Fixed Income

Overview of Bond Sector and Instruments Understanding Yield Spreads

Bond Sector Government Agencies Municipal Corporation Bank Obligations 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

Government 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 price Under 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 price Under 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 system Refers to the issuance and auctions of bonds identical to previously issued bonds

US Treasury 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 Principal strips Coupon strips Refers to strips created from coupon payments stripped from the original security, denoted as ci Principal strips Refers 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

Agencies Federal Agency Debts Instrumen Types 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

Collateralized Mortgage Obligations (CMOs) Agencies Mortgage Backed Securities Mortgage pass through Pooling of several mortgages Sold in the form of participation certificates Cash flows passed through to investors Collateralized Mortgage Obligations (CMOs) Derivative of pass-through Different tranches created Prepayment risk distributed across tranches

Municipal Issued by local government 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

Corporation 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

Factor specific to particular debt issue Corporation Considered Factors for Rating Character, Capacity, Collateral and Covenant The Firm Specific Factors considered Past repayment history Quality of management, ability to adapt to changing conditions The industry outlook and firm strategy Overall debt level of the firm Operating cash flow, ability to service debt Other sources of liquidity (cash, salable assets) Competitive position, regulatory enviroment and union contracts/history Financial management and controls Susceptibility to event risk and political risk Factor specific to particular debt issue Priority of the claim being rated Value/quality of any collateral pledged to secure the debt The covenants of the debt issue Any guarantees or obligations for parent company support

Corporation Corporate Bonds Issues Medium term Notes 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.

Bank Obligation Negotiable Certificate of deposit Bankers Acceptances 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

Asset Back Securities 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

Collateralized Debt Obligations 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

Primary and Secondary Market 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

Exercise Exercise 1 Exercise 2 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 Exercise 4 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

Thank You and Success Agus Salim CFA 0811990573 agussalim09@gmail.com