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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LOS A: Basic Features of a Fixed-Income Security
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LOS D: Legal, Regulatory & Tax Considerations
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LOS E: Structure of a Bond’s Cash Flow
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LOS F: Contingency Provisions
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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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LOS A and B: Bond Market Classification
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LOS C: Primary Markets
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LOD D: Secondary Market
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LOS E: Sovereign Bonds
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LOS F: Non-Sovereign Bonds, Supernational, & Quasi-Government Bonds
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LOS G: Corporate Bonds
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LOS H: Structured Financial Instruments
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LOS I: Short-term Funding
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LOS J: Repurchase Agreements
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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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LOS A: Bond Price and Time Value of Money
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LOS B: Relationships Among a Bond’s Price, Coupon Rate, Maturity, and Market Discount Rate
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LOS C: Spot Rates
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LOS D: Flat Price, Accrued Interest & Full Price
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LOS E: Matrix Pricing
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LOS F, G, and H: Yield Measures
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LOS I: Term Structure of Yield
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LOS K: Yield Spread
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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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Introduction
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LOS A: Benefits of Securitization
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LOS B and C: Securitization
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LOS D: Residential Mortgage Loans
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LOS E: Mortgage Pass-Through Securities
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LOS E: Collateralized Mortgage Obligations (CMOs)
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Non-Agency Residential Mortgage Backed Security
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LOS G: Commercial Mortgage-Backed Securities (CMBS)
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Auto Loan-Backed Securities (ALBs)
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Credit Card Receivable- Backed Securities
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Collateralized Debt Obligations (CDOs)
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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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LOS A: Sources of Return
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LOS B, C, and D: Interest Rate Risk
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LOS F: Duration of a Bond Portfolio
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LOS G: Money Duration
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LOS G: Price Value of a Basis Point
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LOS H: Convexity of a Bond
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Investment Horizon
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LOS L: Credit and Liquidity Risk
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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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LOS A and B: Credit Risk
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LOS C, D, and: E Capital Structure and Seniority
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LOS F, G, H, I: Credit Analysis
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LOS J: Special Consideration
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Fixed Income
About Lesson

Primary markets are the markets where the bonds are issued for the first time. The offerings are made in the primary markets through:

1.1.         Public Offerings

a.  The public offering could be in the form of an underwritten offering, wherein a firm (usually the investment bank) makes the commitment to purchase the entire issue from the issuer and then sell the same to the investors.
The process through which the underwritten offering works is:

     i.  The issuer determines the funding needs, including the quantity and duration of requirements of funds.

    ii.  The issuer selects the underwriters, who buy the bonds from the issuer and sells the same to the investors or dealers. The difference in price at which the underwriters purchase and sells the bonds is called the spread revenue.
The underwriters are usually the investment banks (if the issue is small in size) or a lead investment bank (which is a syndicate of small investment banks, in case the offering is large).

   iii.  The underwriter then structures the offerings, by detailing the terms of the bond, writing the circulars and prospectus, making the regulatory filings, selects the trustee.

    iv.  Then there is the announcement of the issue of the bonds. And, from the announcement day, up to the end of the subscription period, the underwriter gauges the demand for the bonds by analyzing the intrinsic demand for the bonds, through the marketing efforts. It also obtains ‘anchors’, i.e. the large institutional investors. The demand in the gray market or forward market is also analyzed.

    v.  At the end of the subscription period, there is a pricing day, which is the last day to finally commit. On this day the final terms are solidified.

   vi.  After the pricing day, the next day is the offering day. On this day the bond enters the issuing phase.

  vii.  In the issuing phase, the money changes hands, and the investment bank or syndicate, transfers the cash to the issuer and the issuer transfers the bonds to the investment bank. The investment bank transfers the bonds to the investors and dealers and assumes the risk of ownership.

 viii.  Finally, there is a closing date, which is about 14 days from the date of closing. All the transfers of cash and bonds take place by this date and post that all the transactions take place in the secondary markets.

1.2.         Best Offer Offering

a.  In the best effort offering, the investment bank or syndicate serves only as a broker, and in return, they receive the commission only and not the spread.

b.  The investment bankers do not assume any risk of ownership of the bond. They only put the best effort to find the buyers for the issuer.

1.3.         Auction

a.  An auction is a process that involves bidding by the potential buyers for the purchase of bonds.

b.  There are two broad types of auctions, based on the type of items auctioned, i.e. common value auction, and private value auction.

     i.  The common value auctions are for the things that have an objective value that everyone can recognize, but people are not aware of such value until it is actually determined and assigned. The common value auctions can take place for the items such as oil and timber leases, spectrum sales, etc.

    ii.  The private value auctions take place for the items that do not have objective value, such as artwork.

c.  There is also another type of auction, based on the method of auctioning, such as ascending price (or English auction), first price seal bid, the second price sealed bid, and descending price bid.

     i.  The ascending price bid involves people bidding different prices for the same asset. The bid moves in an upward direction. And as it reaches every reservation price level, more and more bidders keep dropping out, until the bid reaches the highest level where there are only as many bidders as is the number of assets to be sold.

    ii.  The first price-sealed bid involves people making a secret bid for the asset under auction. The bid price by each bidder is not known to the other bidders. At the end, the highest bidder pays the bid and receives the asset.
Under this auction, there are more chances of earning the lower price for the asset due to the ‘winner’s curse’ effect.

   iii.  In order to do away with the effect of the ‘winner’s curse’, and get a better deal for the asset under auction, the issuer can opt for a second price sealed bid. This involves bidding just like the first price sealed bid, but the only difference is that the person making the highest bid gets to buy the asset at the price of the second-highest bid.

   iv.  In the descending price bid, the auctions start at a high price and keep on lowering until it reaches the highest reservation bid. This type of auction takes place when there are multiple items to be sold. The highest bidder selects the quantity, then the bid drops until all the quantity is gone. This is also called ‘Dutch Auction’.

    v.  In a modified Dutch auction, all the bidders pay the lowest bid that clears the market.

1.4.         Private Placements

a.  The private placement is a non-underwritten and unregistered allotment or placement of bonds to a single or a small group of investors.

b.  The assets for private placements are generally offered to the investors with a low need for liquidity, long-term time horizon, and a higher need for yields, such as pension funds and insurance companies.

c.  The assets offered for the private placements sometimes do not have any secondary market; they usually trade between institutional investors only.

 

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