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.  These mortgage-backed securities are backed by income-producing real estate, usually in the form of warehouses, shopping centers, apartments, office buildings, senior housing, health care facilities, hotels or resort properties, etc.

Commercial Mortgage-Backed Securities Fixed Income CFA Level 1 Study Notes

b.  These loans are originated usually by conduit organizations like commercial mortgage companies, which negotiate and close commercial real estate loans that are incorporated into CMBS.

c.  The assets held under the pool of commercial mortgages here are the non-recourse loans. Therefore, the credit analysis involves the analysis of cash flow on a loan-by-loan basis.

d.  The credit analysis can be done using the following two ratios:

     i.  Debt-to-Service Coverage Ratio: This ratio can be calculated using the following formula:

Fixed Income CFA Level 1 Study Notes

The higher this ratio, the better it is.

    ii.  Loan-to-Value Ratio: This ratio can be calculated using the following formula:

Loan-to-Value Ratio Formula Fixed Income CFA Level 1 Study Notes

The appraised value in the commercial MBS can be manipulated. Therefore, usually, there is a low loan-to-value for commercial properties in comparison to residential ones.

e.  The commercial MBS, like the non-agency MBS, requires credit ratings. Therefore, if the DSC and LTV ratios are not sufficient for a rating, then there is a need for credit enhancement, especially in the form of subordination.

f.  The rating agencies, thus, require sequential retirement. Therefore, the losses from the defaults are first charged against the lowest priority tranche (usually called the first-loss piece, equity tranche, residual tranche, etc.)

g.  The commercial properties generally offer a higher level of call protection, in form of lower prepayment risk, in comparison to the loans on the residential properties. This call protection is mainly from the prepayment and credit risk and is in form of:

     i.  Prepayment Lockout: This is the initial period of the loan where the restriction is imposed on the prepayment of the same. If the prepayment is made during this period, there is a penalty imposed.

     ii.  Defeasance Premium: Here, the borrower of the loan purchases the securities as collaterals to cover the remaining principal balance along with an amount to substitute for what the yield would have been

   iii.  Prepayment Penalty Points: Here, if the borrower wishes to prepay, there are penalty points attached to them, and the borrower has to pay 100 percent plus the penalty point percent as a premium. For example, a loan has a five-year lock-in period, with penalty points of 5, 4, 3, 2, and 1. Now if the borrower wants to make a prepayment in the first year, he will have to make a payment of 105% of the principal, 104% of the principal in the second year, and so on.

   iv.  Yield Maintenance Charge: This is a kind of penalty imposed on the borrower for prepayment, equivalent to the amount of yield that is lost as a result of the prepayment. The main purpose of this charge is to maintain the yield of the asset even in the case of prepayment. The penalty so imposed is also called the make-whole charge. In case of a change in interest rates, if the borrower gets the assets refinanced to get a lower rate, the borrower must make the yield whole. At the structure level, the manager of the fund can opt for credit tranching.

h.  The CMBS, unlike the residential MBSs, are not always fully amortizing loans. They may also be partially amortizing loans, and hence, may require balloon maturity provisions. This provision requires the borrower to make one big balloon payment at the end of the term of the loan.
Thus, at the end of the term, the borrower may not be able to refinance, sell the property, or pay the loan. This results in balloon risk or extension risk. In such situations, the lender is most likely to extend the loan.