notes

A cash CDO is mainly backed by real assets such as bonds and loans. However, synthetic CDOs are mainly backed by derivatives.

These two categories can be further divided into the arbitrage driven CDO and balance sheet driven CDO. The arbitrage-driven CDOs capture the spread and derive profits from the difference in yields on the assets. The balance sheet-driven CDO, on the other hand, removes the assets from the sponsor’s balance sheet.

g.  The main motivation behind the CDOs is active management.

h.  The timeline of a CDO basically has two types of periods, i.e. the ramp-up period and the reinvestment period.

The ramp-up period is the initial phase on the timeline of a CDO, usually the first year, where the management is engaged in buying the assets. The phase after the initial year is the reinvestment period, where the assets are sold, the securities are retired and the proceeds are reinvested.