Fixed Income

Overview of Bond Sector and InstrumentsUnderstanding Yield Spreads

Government• US Treasury

Agencies• Federally

Related Institution

• Government Sponsored Enterprises

Municipal • General

Obligation• Revenue• Special Bonds

Structure

Corporation • Secured

Bonds• Unsecured

Bonds• Medium Term

Notes• Commercial

Paper

Bank Obligations • Negotiabl e

CDs• Bankers

Acceptances

Bond Sector

Sovereign Bonds• Bonds issued by a country’s central

government • Issued in domestic market, another

country”s foreign market, or in the Eurobonds market

• Typically issued in the currency of the issuing country, but can be issued in other currencies as well

Government

Four Primary Methods of issuance

Regular cycle auction – single

priceUnder this method

highest price (lowest yield) at which the entire issue to be auctioned can be sold is awarded to winning bidders

Regular cycle auction – multiple

priceUnder this method,

winning bidders receive the bonds at the price that they

bid

An ad hoc auction system

Refers to a method where the central

government auctions new securities when it determines market

conditions are advantageous

A tap systemRefers to the issuance and

auctions of bonds identical to

previously issued bonds

Government

US Treasury

Fixed-Principal Treasuries

Treasury Bills Treasury Notes Treasury Bonds

Inflation-Indexes Treasuries

(TIPSs)

Treasury Strips (created by

private sector)

Coupon Strips Principal Strips

US Treasury

On The Run and Off The Run• Treasury issues are divided into 2 categories based

on their vintage :• On the run issues, the most recently auctined

Treasury issues.• Off the run issues, older issues that have been

replaced (as most traded issue) by a more recently auctioned issued. Issues replaced by several more recent issues are known as well off the run issues

US Treasury

TIPSs• Coupon rate reflects real rate, net of inflation, change in inflation reflected

in the principal• TIPS Coupon payment = inflation-adjusted par value x

(stated coupon rate/2)• Cons: if consumer prices decline, so does the principal. Also, inflation

adjustments are taxed• Example of TIPS : A TIPS has coupon rate of 3%, par value of $100,000.

Annual inflation rate: 4%, compute the semi-annual coupon payment!• Answer:

• Semi annual inflation = 4% x 0.5 = 2%• Inflation-adjusted principal = $100,000 x (1+0.02) = $102,000• Semi annual coupon payment = $102,000 x 1.5% = $1530

US Treasury

Treasury Strips

Coupon stripsRefers to strips created from coupon payments stripped from the original security, denoted as ci

Principal stripsRefers to bond and note principal payments with the coupons stripped off. Those derived from stripped bonds are denoted bp and those from stripped notes np

US Treasury

Federal Agency Debts

• Debt securities issued by various agencies and organizations of the U.S Government

• There are two types of federal agencies :• federal government agencies such as Ginnie Mae, TVA• government sponsored entities (privately owned) such

as Fannie Mae, Freddie Mac, Sallie Mae

Instrumen Types

• Debentures, securities not backed by collateral• Mortgage and Asset backed securities

Agencies

Mortgage Backed Securities

Mortgage pass throughPooling of several mortgagesSold in the form of participation certificatesCash flows passed through to investors

Collateralized Mortgage Obligations (CMOs)

Derivative of pass-throughDifferent tranches created Prepayment risk distributed across tranches

Agencies

Issuer

• Issued by local government

• In US issued by state, local government and entities that they create

Types

• Tax-Backed Debt• Revenue Bonds• Special Bonds

Structure

Municipal

Tax-Backed Debt

General Obligation Debt (G.O. Debt)

Unlimited Tax

Issuer has unlimited taxing authority

Lmited Tax

Issuer has a statutory limit on

tax increase

Doule Barelled

Backed also by additional revenues

Appropriation-Backed Obligation (Moral Obligation

Bonds)

State Issue a non-binding pledge to cover shortfalls

Public Credit Enhanced Programs

State or Federal agency guarantees

payment

Municipal

Corporate Debt

Securities

Corporate Bonds

Secured Bonds

Mortgage Debt

Collateral Trust Bonds

Unsecured Bonds

Credit Enhanced

Bonds

Third-Party Bank Letter of Credit

Medium Term Notes (MTNs)

Structured Notes

Commercial Paper

Directly-placed Dealer-placed

Corporation

Considered Factors for RatingCharacter, Capacity, Collateral and Covenant

The Firm Specific Factors considered Past repayment historyQuality of management, ability to adapt to changing conditionsThe industry outlook and firm strategyOverall debt level of the firmOperating cash flow, ability to service debtOther sources of liquidity (cash, salable assets)Competitive position, regulatory enviroment and union contracts/historyFinancial management and controlsSusceptibility to event risk and political risk

Factor specific to particular debt issue

Priority of the claim being ratedValue/quality of any collateral pledged to secure the debtThe covenants of the debt issueAny guarantees or obligations for parent company support

Corporation

Corporate Bonds Issues

• Corporate bond issues typically are :• Sold all at once• Sold on a firm commitment basis whereby an understanding

syndicate guarantees the sale of the whole issue• Consist of bonds with a single coupon rate and maturity

Medium term Notes

• Medium term notes (MTNs) differ from a regular corporate bond offering in all of these characteristics

Corporation

Structured Notes• A debt security created when the issuer combines a typical bond or note with

derivative.• Types of structured notes include :• Step up notes, coupon rate increases over time on a preset schedule.• Inverse Floaters, coupon rate increases when the reference rate decreases and

decreases when the reference rate increases.• Deleveraged Floaters, coupon rate equals a fraction of the reference rate plus a

constant margin.• Dual Indexed Floaters, coupon rate is based on the difference between two

reference rates.• Range Notes, coupon rate equals the reference rate if the reference rate falls

within a specified range, or zero if the reference rate falls outside that range.• Index amortizing Notes, coupon rate is fixed but some principal is repaid before

maturity with the amount of principal prepaid based on the level of the reference rate.

Corporation

Commercial paper• A short term unsecured debt instrument used by corporations

to borrow money at rates lower than bank rates.• Directly placed paper , commercial paper that is sold to

large investors without going through an agent or broker dealer. Large issuers will deal with a select group of regular commercial paper buyers who customarily buy very large amounts.

• Dealer placed paper, sold to purchasers through a commercial paper dealer. Most large investment firms have commercial paper desk to serve their customers’ needs for short term cash management products.

Corporation

Negotiable Certificate of deposit

• Certificate of deposit, promise by the bank to repay a certain amount plus interest with specific and for specific periods of time, that can be trade on the secondary market

Bankers Acceptances

• Guarantees by a bank that a loan will be rapaid. Created as part of commercial transaction, especially international trade

Bank Obligation

Special Purpose Vehicle/Corporation• a separate legal entity to which a corporation transfers the financial assets

for an ABS issue.• The Motivation for a corporation to issue asset backed securities to reduce

borrowing costs. By transferring the assets into a separate entity, the entity can issue the bonds and receive a higher rating than the unsecured debt of the corporation.

• External Credit Enhancements :• Corporate guarantees, which may be provided by the corporation

creating the ABS or its parent.• Letters of credit, which may be obtained from a bank for a fee• Bond Insurance, which may be obtained from an insurance company or a

provider specializing in underwriting such structures. This is also referred to as an insurance wrap

Asset Back Securities

Collateralized Debt Obligation (CDO) • A debt instrument where the collateral for

the promise to pay is an underlying pool of other debt obligations and even other CDOs

• Tranches of CDO are created based on the seniority of the claim to the cash flows of underlying assets, and given different credit rating based on seniority

Collateralized Debt Obligations

Primary Market

• The Primary Market for debt typically used an investment banker to involved in advising the debt issuer and in distributing (selling) the debt securities to investors.

• Two type of underwriting : firm commitment and best effort.

Secondary Market

• The Secondary Market for debt securities includes exchanges, an over the counter dealer market and electronic trading networks

Primary and Secondary Market

Exercise 1

• A treasury note (T-note) principal strip has six months remaining to maturity. How is its price likely to compare to a 6 month treasury bill (T-bill) that has just been issued ? The T-note price should be :• A. lower• B. higher• C. the same

Exercise 2

• Which of the following statements about treasury securities is most accurate? • A. Treasury principal strips are usually created from treasury bills• B. Treasury bonds may be used to create treasury coupon strips• C. Treasury coupon strip make lower coupon payments than treasury

principal strips

Exercise

Exercise 3

• Which of the following municipal bonds typically has the greater risk and is issued with higher yields ?• A. Revenue bonds• B. Limited tax general obligation bonds• C. Unlimited tax general obligation bonds

Exercise 4

• A debt security that is collateralized by a pool of the sovereign debt of several developing countries is most likely a (n) :• A. CMO• B. CDO• C. ABS

Exercise

Exercise 5• Activities in the primary market for

debt securities would least likely include :• A. market making• B. a best efforts offering• C. a firm commitment

Exercise

Thank You and Success

Agus Salim CFA

0811990573agussalim09@gmail.com