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.
0/4
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.
0/9
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.
0/8
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.
0/11
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.
0/8
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.
0/4
Fixed Income
About Lesson

a.  Credit analysis is an assessment of the issuer’s ability to pay the obligations of interest and principal repayments. It is the financial analysis used for determining the creditworthiness of an issuer using various quantitative and qualitative factors.

b.  The ability to pay an issuer is the function of credit quality and the industrial fundamentals. Or, to say, it is the function of the sources, predictability, and sustainability of the cash flows.

Issuers's Ability to Pay Fixed Income CFA Level 1 Study Notes

1.1.         4 C’s of Credit Analysis

The four C’s of credit analysis are: Capacity, Collaterals, Covenants, and Character.

1.1.1.     Capacity

a.  The capacity is the capability of the borrower to repay the debt. It reflects the volatility in the borrower’s earnings.

b.  If the repayment of debt contracts proves to be a constant stream over time, but earnings are volatile (and thus have a high standard deviation), it’s highly probable that the firm’s capacity to repay debt claim s would be at risk.

c.  The capacity to pay can be determined using both industry and company analysis.

d.  The industry analysis can be done using Porter’s Model, which basically has 5 factors that determine the level of credit risk faced by the securities. These factors are:

     i.  Level of Competition

    ii.  Barriers to entry

   iii.  Power of the buyer

   iv.  Power of the supplier

    v.  Substitution risk

The following figure shows how the above-mentioned factors affect the credit risk:

Capacity to pay Fixed Income CFA Level 1 Study Notes

e.  There are companies with fixed cost structures, and there are others with variable cost structures. The companies with the fixed cost structure have higher credit risk due to low liquidity and high fixed cost coverage, in comparison to the companies with the relatively variable cost structure.

f.  One can also have a fair idea of the capacity from the fundamental analysis of the company and the industry.

One can look at the cyclicality of the industry. The companies belonging to the non-cyclical industries have lower credit risk in comparison to the companies from the cyclical industries, due to the steadiness of the cash flows.

One can also do an analysis of the growth prospects of the company, and also refer to the published industry statistics to identify the credit risk.

g.  After the industry analysis, the analyst can also look into the company’s statistics to make inferences about the company’s capacity to pay.

One should look into the company fundamentals such as:

     i.  competitive positions,

    ii.  track record or operating history

   iii.  management strategies and execution

   iv.  ratio analysis (including profitability and cash-flow analysis, leverage ratios, coverage ratios, etc.)

h.  Different ratios that can be analyzed are:

     i.  Profitability and Cash Flow Ratios: The important profitability and cash flow ratios that can be analyzed are:

          #  EBITDA

          #  FFO (Funds From Operations)

          #  FCFE (Free Cash Flow to Equity)

    ii.  Leverage Ratios: While calculating the leverage ratios for analysis, the debt should include the debt-like liabilities, such as leases. The important leverage ratios that can be calculated are:

          #  Debt/Capital Ratio

          #  Debt/EBITDA

          #  FFO/Debt

   iii.  Coverage Ratios: These ratios measure the company’s ability to meet interest payments. Some of the important coverage ratios that need to be calculated are:

          #  EBITDA/Interest Expense

          #  EBIT/Interest Expense

1.1.2.     Collaterals

a.  In the event of default, a lender has the claim on the collateral pledged by the borrower.

b.  The greater the proportion of the claim over the assets and the greater the market value of the underlying collaterals, the lower is the remaining exposure risk in the case of a default.

c.  The main focus in the analysis of collaterals is on estimating the exposure due to the inability to recover the losses. It mainly involves the estimate of the market value of the tangibles and the intangible assets, underlying the issue.

1.1.3.     Covenants

a.  These are the agreed terms and conditions between the borrower and the lender.

b.  There are two types of covenants that can be seen in lending agreements, i.e. the affirmative covenants and negative covenants.

c.  The affirmative covenant is the promise of the borrower to meet certain promises like paying interest, principal, taxes, etc.

d.  The negative covenant is the restriction to the borrower regarding what actions are prohibited.

e.  The covenants are mostly listed in the bond’s prospectus.

1.1.4.     Character

a.  It is the measure of the firm’s reputation, its willingness to repay, accounting policies, tax strategies, and credit history.

b.  In particular, it has been established empirically that the age factor of an organization is a good proxy for its repayment reputation.

c.  The history of business and the experience of its management are critical factors in assessing a company’s ability to satisfy its financial obligations.

1.2.         Credit Risk Vs. Return

a.  There is always a trade-off between the risk and return for all investments. Thus, if a bond is having a higher credit risk, it will also be accompanied by a higher potential return to compensate for the high volatility and lower certainty of cash flows.

b.  The total return on any bond consists of premiums for different costs and opportunities foregone. This can be explained with the help of the following:

Yield On Corporate Bonds Fixed Income CFA Level 1 Study Notes

The government bonds offer a premium for inflation and maturity over and above the real rate. However, the corporate bonds have to pay the premium in the form of credit spread as well as on the liquidity risk over the yield on the government bonds.

c.  The spread on the corporate bonds, over and above the yield on a government bond is affected by the following factors:

     i.  credit cycle

    ii.  broader economic conditions

   iii.  financial market performance

   iv.  market-making willingness (i.e. efficient over-the-counter market)

    v.  supply and demand

d.  The spread risk results from the changes in return due to changes in the spread. It can be calculated using the following formula:

(This is discussed in details in the previous chapter)