Fixed Income Investments - Government Bonds The U.S. Government issues four types of securities: 1.

Treasury Bills - Treasury bills have a maturity of less than 12 months, no coupon rate, are issued at a discount to par value, mature at par value and pay no coupon interest. The return the investor receives is the difference between the purchase price and the maturity price. 2.Treasury Notes - Treasury notes have a maturity of one to ten years. They have a coupon rate set by the market place at issue. They are issued approximately at par value and mature at par value. 3.Treasury Bonds - Treasury bonds are the same as treasury notes except that they have maturities that are greater than ten years. The U.S. Government has not issued this type of bond for a while, but there are still some issues that are outstanding. 4.Treasury Inflation Protected Securities (TIPS) - TIPS are issued as notes or bonds and help to protect the investor against inflation risk. The example below illustrates how these securities work. Example: The coupon rate on an issue is set at a fixed rate, which is determined when the bonds are auctioned. This is considered the "real rate" because it is what the investor will earn over the inflation rate.

The inflation index the government uses is the non-seasonally adjusted U.S. City Average All Item Consumer Price Index for All Urban Consumers (CPI-U) These indexes work in deflationary environments as well, but the government has structured them so that the investor receives the higher inflation-adjusted amount, or par value, when redeemed at a later date.

Now on to the number crunching part concerning TIPS: Coupon Rate = 4% Annual Inflation Rate = 2% Investor buys 1,000,000.00 USD of TIPS At the end of the first six months the investor's coupon she will receive: Inflation rate (2%/2) =1% Coupon rate (4%/2) = 2% Answer: Inflation adjusted principle amount = (par value * 1+ semi-annual inflation rate) = 1,000,000 * 1.01 = 1,010,000.00 Coupon Payment = (Inflation adjusted principle amount * semi-annual coupon rate) = 1,010,000 * .02 = 20,200.00 Now let's move ahead another six months:

Coupon rate= 4% or 2% in semi-annual terms Inflation rate = 3 % or 1.5 % in semi-annual terms Inflation adjusted principle amount = (new par value * 1 + semi-annual inflation rate) = 1,010,000 * 1.015 = 1,025,150 Coupon Payment = (Inflation adjusted principle amount * semi-annual coupon rate) = 1,025,250 * .02 = 20,503.00 On-the-run vs. Off-the-run Government Securities On-the-run Securities On-the-run securities are the most current security issued by the U.S.Treasury Department. These issues tend to be more liquid in the marketplace. Off-the-run Securities Off-the-run securities are the securities that are replaced by the on-the-run securities. These issues tend to be less liquid in the marketplace. How Stripped Government Securities, & Coupon and Principal Strips Are Created The U.S. government does not issue zero coupon notes and bonds and there is a strong demand for an instrument with no credit risk and a maturity of greater than one year. Based on consumer demand, therefore, the private sector created securities with these features. Let's look at a treasury bond that has five years to maturity with a coupon rate of 7 %. This constitutes ten interest payments of US$70 based on $1,000 par value and one principal payment of $1,000 for a total of 11 payments. You now can discount these 11 single payments and create zero coupon instruments with maturity dates that correspond with the payment dates of the Treasury securities.

These are issued through the Treasury's Separate Trading and Registered Interest and Principal Securities (STRIPS) program to facilitate the stripping process. The zero-coupon securities created are the obligations of the U.S. Government.

These securities come in two different forms: 1.Coupon Strips Coupon strips come from the coupon payment part of the security. 2.Principal Strips Principal strips come from the principal payment. The difference between coupon strips and principal strips, besides maturity dates and amount received, has to do with taxes. Coupon strips accrue interest and are taxed each year even though interest is not paid until maturity. This causes negative cash flows for a taxable entity. Foreign investors often like principal strips because of the preferred tax treatments they can receive in their home countries.

Fixed Income Investments - Mortgage-Backed Securities (MBS) An investment instrument that represents ownership of an undivided interest in a group of mortgages. Principal and interest from the individual mortgages are used to pay investors' principal and interest on the MBS. When you invest in a mortgage-backed security you are lending money to a homebuyer or business. An MBS is a way for a smaller regional bank to lend mortgages to its customers without having to worry if the customers have the assets to cover the loan. Instead, the bank acts as a middleman between the homebuyer and the investment markets. A mortgage-backed security (MBS) is secured by the collateral of mortgages on real estate for which the borrower has agreed to make a predetermined series of payments. The mortgage gives the lender the right to take a property in case the borrower fails to make the payments on his loan, thus ensuring that the debt is paid off. These securities are amortizing, meaning they will decrease to zero as the payments are made. The cash flows consist of a principal payment and an interest payment that can be paid in full at anytime by the borrower. The investor in an MBS does not receive the full payment made by the borrower because the issuer charges servicing fees for doing the administrative work and prepayments. Example: Let's look at a $150,000 mortgage with a mortgage rate of 6%, a monthly payment of $1,000 and a term of 30 years or 360 months.

Beginning Mont Month h Mortgage Bal

Schedule Mortga End of d ge Intere Month Principle Payme st Mortgage Repaym nt Bal ent

$150,000 $1,000 $750

$250

$149,750

$149,750 $1,000

$748. $251 75

$149,498. 75

$149,498 $747. $149,246. $1,000 $252.51 .75 49 62

This process continues until the mortgage balance reaches zero, either by the scheduled payments or through any sort of prepayment.As you can see the interest decreases through the term of the loan as the mortgage balance decreases. This also means that that as the loan matures, more of the scheduled mortgage payment is applied to the mortgage balance. Prepayment Prepayment occurs when a bond's payments to its holders incorporates both interest and principal. Typically, in asset-backed securities (ABS) and Mortgagebacked securities (MBS) there is always a chance for a prepayment. To go back to an old example, a homeowner may only have to pay $500 a month on his mortgage, but decide to pay $700 a month. This additional amount is an example of prepayment. It can occur in chunks like this or it may be paid off in one lump sum. Risk of Prepayment The risk of prepayment is that they typically occur in declining rate environments. When this happens, individuals tend to refinance their mortgages or credit cards at lower rates, causing the securities that were made of these obligations to be prepaid before their stated maturity date. This causes the investors in these securities to have to reinvest their proceeds at a lower market rate.

Fixed Income Investments - Federal Issues Central governments can develop entities that issue bonds. These securities are referred to as semi-government bonds or government agency bonds. In the U.S. they are referred to as federal agency securities. The agency bond market can be further broken down into two categories: 1. Federally Related Institutions Federally related institutions are arms of the federal government. They include Export-Import, Tennessee Valley Authority (TVA), Government National Mortgage Association (Ginnie Mae). With exception to TVA and the Private Export Funding Corp., these securities are backed by the full faith and credit of the U.S. Government. 2.Government Sponsored Enterprises (GSEs) Government sponsored enterprises are privately owned, publicly chartered entities that were developed to help lower the cost of funding in certain sectors of the marketplace that the government feels are important enough to warrant assistance. They include the more familiar names such as: Federal National Mortgage Association (Fannie Mae) - provides credit for the residential housing sector. Federal Home Loan Mortgage Corporation (Freddie Mac) - provides credit for the residential housing sector.

Federal Home Loan Bank - provides credit for the residential housing sector. Federal Agriculture Mortgage Corporation - provide credit for farm proprieties Federal Farm Credit System - provide credit for agricultural part of the economy Student Loan Marketing Association (Sallie Mae) -provides support for higher education.

GSEs issue two forms of debt: debentures are notes or bonds with typical maturities of one to 20 years, while discount notes are short-term papers with maturities ranging from overnight to 360 days. Fannie Mae and Freddie Mac, as noted above, provide credit and support for the housing sector. In doing so, they issue securities that are backed by the mortgage loans that they purchase. The loans act as collateral for the bonds and they come in three forms: 1.Mortgage Pass through Securities Mortgage pass through securities are created when one or more bondholders form a pool (or collection) of mortgages and sell shares or certificates in the pool. The cash flows depend on the payments of the mortgage and opens the investor to prepayment risk. The monthly cash flows include net interest, scheduled principal payments and any principal prepayments. 2.Collateralized Mortgage Obligations (CMOs) CMOs are a derivative securities. They help an investor pick the type of cash flows he wants to be exposed to based on how the pool of mortgages are sliced up into tranches. The tranches offer investors different payment rules and par values. For example Tranche A might receive all principal payments until the balance is zero then the payments would flow to Tranche B and so on. 3.Stripped Mortgage-Backed Securities For CFA exam purposes, just know that the name exists in case they want three examples of Freddie or Fannie. Motivation Behind CMO Creation The motivation behind creating a CMO is to spread the risk of prepayment among different classes of bonds. A CMO has several tranches that splits the mortgage pool into different layers. These layers have different par values and prepayment speeds. This aids investors in helping them manage the risk exposures they want in this arena. GSEs issue two forms of debt: debentures are notes or bonds with typical maturities of one to 20 years, while discount notes are short-term papers with maturities ranging from overnight to 360 days. Fannie Mae and Freddie Mac, as noted above, provide credit and support for the

housing sector. In doing so, they issue securities that are backed by the mortgage loans that they purchase. The loans act as collateral for the bonds and they come in three forms: 1.Mortgage Pass through Securities Mortgage pass through securities are created when one or more bondholders form a pool (or collection) of mortgages and sell shares or certificates in the pool. The cash flows depend on the payments of the mortgage and opens the investor to prepayment risk. The monthly cash flows include net interest, scheduled principal payments and any principal prepayments. 2.Collateralized Mortgage Obligations (CMOs) CMOs are a derivative securities. They help an investor pick the type of cash flows he wants to be exposed to based on how the pool of mortgages are sliced up into tranches. The tranches offer investors different payment rules and par values. For example Tranche A might receive all principal payments until the balance is zero then the payments would flow to Tranche B and so on. 3.Stripped Mortgage-Backed Securities For CFA exam purposes, just know that the name exists in case they want three examples of Freddie or Fannie. Motivation Behind CMO Creation The motivation behind creating a CMO is to spread the risk of prepayment among different classes of bonds. A CMO has several tranches that splits the mortgage pool into different layers. These layers have different par values and prepayment speeds. This aids investors in helping them manage the risk exposures they want in this arena. Determining Credit Rating A credit rating can be determined for a single issue or for an entire corporation. The rating can be affected by how senior or junior the issue is compared to the structure of the entity. There are four main factors that rating agencies look at in developing their ratings: 1.Character Character is a factor that is used to determined the quality of management in a corporation. Character includes: strategic direction, financial philosophy, whether or not they are conservative, track record, control systems and succession planning. 2.Capacity Capacity describes a corporation's ability to pay its obligations. This factor includes: trends, regulatory environment, position in the industry, parent support and event risk. 3.Collateral Collateral is the assets pledged to secure the debt. This also includes the unpledged assets of the firm. 4.Covenants Covenants are the limitations or restrictions placed on the borrowers' activities.

There are positive and negative covenants, both of which were discussed earlier in the chapter. Secured Debt Secured debt is a type of corporate bond that has some form of collateral, which is pledged to ensure that there is payment of the debt. The collateral can be either real property or personal property the bondholder has a lien against in case of default. Another form of secured debt is Collateral Trust Bonds.With these issues, a company may have no real assets and use stocks, bonds and other securities they own in other companies as the collateral. There tend to be limitations placed on how much a company can issue of this type of debt and this applies not only in the indenture but also through various tests. Such tests include issuance tests and earnings tests. Unsecured Debt Unsecured debt is known as a debenture bond.It is the same as a secured bond only it doesn't have the collateral pledge. The holders fall in the same range as general creditors if a default occurs. In case of default, secured debt is paid first, unsecured is paid second and if there is anything left, subordinated debenture bonds, or those held junior holders are finally paid. Credit Enhancements Credit enhancements are a way to reduce risk for the bondholders. This entails another company guaranteeing their loans, typical through a third-party guarantee. This helps finance special projects for the parent company, which may finance at higher rates but still uses the parent company to guarantee the debt to reduce those funding costs. Letters of Credit (LOC) are another form of enhancement. The LOC requires that the bank that issued the LOC make payments to the trustee when requested so that funds will be available for the issuer to make its payments. Even though this may reduce a layer of risk, the issuer and the firm that grants the LOC should be analyzed to ensure the bond is a solid investment. Fixed Income Investments - Other Types of Bonds Corporate Bonds vs. Medium-term Notes The main difference between medium-term notes and corporate bonds is the way they are issued in the marketplace. MTNs can be offered to investors by the issuer's agent instead of being underwritten by investment banks and then sold to the public in one shot.

This helps to cover the funding gap between commercial paper and longterm bonds, hence the "medium-term" designation. When a firm what to issue this type of debt they have to file a "shelf registration" that lists the details of the offering, such as rates, maturities and the investment banks acting as their agent. It is also important to know that MTNs can also come in different structures instead of mirroring a corporate bond.These include: step up notes, inverse floaters, deleveraged floaters, range notes and index amortizing notes.

What is a Structured Note? A synthetic medium-term debt obligation with embedded components and characteristics that adjust the risk/return profile of the security. A structured note is a hybrid security that attempts to change its profile by including additional modifying structures. A simple example would be a 5 year bond tied together with an option contract for increasing the returns. A motivation for their issuance is the fact that they allow investors to realize a profit from favorable price movements. What is Commercial Paper? Commercial paper is a short term unsecured promissory note that is fewer than 270 days to maturity and is issued as a zero-coupon security. Companies continue to "roll over" or pay off the holders by issuing new commercial paper in the market. The risk to investors is that the issuing company will not be able to place the new commercial paper to pay off their older debt. Commercial Paper is issued in two ways: 1.Directly Placed The issuing company sells the paper directly to the investing public without the help of an agent or intermediary. An example would include GE Capital. 2.Dealer-Placed The issuing company uses an agent to help sell its paper in the marketplace. Commercial paper has its own credit rating and can de divided into financial and non-financial companies. Bank Obligations Negotiable CDs - A savings certificate entitling the bearer to receive interest. A CD bears a maturity date, a specified fixed interest rate and can be issued in any denomination. CDs are generally issued by commercial banks and are insured by the Federal Deposit Insurance Corporation (FDIC). The term of a CD generally ranges from one month to five years. A certificate of deposit is a promissory note issued by a bank. It is a time deposit that restricts holders from withdrawing funds on demand. Although it is still possible to withdraw the money, this action will often incur a penalty. For example, let's say that you purchase a $10,000 CD with an interest rate of 5% compounded annually and a term of one year. At year's end, the CD will have grown to $10,500 ($10,000 * 1.05). CDs of less than $100,000 are called "small CDs"; CDs for more than $100,000 are called "large CDs" or "jumbo CDs". Almost all large CDs, as well as some small CDs, are negotiable. Bankers Acceptances - A short-term credit investment created by a non-financial firm and guaranteed by a bank. Acceptances are traded at a discount from face value on the secondary market. Banker's acceptances are very similar to T-bills and are often used in money market funds.

Fixed Income Investments - Asset-Backed Securities (ABS) An asset-backed security is a security that is backed by a pool of loans or receivables. These include: auto loans, consumer loans, commercial assets (planes, receivables), credit cards, home equity loans, and manufactured housing loans. ABSs are essentially the same thing as a mortgage-backed security except that the security is backs assets such as loans, leases, credit card debt, a company's receivables, royalties, etc and not mortgage based securities. Special Purpose Vehicles and Their Effect on Asset-backed Securities SPVs are also referred to as a "bankruptcy-remote entity" whose operations are limited to the acquisition and financing of specific assets. The SPV is usually a subsidiary company with an asset/liability structure and legal status that makes its obligations secure even if the parent company goes bankrupt. Thanks to Enron, SPVs/SPEs are household words. These entities aren't all bad though. They were originally (and still are) used to isolate financial risk. A corporation can use such a vehicle to finance a large project without putting the entire firm at risk. Problem is, due to accounting loopholes, these vehicles became a way for CFOs to hide debt. Essentially, it looks like the company doesn't have a liability when they really do. As we saw with the Enron bankruptcy, if things go wrong, the results can be devastating. Why Issue Asset- Backed Securities? The primary motive for issuing asset-backed securities is to take an asset, such as a receivable, a loan or some other form of illiquid asset, and move it off the balance sheet. This helps the parent to clean up its balance sheet and monetize those receivables rather than waiting for the payments to come in. It can also help protect those assets in case the parent defaults. This is possible because the SPV that was created is a separate entity. Types of Credit Enhancements Credit enhancement is designed to reduce risk. It comes in two forms:

1.Internal Enhancements Internal enhancements come in the form of reserve funds over collateralization and senior/subordinated structures. These will be covered in more detail in the CFA Level II exam. 2.External Enhancements External enhancements come in three forms of third-party guarantees. These include: corporate guarantee, letter of credit and bond insurance. The enhancement can come from the parent company or from the newly created company that holds the assets. One problem with external enhancements is that one not only has to analyze the assets and the company that owns them but also the company that is "wrapping" or insuring the debt.

Collateralized Debt Obligations An investment-grade security backed by a pool of bonds, loans and other assets. CDOs do not specialize in one type of debt but are often non-mortgage loans or bonds. Similar in structure to a collateralized mortgage obligation (CMO) or collateralized bond obligation (CBO), CDOs are unique in that they represent different types of debt and credit risk. In the case of CDOs, these different types of debt are often referred to as 'tranches' or 'slices'. Each slice has a different maturity and risk associated with it. The higher the risk, the more the CDO pays.

Fixed Income Investments - Yield Curves The U.S Federal Reserve (the Fed) has four tools it uses to directly influence short-term and, indirectly, long-term rate as well. They are: 1. Open Market Operations The Fed buys Treasuries or adds funds to the system; this reduces short-term rates. The Fed also sells Treasuries or takes funds out of the system to increase short-term rates. 2. The Discount Rate This is the rate at which banks can borrow on a collateralized basis at the Fed's discount window. If the Fed raises rates, they makes it more costly for the banks to do business, which drains cash from the system. If the Fed eases this rate, banks will find it cheaper to borrow additional funds, which will add cash to the system. 3. Bank Reserve Requirements This is hardly used these days. If the Fed raises these requirements, money is kept out of the economy. If they lower the rate, additional money will hit the economy. 4.Verbal persuasion to influence how bankers supply credit to businesses and consumers This simple method requires no additional explanation. What is a Yield Curve? A yield curve represents the relationship between maturity and yields. As an example:

1 Month 3 Month 6 Month

1.00% 1.25% 1.50%

1 Year 2 Year 5 Year 10 Year 30 Year

1.75% 2.00% 2.35% 2.68% 3.00%

If you were to graph this data you would see the yield curve develop. This date is only good for one single point in time because rates are constantly moving. If you are searching for a point on the yield curve that does not have a maturity represented by an actual "on the run security", that point will only be an approximation. Yield Curve Shapes Yield Curves come in three shapes: 1. Upward or Normal Yield Curve This curve occurs when short-term rates are lower than long-term rates, as noted in the above example.

2.Inverted Yield Curve This curve is formed when short-term rates are higher than the longer part of the curve.

3.Flat Yield Curve This curve occurs when there is little or no change between short-term andlongterm rates.

Fixed Income Investments - The Term Structure of Interest Rates There are three main theories that try to describe the future yield curve: 1. Pure Expectation Theory Pure expectation is the simplest and most direct of the three theories. The theory explains the yield curve in terms of expected short-term rates. It is based on the idea that the two-year yield is equal to a one-year bond today plus the expected return on a one-year bond purchased one year from today. The one weakness of this theory is that it assumes that investors have no preference when it comes to different maturities and the risks associated with them. 2.Liquidity Preference Theory This theory states that investors want to be compensated for interest rate risk that is associated with long-term issues. Because of the longer maturity, there is a greater price volatility associated with these securities. The structure is determined by the future expectations of rates and the yield premium for interest-rate risk. Because interest-rate risk increases with maturity, the yield premium will also increase with maturity. Also know as the Biased Expectations Theory.

3.Market Segmentation Theory This theory deals with the supply and demand in a certain maturity sector, which determines the interest rates for that sector. It can be used to explain just about every type of yield curve an investor can came across in the market. An offshoot to this theory is that if an investor wants to go out of his sector, he'll want to be compensated for taking on that additional risk. This is known as the Preferred Habitat Theory. Implications of the Yield Curve for the Yield-Curve Theories 1.Pure Expectation Theory. According to this theory, a rising term structure of rates means the market is expecting short-term rates to increase. So if the two-year rate is higher than the one-year rate, rates should rise. If the curve is flat, the market is expecting that short-term rates will remain low or hold constant in the future. A declining rateterm structure indicates the market believes that rates will continue to decline. 2.Liquidity Preference Theory. Under this theory, the curve starts to get a little bit more bent. With an upward sloping yield curve, this theory really has no opinion as to where the yield curve is headed. It could continue to be upward sloping, flat, or declining, but the yield premium will increase fast enough to continue to produce an upward curve with no concerns about short-term interest rates. When it comes to a flat or declining term structure of rates, this suggests that rates will continue to decline in the short end of the curve given the theory's prediction that the yield premium will continue to increase with maturity. 3.Market Segmentation Theory. Under this theory, any type of yield curve can occur, ranging from a positive slope to an inverted one, as well as a humped curve. A humped curve is where the yields in the middle of the curve are higher than the short and long ends of the curve. The future shape of the curve is going to be based on where the investors are most comfortable and not where the market expects yields to go in the future. Fixed Income Investments - Types of Yield Measures Even though the way most investors discuss spreads is based on a Treasury security with the same maturity as the one it is being compared to, an investor can also talk about spreads between any two bonds with the following measures:

1. Absolute Yield Spread This is the way most spreads are measured in the market. This spread measures the difference in spread between two bonds in terms of basis points. The equation is: Yield Spread = Yield on Bond A - Yield on Bond B 2.Relative Yield Spread This ratio measures the yield spread relative to the reference bond. This equation is: Relative Yield Spread =Yield on bond A- Yield on Bond B/

Yield on Bond B 3.Yield Ratio This is just the ratio of the yields between the two bonds. The equation is: Yield on Bond A / Yield on Bond B Market convention is to use the on-the-run government security as the reference yield or bond. So in the above equations, one would replace Bond B with the comparable government security. Example: Yield Ratios We want to compare an IBM five-year bond with a yield of 4.5 % and the on- therun government five-year with a yield of 3.75% Answer: Absolute Yield Spread = 4.5% - 3.75% = .75% or 75 basis points Relative Yield Spread = 4.5%- 3.75% / 3.75% = .20 = 20% Yield Ratio = 4.5% / 3.75% = 1.20 Why Relative Spreads Are Better Investors may find relative spreads a better measure because they measure the magnitude of the yield spread and the way it is affected by interest-rate levels. While absolute spread may be maintained as rates change, relative spreads will move in or out depending on the level of rates. Example: Use the IBM and Treasury bond from the previous example, except now assume that yields have increased. Absolute Yield Spread 5.75%- 5.00% = .75% or 75 basis points. Even though yields have increased the spread is the same. However, the Relative Spread has changed too: Answer: 5.75% - 5.00% / 5.00% = .15 or 15%. This example shows that the relative spread can give an investor a better reading of how spreads are actually moving relative to the generic yield spread. Fixed Income Investments - Intermarket vs. Intramarket Sector Spreads The bond market is carved into different sectors based on the issuer. Typically, these sectors are: 1. U.S. Government Securities 2.U.S. Government Agency Securities 3.Municipal Securities 4. Corporate Bonds

5. Mortgage Backed Bond 6.Asset Backed Bonds 7.Foreign Bonds These sectors also can be broken down even further. For example, in the Corporate Sector, issuers can fall into one and sometimes more categories such as industrial, utilities, financials and bank. Spreads tend to be wider the farther one goes out the curve. Spreads can be based on individual sectors or crossed between them. Intermarket Sector Spreads Intermarket sector spreads deal with the yield spreads between two bonds in different sectors of the market. The most popular of these is a non-treasury security as opposed to a comparable treasury security. A comparable treasury security would be one with the same maturity. Intramarket Sector Spreads Intramarket sector spreads deal with the yield spread between two bonds in the same market sector. This can be done by developing a yield curve that is similar to the treasury yield curve but instead using the issuers' securities to develop the curve. Some other factors that affect spreads between bonds besides maturity are credit risk, any options that the bonds may have, the liquidity of the issuers and the tax bracket of investors who receive interest payments. Credit Spreads and Their Relationship to Economic Activity A Credit Spread is the yield spread between non-treasury and treasury securities. These are equal in all respects except their individual credit ratings. This means that their maturities are the same and that there are no options thrown into the equation. Look Out! It is important to note that spreads increase with maturity and lower credit ratings. Spreads interact with economic growth or decline in two key ways: 1. Spreads narrow or tighten - When the economy is growing, cash flows are increasing. Therefore, a corporation should have an easier time paying off its debt. Individuals will purchase more non-treasury securities than treasury securities because the increased economic activity reduces the default risk, causing spreads to tighten. 2. Spreads widen - When economy is faltering or slowing down, spreads widen.

When this happens, the possibility of defaults increases because cash flows are declining. Individuals will sell or dump non-treasury securities for government securities because there is less of a chance that the government will default on their debt when compared to a corporation. This is also known as a flight to safety.

Fixed Income Investments - Options and their Benefits For options that benefit the issuer, such as calls, investors will want yield spreads that are greater than bonds and that do not have options embedded in them. Because there is a risk that the bonds will be called, investors want a higher yield to compensate for that risk, causing the spread to widen over the treasury security when compared to bonds without options. The longer the call period, the less spread widening investors will be needed because of a longer protection period against the call. Options That Benefit the Holder For options that benefit the holder, such as puts, investor will require a smaller yield spread than bonds that do not have embedded options in them, such as treasury bonds. There is even the possibility that the coupon rate could be lower than the treasury coupon rate, depending on how favorable the option is to the investors. Spreads and Liquidity When issues are less liquid, yield spreads tend to widen because there are fewer bonds to buy or it is harder to find a buyer. When issues are more liquid, such as on-the-run treasuries, yield spreads are tighter or narrower because there are plenty of buyers and sellers. The larger the issue size, the more liquidity compared to a smaller issues in the market leads to tighter or narrower spreads and vice versa.

Fixed Income Investments - After Tax Yield of a Taxable Security The after-tax yield is the yield on a taxable bond after federal income taxes are paid. It is computed with the following formula. Formula 14.5

After-tax yield = pre-tax yield * (1- marginal rate)

The marginal rate will vary depending on the tax bracket the investor is at that

given time. Example: Taxable Bond Yield Taxable bond yield is 7.5% The Marginal tax rate for this investor is 31% Answer: After-tax yield = .075 * (1-.31) = .05175 = 5.175% Tax-Equivalent Yield The tax-equivalent yield is the yield that must be offered on a taxable bond issue to give the same after-tax yield as a tax-exempt issue. It is computed with the following formula. Formula 14.6 Taxable-equivalent yield = tax-exempt yield / (1marginal tax rate)

Example: Tax-Exempt Yield Tax exempt yield = 5.00% Marginal Tax Rate = 31% Answer: Taxable-equivalent yield = .05 / (1-.31) = .05 / .69 = .072464 = 7.2464 % This means that a taxable issue must yield more than 7.25 % for the investor at the 31% tax bracket in order to beat the 5% yield offer in the tax-exempt bond. Look Out! Notice that the higher the marginal tax rate, the higher the taxable equivalent yield would be needed in the taxable bond market.

Fixed Income Investments - London Interbank Offer Rate (LIBOR) An interest rate at which banks can borrow funds, in marketable size, from other banks in the London interbank market. The LIBOR is fixed on a daily basis by the British Bankers' Association. The LIBOR is derived from a filtered average of the world's most creditworthy banks' interbank deposit rates for larger loans with

maturities between overnight and one full year. The LIBOR is the world's most widely used benchmark for short-term interest rates. It's important because it is the rate at which the world's most preferred borrowers are able to borrow money. It is also the rate upon which rates for less preferred borrowers are based. For example, a multinational corporation with a very good credit rating may be able to borrow money for one year at LIBOR plus 4 or 5 points. Countries that rely on the LIBOR for a reference rate include the United States, Canada, Switzerland and, of course, England.

14. Fixed Income Investments

14.1 Introduction 14.2 Bond Features 14.3 Basic Coupon Structures 14.4 Early Retirement 14.5 Provisions for Redeeming Bonds 14.6 Refunding 14.7 The Importance of Embedded Options 14.8 Institutional Investors and Financing Purchases 14.9 Interest Rate Risk 14.10 Call and Prepayment Risk 14.11 Reinvestment Risk 14.12 Yield Curve Risk 14.13 Credit Risk 14.14 Liquidity Risk 14.15 Exchange-Rate Risk 14.16 Volatility Risk 14.17 Inflation Risk 14.18 Event Risk 14.19 Pricing Bonds 14.20 Duration

14.21 International Bonds 14.22 Government Bonds 14.23 Mortgage-Backed Securities (MBS) 14.24 Federal Issues 14.25 Bondholder's Rights 14.26 Other Types of Bonds 14.27 Asset-Backed Securities (ABS) 14.28 Yield Curves 14.29 The Term Structure of Interest Rates 14.30 Types of Yield Measures 14.31 Intermarket vs. Intramarket Sector Spreads 14.32 Options and their Benefits 14.33 After Tax Yield of a Taxable Security 14.34 London Interbank Offer Rate (LIBOR) 14.35 Bond Valuation Basics 14.36 Cash Flow 14.37 Bond Value and Price 14.38 Arbitrage-free Valuation Approach 14.39 Typical Yield Measures 14.40 Assumptions Underlying Traditional Yield Curve Measures 14.41 Importance of Reinvestment Income and Reinvestment Risk 14.42 Spot Rates and Bond Valuation 14.43 Differentiating Between Spreads 14.44 What are Forward Rates? 14.45 Forward Rates vs Spot Rates 14.46 Measuring Interest Rate Risk 14.47 Price Volatility 14.48 Effective, Modified, and Macaulay Duration 14.49 Convexity 14.50 Price Value of a Basis Point (PVBP)

Fixed Income Investments - Bond Valuation Basics The fundamental principle of valuation is that the value is equal to the present value of its expected cash flows. The valuation process involves the following three steps: 1. Estimate the expected cash flows. 2. Determine the appropriate interest rate or interest rates that should be used to discount the cash flows. 3. Calculate the present value of the expected cash flows found in step one by using the interest rate or interest rates determined in step two. Fixed Income Investments - Cash Flow Bonds With Difficult Expected Cash Flow Estimation The bonds for which it is difficult to estimate expected cash flows fall into three categories: 1.Bonds for which the issuer or investor has an option or right to change the contract due date for the payment of the principal. These include callable bonds, puttable bonds, MBSs and ABSs. 2.Bonds for which coupon payment rate is reset occasionally based on a formula with values that change, such as reference rates, prices or exchange rates. A floating-rate bond would be an example of this type of category. 3. Bonds for which investor has the option to convert or exchange the security for common stock. The problems when estimating the cash flows of these types of bonds include: 1.In the case of bonds for which the issuer or investor has the option/right to change the contract due date for the payment of principal, the bonds can be affect by future interest rates. If rates decline, a corporation may issue new bonds at a lower cost and call the older bonds. The same thing happens with MBSs and ABSs. As rates decline, borrowers have the right to refinance their loans at cheaper rates. This causes the bond to be paid off earlier than the stated maturity date. 2.When rates increase, a puttable bond will be sold back to the issuing corporation at the put price once the increase in rates drives the price of the security below the put price. 3.For bonds in which the coupon payment rate is reset occasionally based on a

formula with changing values, because the rate is always changing based on other variables it is hard to estimate the cash flows. Also, for bonds that give the investor the option to convert or exchange the security for common stock, the cash flows will stop altogether once the investor decides that it would be more profitable to exchange the fixed income security for equity. The investor will have no certain idea as to when this may occur, making it difficult to value the cash flows until the maturity of the bond. 4.Because the value of the bond rests on the performance of the securities that back the bond, it is hard to determine whether the bonds may be converted into those securities. Determining Appropriate Interest Rates The minimum interest rate that an investor should accept is the yield that is available in the market place for a risk-free bond, or the Treasury market for a U.S. investor. The Treasury security that is most often used is the on-the-run issues because they reflect the latest yields and are the most liquid securities. For non-treasury bonds such as corporate bonds, the rate or yield that would be required would be the on-the-run government security plus a premium that takes up the additional risks that come with non-treasury bonds. As for the maturity, an investor could just use the final maturity date of the issue compared to the Treasury security. However, because each cash flow is unique in its timing, it would be better to use the maturity that matches each of the individual cash flows. Computing a Bond's Value First of all, we need to find the present value (PV) of the future cash flows in order to value the bond. The present value is the amount that would be needed to be invested today to generate that future cash flow. PV is dependant on the timing of the cash flow and the interest rate used to calculate the present value. To figure out the value the PV of each individual cash flow must be found. Then, just add the figures together to determine the bonds price. Free Trading Guide - GFT Formula 14.7

PV at time T = expected cash flows in period T / (1 + I) to the T power

After you develop the expected cash flows, you will need to add the individual cash flows: Formula 14.8

Value = present value @ T1 + present value @ T2 + present value @Tn

Let's throw some numbers around to further illustrate this concept. Example: The Value of a Bond Bond GHJ matures in five years with a coupon rate of 7% and a maturity value of $1,000. For simplicity's sake, the bond pays annually and the discount rate is 5%. Answer: The cash flow for each of the years is: Year one = $70 Year Two = $70 Year Three = $70, Year Four is $70 and Year Five is $1,070. PV of the cash flows is: Year one = 70 / (1.05) to the 1 st power = $66.67 Year two = 70 / (1.05) to the 2nd power = $ 63.49 Year three = 70 / (1.05) to the 3rd power = $ 60.47 Year four = 70 / (1.05) to the 4th power = $ 57.59 Year five = 1070 / (1.05) to the 5th power = $ 838.37 Now to find the value of the bond: Value = 66.67 + 63.49 + 60.47 + 57.59 + 838.37 Value = 1, 086.59 Fixed Income Investments - Bond Value and Price How Does the Value of a Bond Change? As rates increase or decrease, the discount rate that is used also changes appropriately. Let's change the discount rate in the above example to 10% to see how it affects the value of the bond. Example: The Value of a Bond when Discount Rates Change PV of the cash flows is: Year one = 70 / (1.10) to the 1 st power = $ 63.63 Year two = 70 / (1.10) to the 2nd power = $ 57.85 Year three = 70 / (1.10) to the 3rd power = $ 52.63 Year four = 70 / (1.10) to the 4th power = $ 47.81 Year five = 1070 / (1.10) to the 5th power = $ 664.60 Answer: Value = 63.63 + 57.85 + 52.63 + 47.81 + 664.60 = $ 886.52 As we can see from the above examples, an important property of PV is that for a given discount rate, the older a cash flow value is, the lower its present value. We can also compute the change in value from an increase in the discount rate used in our example. The change = 1,086.59 - 886.52 = 200.07.

Another property of PV is that the higher the discount rate, the lower the value of a bond and the lower the discount rate the higher the value of the bond. Look Out!

If the discount rate is higher than the coupon rate the PV will be less than par. If the discount rate is lower than the coupon rate, the PV will be higher than par value. How Does a Bond's Price Change as it Approaches its Maturity Date? As a bond moves closer to its maturity date, its price will move closer to par. The break down on the three scenarios is as follows: 1.If a bond is at a premium, the price will decline over time towards its par value. 2.If a bond is at a discount, the price will increase over time towards its par value 3.If a bond is at par, its price will remain the same. To show how this works lets use our original example of the 7% bond, but now let's assume a year has passed and a discount rate remains the same at 5%. Example: Price Changes Over Time Let's compute the new value to see how the price moves closer to par. You should also be able to see how the amount by which the bond price changes is attributed to it being closer to it's maturity date. PV of the cash flows is: Year one = 70 / (1.05) to the 1 st power = $66.67 Year two = 70 / (1.05) to the 2nd power = $ 63.49 Year three = 70 / (1.05) to the 3rd power = $ 60.47 Year four = 1070 / (1.05) to the 4th power = $880.29 Answer: Value = 66.67 + 63.49 + 60.47 + 880.29 = 1,070.92 As the price of the bond decreases, it moves closer to its par value. Theamount of change attributed to the year's difference is 15.67. An individual can also decompose the change that results when a bond approaches its maturity date and the discount rate changes. This is accomplished by first taking the net change in the price that reflects the change in maturity, and then adding it to the change in the discount rate. The two figures should equal the overall change in the bond's price. Computing the Value of a Zero-coupon Bond This may be the easiest of securities to value because there is only one cash flow - the maturity value. Value of a zero coupon bond that matures N years from now is: Formula 14.9

Maturity value / (1 + I) to the power of the number of years * 2 Where I is the semi-annual discount rate.

Example: The Value of a Zero-Coupon Bond For illustration purposes, let's look at a zero coupon with a maturity of three

years and a maturity value of $1,000 discounted at 7% Answer: I = 0.035 (.07 / 2) N=3 Value of a Zero = 1,000 / (1.035) to the 6th power (3*2) = 1,000 / 1.229255 = 813.50

Fixed Income Investments - Arbitrage-free Valuation Approach Under a traditional approach to valuing a bond, it is typical to view the security as a single package of cash flows, discounting the entire issue with one discount rate. Under the arbitrage-free valuation approach, the issue is viewed, instead, as various zero-coupon bonds that should be valued individually and added together to determine value. The reason this is the correct way to value a bond is that it does not allow a risk-free profit to be generated by "stripping" the security and selling the parts at a higher price than purchasing the security in the market. As an example, a five-year bond that pays semi-annual interest would have 11 separate cash flows, and be valued using the appropriate yield on the curve that matches its maturity. So the markets implement this approach by determining the theoretical rate the U.S. Treasury would have to pay on a zero-coupon treasury for each maturity. The investor then determines the value of all the different payments using the theoretical rate and adds them together. This zerocoupon rate is the treasury spot rate. The value of the bond based on the spot rates is the arbitrage-free value. Determining Whether a Bond is Under or Over Valued What you need to be able to do is value a bond like we have done before using the more traditional method of applying one discount rate to the security. The twist here, however, is that instead of using one rate, you will use whatever rate the spot curve has that coordinates with the proper maturity. You will then add the values up as you did previously to get the value of the bond. You will then be given a market price to compare to the value that you derived from your work. If the market price is above your figure, then the bond is undervalued and you should buy the issue. If the market price is below your price, then the bond is overvalued and you should sell the issue. How Does a Dealer Generate Arbitrage Profits? A dealer has the ability to strip a security or to take apart the cash flows that make up the bond. These Treasury strips can be sold to investors. So if the market price of a Treasury security is less than the value using the arbitrage-free valuation, a dealer will buy the security, strip the bond and then sell the Treasury strips at a higher amount than the purchase price for the whole bond.

On the other hand, if the market price is more than the value using the arbitrage-free valuation, the dealer will buy the strips, make the bond "whole" and sell it at a higher price than that of the purchased strips. Fixed Income Investments - Typical Yield Measures There are three sources of return an investor can expect to receive by investing in bonds: 1.The coupon payment made by the issuer. 2.Any capital gain or loss (negative dollar return) when the bond matures, is called or is sold. This is the difference between the purchase price and the price when the bond is no longer owned by you. 3.Income from the reinvestment of interim cash flows such as interest payments and any prepayments of principal prior to the final or stated maturity date. You take the interim payment and invest it in another fixed income security to earn additional returns. This is also known as interest on interest. This section is all about formulas and bond math; some of the questions you see on your CFA Level 1 exam will almost certainly come out of this section. 1.Current Yield Current yield relates the annual dollar coupon interest to the bond's market price: Formula 14.10

Current Yield = annual dollar coupon interest / price

Example: Current Yield IBM ten-year bond with a rate of 5% and market price of 98. Answer: Step1 - Figure out the annual dollar coupon interest= .05 * $100 = 5$ Current Yield = $5 / 98 = .05102= 5.1% Current yield is greater when bond is selling at a discount. The opposite is true for a premium bond. If a bond is selling at par, the current yield will equal the coupon rate. The drawback using current yield is that it only considers the coupon interest and nothing else. 2.Yield to Maturity (YTM) Yield to maturity is the most popular measure of yield in the market. It isthe rate that will make the present value of a bond's cash flows equal toits market price plus accrued interest. To find YTM, one has to develop the cash flows and then,

through trial and error, find the interest rate thatmakes the present value of cash flow equal to the market price plus accrued interest. This is basically a special type of internal rate of return (IRR). Example: Yield to Maturity An example using the above IBM bond the cash flows will consist of 20 payments of $2.50 every six months and a payment, twenty six-month periods from now, of $100. The present values, using various semi-annual discounts, are as follows: Semi-annual interest RatePercent Value 2.5%100 2.6%99.5 2.7%99.00 2.8%98.5 2.9%98.00 When the rate is 2.9% is used the present value of the cash flows is equal to a price of $98.00. Hence the semi-annual yield to maturity is 2.9%. Now that we have found this we must make it into a market convention rate or the bondequivalent yield. To get this yield, just double the semi-annual rate. In this example, it would be 5.8% yield to maturity. Bond Price, Coupon Rate, Current Yield and Yield to Maturity For a bond selling at par: Coupon Rate = Current Yield = Yield to Maturity For a bond selling at a discount: Coupon Rate < Current Yield < Yield to Maturity

For a bond selling at a premium: Coupon Rate > Current Yield > Yield to Maturity

The limitations of the yield to maturity measure are that it assumes that thecoupon rate will be reinvested at an interest rate equal to the YTM. Besides that it does take into considerationthe coupon income and capital gains orloss as well as the timing of the cash flows. FXCM -Online Currency Trading Free $50,000 Practice Account 3.Yield to First Call Yield to first call is computed for a callable bond that is not currently callable. The actual calculation is the same as the Yield to Maturity with the only difference being that instead of using a par value and the stated maturity, the analyst will use the call price and the first call date in calculating the yield. 4.Yield to First Par Call Again, yield to first par call is the same procedure as above, with the difference being that the maturity date that will be used instead of the stated maturity date is the first time the issuer can call the bonds at par value. 5.Yield to Refunding Yield to refunding is used when the bonds are currently callable but there are certain restrictions on the source of funds used to buy back the debt when a call

is exercised. The refunding date is the first date the bond can be called using a lower-cost debt. The calculation is the same as YTM. 6.Yield to Put Yield to put is the yield to the first put date. It is calculated the same way as YTM but instead of the stated maturity of the bond, one uses the first put date. 7.Yield to Worst Yield to worst is the yield occurs when one calculates every possible call and put date that has the lowest possible yield. For example if you calculate all the call dates and the yield comes out as follows 5.6%, 7.6%, 8.2% and 7.5%, the yield to worst would be 5.6%. This measure means little to the potential return; it is supposed to measures the worst possible return the investor will receive if the bond is called or put. 8.Cash Flow Yield Cash flow yield deals with mortgage-backed and asset-backed securities. The cash flows of these securities are interest and principal payments. What makes this complicated is that the borrowers who make up the mortgage or asset pool can prepay their loans in whole or in part prior to the scheduled principal payment. Because of this, the cash flows have to be estimated and an assumption must be made as to when these principle prepayments may occur. The rate that exists when the prepayments occurs is called the prepayment rate or prepayment speed.Once this rate is estimated, a yield can be calculated. The yield is the interest rate that will make the present value of the estimated cash flows equal the price plus accrued interest. Example: Cash Flow Yield Because cash flows for these securities are usually monthly, a bond-equivalent yield must be developed. The math here is a little different than in the above examples: Step 1 - the effective semi-annual yield must be computed from the monthly yield by compounding it for six months. Effective semi-annual yield = (1 + monthly yield) to the 6 th power -1 Step 2 - Double the effective semi-annual yield to get the annual cash flow on a bond equivalent basis. Cash flow yield = 2 * {(1 + monthly yield) to the sixth power-1} Answer: So if the monthly yield is .8% then: Cash flow yield = 2*{ 1.008) to the sixth power -1} = 2*.04897 = 9.79% Fixed Income Investments - Assumptions Underlying Traditional Yield Curve Measures

The main underlying assumptions used concerning the traditional yield measures are: 1.The bond will be held to maturity. 2. Coupons can be reinvested at the yield to maturity Limitations: 1.Current yield- Current yield only considers the coupon interest and no other sources for an investors return. It does not take into consideration the capital gain when a bond is purchased at a discount or the capital loss when the bond is purchased at a premium. Also, reinvestment income is not taken into consideration. 2. Yield to Maturity - Yield to maturity measures assume that the coupon payments will be reinvested at the coupon rate 3.Yield to Call - Yield to call assumes investor will hold the bond to the assumed call price and that the issuer will call the bond on that date which both are unrealistic. Also, the comparison of different yields to call with the YTM are meaningless because the cash flows stop once the issuer calls the bond. 4.Yield to Put - This assumes that coupon payments will be reinvested at the calculated yield and that the bonds will be put on the first date. 5.Yield to Worst - This measure does not identify the potential return over some time horizon and fails to take into account that the calculation for a YTW has different exposures to reinvestment risk. 6.Cash Flow Yield - Cash flow yield assumes that the coupons will be reinvested at the coupon rate and that the bond will be held to maturity. However, because cash flow yield tend to be used for MBSs or ABSs there is a risk that the bonds will be prepaid and the measure of cash flow yield will be thrown out the window.

Fixed Income Investments - Importance of Reinvestment Income and Reinvestment Risk Reinvestment income can make up a large portion of the return for a bond. Before beginning with calculations, it is important to understand the difference between total future dollars, which is equal to all the dollars an investor expects to receive and the total dollar return, which is equal to the dollars the investor will realize from the three sources of income for a bond (coupon payment, capital gain/loss, and reinvestment income). Example: Reinvestment Income let's look at an investor that has $96 to invest in a certificate of deposit (CD) that will mature in five years. The bank will pay 3% every six months, which equals a bond equivalent basis of 6%. The total future value of this investment today

would be: Answer: 96 * (1.03) to the tenth power = $129.02 So the investment of $96 for five years at 6% on a BEY will generate $129.02 To further break it down: Total Future Dollars = 129.02 Return of Principle =96.00 Total interest= 33.02 Now let's turn to a bond that has a price of $96, five-year maturity and with a coupon of 5% and YTM of 6%. As shown above an investor must generate $129.02 to provide a yield of 6% or the total dollar return must be $33.02. So with this bond, the sources of return are a capital gain of: $4 ($100 - $96) and coupon interest of $2.50 for ten periods or $25. That equals $29 without the reinvestment of the coupon payments. As we can see, this leads to a shortfall of $4.02 when compared to the CD example above. This $4.02 can be generated if the coupon payments are invested at a 3% semi-annual rate at the time it is paid. For the first payment the reinvestment income earned is: $2.50(1.03) to 10 -1 power - 2.50 = $0.76. If you were to continue this effort, which is unlikely to be required on the exam, you would find the reinvestment income would equal $4.02. To continue this with the three sources of income would produce the following: Capital Gain of $4 Coupon Interest of $25 Reinvestment Income or $4.02 The total would be $33.02. Therefore, reinvestment income accounts for 12% of the total return, illustrating how important reinvestment income can be for an investor. Factors That Affect Reinvestment Risk There are two characteristics that affect reinvestment risk: 1.For a given yield to maturity and a given non-zero coupon rate, the longer the maturity, the more the bond's total return depends on reinvestment revenue to realize the yield to maturity at purchase time. Longer maturity = greater reinvestment risk. 2. For a given coupon-paying bond with a given maturity and yield to maturity, the higher the coupon rate, the more the total dollar return depends on the reinvestment of the coupon payments. This must occur in order to produce the yield to maturity at the time of purchase.

Fixed Income Investments - Spot Rates and Bond Valuation On some occasions, such as with non-U.S. government bonds which pay annual interest compared to semi-annual interest in the U.S., an adjustment needs to be made in order to compare their yields. The computation is as follows: Formula 14.11 Bond-equivalent yield of an annual-pay bond = 2[(1 + yield on annual-pay bond) to the .5 power - 1]

Example: Assume that the YTM on an annual-pay bond is 8%. Answer: Bond-equivalent yield = 2 [(1 + .08) to the .5 power - 1] = 2 [.03923] = .078461 = 7.95% Look Out! The bond equivalent yield will always be less than the annualyield. Example: Now if you want to convert the bond equivalent yield of a U.S. bond into an annual-pay bond the calculations are as follows: Formula 14.12 Yield on annual-pay basis = [(1 + yield on bond-equivalent basis/2) 2-1

Example: The yield of a U.S. bond quoted on a bond-equivalent basis of 8%: Answer: Yield on annual-pay basis = [(1 + 8/2 to the 2 nd power) -1] = [(1.04) to the 2nd power - 1] = .0816 = 8.16% Look

Out! The yield on an annual-pay basis is always greater than the yield on a bond-equivalent basis. This is because of compounding.

Example: Computing the Value of a Bond Using Spot Rates Suppose you have a bond that matures in 1.5 years that has a coupon rate of 8% and the spot curve is 5% for six months, 5.25% for 1 year and 5.50% for 1.5 years. Answer: Bond price = 40/ (1.05) + 40 / (1.0525) to the second power + 1040 / (1.055) to the third power. Bond Price = 38.09 + 36.12 + 931.06 Bond Price = 1005.27 This can be applied to any maturity; all you need to do is to continue theformula out to that maturity to discover the price of the bond. Example: Compute the Theoretical Treasury Spot Rate Curve Using Bootstrapping Again let's look at an example to get through this LOS. We have a six month annualized yield of 4% and similarly of the 1 year Treasury Security the rate is 4.40%. Given these two rates we can compute the 1.5 year theoretical spot rate of a zero coupon bond. For our example let's use a coupon of 6% with them selling at par. Answer: First let's get the cash flows: 0.5 year = .06 * $100 * .5 = 3.00 1.0 year = .06 * $100 * .5= 3.00 1.5 year = .06 * $100 * .5 = 3.00 +100(par value) = 103 On to the next step: 3.00/ 1.02 + 3 / (1.02) to the second power + 103 / (1 +x3) to the third power = 100 2.94+ 2.88 + 103 / (1 + X3 ) to the third power =100 103/ (1 +x3) to the third power = 94.18 (1 + x3) to the third power = 103 /94.18 Limitations of the Nominal Spread As we discussed earlier, a nominal spread is the spread between a non-treasury bond's yield and the yield to maturity on the comparable Treasury security in terms of maturity. For example, if an IBM is trading at a YTM or 6.25% and the comparable Treasury is at 5%, then the nominal spread is 125 basis points. This

spread measure takes into consideration the extra credit risk, option risk and any liquidity risk that may be associated with the non-treasury security. Even though this is a quick and dirty way to describe the yield difference, it has two drawbacks. They are: 1.For bond bonds, the yield does not take into consideration the term structure of spot rates. 2.In the case of callable/puttable bonds, expected interest-rate volatility may change the cash flows of the non- Treasury security.

Fixed Income Investments - Differentiating Between Spreads The nominal spread is simply the difference in basis points between the Treasury and non-treasury security. For example, if the Stone & Co. bonds have a yield of 5.5% and the comparable Treasury security has a yield of 4.5% the nominal spread is 100 bps. (5.5% - 4.5%). Zero-Volatility Spread or Z-spread This measures the spread the investor would capture over the entire Treasury spot- rate curve if the bond was held to maturity. The Z-spread is calculated as the spread that will make the present value of cash flows from the non-treasury security when they are discounted at the Treasury spot rates plus the Z-spread equal to the non-Treasury securities price. This is done by trial and error. This is different than the nominal spread because the nominal spread just uses one point on the curve. For example, take the spot curve and add 50 basis points to each rate on the curve. If the two year spot rate is 3%, the rate you would use to find the present value of that cash flow would be 3.50%. After you have calculated all of the present values for the cash flows, add them up and see whether they equal the bonds price. If they do, then you have found the Z-spread, if not, you have to go back to the drawing board and use a new spread until the present value of those cash flows equals the bonds price. Option-Adjusted Spread (OAS) This takes the dollar difference between the fair price and the market price and converts it into a yield measure. The OAS helps reconcile the value to market price by finding a spread that will equate the two. This is also done on a trial-and-error basis and is very model dependent.

Remember:

Interest rate volatility is critical. The higher the volatility, the lower the OAS. Check this assumption when making comparisons.

The OAS is a spread over the Treasury spot-rate curve or benchmark that is used in the analysis. As the name implies, the security's embedded option can change the cash flows and the value of the security should take this change in account. The difference between the OAS And the Z-spread is that the Z-spread doesn't take this into consideration. Option Cost This cost can be derived by calculating the difference between the OAS at the assumed interest rate or yield volatile and the Z-spread. Z-spread = OAS + option cost Therefore, Option Cost = Z-spread - OAS The option cost is measured in this way because if rates do not change, the investor would earn the Z-spread. When future rates are uncertain, the speed tends to be different because of the embedded option. The option cost for a callable bond and most MBS and ABS securities are positive. This is because the issuer's ability to alter the bond's cash flows will result in an OAS that is less than the Z-spread. For puttable bonds the option cost is negative because of the investor's ability to alter the cash flows.

Fixed Income Investments - What are Forward Rates? Forward rates can be defined as the way the market is feeling about the future movements of interest rates. They do this by extrapolating from the risk-free theoretical spot rate. For example, it is possible to calculate the one-year forward rate one year from now. Forward rates are also known as implied forward rates. To compute a bond's value using forward rates, you must first calculate this rate. After you have calculated this value, you just plug it into the formula for the prices of a bond where the interest rate or yield would be inserted. Example: An investor can purchase a one-year Treasury bill or buy a six-month bill and roll it into another six-month bill once it matures. The investor will be indifferent if they both produce the same result. An investor will know the spot rate for the six-month bill and the one-year bond, but he or she will not know the value of a six-month bill that is purchased six months from now. Given these two rates though, the forward rate on a six-month bill will be the rate that equalizes the dollar return between the two types of investments mentioned earlier. Answer: An investor buys a six-month bill for $x. At the end of six months, the value would equal: x(1 + z1) where z1 = one half of the bond equivalent yield on the six month spot rate. F= one half the forward rate (expressed as a BEY) of a six-month rate six months

from now. If he bought the six-month bill and reinvested the proceeds for another six months the dollar return would be calculated like this: X(1 +z1) (1 + F) For the one year investment the future dollars would be x(1 +z) 2 So F = (1 + z2)2/ (1 + z1) - 1 Then double F to get the BEY. Here are some numbers to try in this formula: Six-month spot rate is 0.05 = 0.025 = z1 1-year spot rate is 0.055 = 0.0275= z2 F = ( 1.0275)2/ (1.025) -1 F = .030 or .06 or 6% BEY To confirm this: X(1.025)(1.03) = 1.05575 X(1.02575)2 = 1.05575 Once you have developed the future rate curve, you can continue to run and gun in the basic bond equation using the forward rates instead of the discount rate to value the bond.

Fixed Income Investments - Forward Rates vs Spot Rates Let's say an investor buys a two-year zero-coupon bond. The proceeds will equal: X (1 + z6)6. The investor could also buy a six-month Treasury bill and reinvest the proceeds every six months for two years. In this case, the value would be: X (1 + z1)(1+ future rate at time 1)(1 + future rate at time 2)(1+ future rate at time 3) (1 + future rate at time 4) Because these two investments must be equal this tells us that: X (1 + z6)6 = X (1 + z1)(1+ future rate at time 1)(1 + future rate at time 2)(1+ future rate at time 3) So Z6 = [(1 + z1)(1+ future rate at time 1)(1 + future rate at time 2)(1+ future rate at time 3)] - 1 This equation states that the two-year spot rate depends on the current sixmonth rate and the following three six-month spot rates.

As we can see, short-term forward rates must equal spot rates or else an arbitrage opportunity can exist in the market place. Compute Spot Rates if Given Forward Rates, and Forward Rates if Given Spot Rates Computing a forward rate by using spot rates is covered above. Using spot rates, an investor can develop any forward rate. There are two elements to the forward rate. The first is when the future rate begins. The second is the length of time for that rate. The notation is length of time of the forward rate f when the forward rate began. For example, a 2 f 8 would be the 1-year (two six-month periods) forward rate beginning four years (eight six-month periods) from now. To solve for tFm use the following equation: Formula 15.13

tFm =[ (1 + Zm+t)m+t / (1 + Zm)m]

1/t

-1

So for a 3f5 it would equal an equation of: [(1 + z 8)8/ (1 + z5)5]1/3 -1 Example: Z3(the 1.5 year spot rate) = 3.5%/2 = .0175 Z5 (the 2.5 year spot rate) = 4.25%/2 = .02125 Answer: So 3f5 =[(1.02125)/ (1.0175)5]1/3 -1 S3f5 = .027916 Doubling this rate gives you a rate of 5.58%

Fixed Income Investments - Measuring Interest Rate Risk The Full Valuation Approach The full valuation approach to measuring the interest rate risk is to re-value the bond or portfolio for a given interest-rate change scenario. This rate change can be parallel or non-parallel. It is also referred to as a scenario analysis because it involves the way in which your exposure will change as a result of certain interest rate scenarios.For example, an investor may evaluate the portfolio based on an increase in rates of 50, 100 and 200 basis points. Each bond is

valued and then the total value of the portfolio is computed under the various scenarios. The Duration/Convexity Approach In contrast, the duration/convexity approach just looks at one time parallel move in interest rates using the properties of price volatility. Because the full valuation approach uses various outcomes to measure the risk of the bond or portfolio, as compared to a one time move for the duration/convexity approach, it bears that the full valuation approach is better suited to measuring interest-rate risk even though it can be very time consuming. Example: Compute the Interest-Rate Risk Exposure Let's take an option-free bond with an 8% coupon, ten-year bond with a price of 125. Yield to maturity is 7% Answer: Scenario 1 is an increase of 50bps that drives the price down to 120 (this is just an estimate). To see the percentage change you take the new price after the yield change and subtract it from the initial price after the change divided by the initial price. 120 - 125 / 125 = -.04 = a 4 % decrease in the price of the bond due to a 50 bps change Scenario 2 is an increase of 100 bps that drives the price down to 114. 114 - 125 / 125 = - .088 = an 8.8% decrease in price due to a 100 bps change. You can use this for any type of scenario concerning a change in yields.

Fixed Income Investments - Price Volatility Price Volatility for Option-free Bonds The fundamental change in price is that which causes yields to increase as price decreases and vice versa. This relationship is not linear, however, it is convex. There are four properties concerning the price volatility of an option free bond: 1. Price moves in the opposite direction of a change in yields, but the percentage change is not the same for all bonds. 2. For small changes in yields, the percentage change is roughly the same no matter what direction rates move. 3. For large changes in yields, the percentage price change is not the same for an increase in yield as it is for a decrease in yield 4. For a given large change in yield, the percentage price increase is greater than the percentage price decrease.

Although the above properties apply to percentage change they still apply to dollar changes. Properties three and four involve the convex shape of the price yield relationship. Property four states that with a long a bond, the price increase when rates decline will be greater than the price decrease when rates rise.

Positive Convexity Positive convexity is what market participants refer to the yield/price relationship of option free bonds. Price-Volatility Characteristics of Callable and Prepayable Securities The price of a callable bond will react in the same way as an option-free bond when market rates are high. This is because there is less of a chance of the bonds being called by the issuer because they probably will not be able to refinance the bonds at a lower interest rate. When rates decline, on the other hand, the price increase of a callable bond will be held to that call price because of the increased chance of the bonds being called by the issuer. Meanwhile, option-free bonds will continue to see an increase in price as rates fall. Would you pay $105, for example, for a bond that could be called at $101 as rates drop? In essence, you give $4 dollars away. It is for this same reason that bonds are unlikely to be called by issuer when the rates are low. These bonds contain negative convexity. That is, the price appreciation is less than its price decline when rates change by a large amount. The bonds will not always exhibit negative convexity; at higher rates they will exhibit positive convexity just like an option-free bond. Price Volatility Characteristics of Putable Bonds A bondholder can redeem puttable bonds on certain dates and at certain prices. The advantage of these bonds to an investor is that if market yields rise and the value of the bond falls below the put price, the investor can exercise the put option and stem his losses to the put price. This can not be done with an optionfree bond. Value of puttable bond = value of option free bond + the option. The price of a puttable bond will react same way as an option-free bond at low yield levels. As rates rise, the puttable bond's price will decrease at the same rate as an option-free bond, but the decline will be lessened because of the value of the put option.

Fixed Income Investments - Effective, Modified, and Macaulay Duration Effective Duration Duration is the approximate percentage change in price for a 100 basis point change in rates. To compute duration, you can apply the following equation that

was presented earlier in the guide. Price if yield decline - price if yield rise / 2(initial price)(change in yield in decimal) Let's make: ?y = change in yield in decimal (? = "delta") V1 = initial price V2 = price if yields decline by ? y V3 = price if yields increase by ? y Duration = V2 - V3 / 2(V1)(? y) Example: Stone & Co 9% of 10 are option free and selling at 106 to yield 8.5%. Let's change rates by 50 bps. The new price for the increase in 50 bps would be 104 and the new price for a decrease in rates would be 109. Then: Answer: Duration = 109 - 104 / 2 *(106) * (.005) Duration = 5 / 1.06 Duration = 4.717 This means that for a 100 basis point change, the approximate change would be 4.717% Price Change Given the Effective Duration and Change in Yield Once you have computed the effective duration of a bond it is easy to find the approximate price change given at change in yield. Formula 14.13

Approximate Percent Price change = - duration * change in yield * 100

Example: Using the duration for 4.717% obtained from the previous example, let's see the approximate change for a small movement in rates such as a 20 bps increase. Percentage Price Change = - 4.717 * (+0.0020) * 100 = -.943% And for a large change, a 250 bps increase: Percentage Price Change = -4.717. (+0.0250) * 100 = -11.79%

As noted before, these changes are estimates. For small changes in rates, the estimate will be almost dead on. For larger movements in rates, the estimate will be close but will underestimate the new price of the bond regardless of whether the movement in rates is up or down. Modified Duration Modified duration is the approximate percentage change in a bond's price for a 100 basis points change in yield, assuming that the bond's expected cash flow does not change when the yield changes. This works for option-free bonds such as Treasuries but not with option-embedded bonds because the cash flows may change due to a call or prepayment. Effective Duration Effective duration takes into account the way in which changes in yield will affect the expected cash flows. It takes into account both the discounting that occurs at different interest rates as well as changes in cash flows. This is a more appropriate measure for any bond with an option embedded in it. Macaulay Duration In order to better understand Macaulay duration, let's first turn to the modified duration equation: Formula 14.14

modified duration= 1/(1+yield/k)[1 * pvcf1 + 2*pvcf2 +...+n *pvcfn / k *Price

Where: k= the number of periods: two for semi-annual, 12 for monthly and so on. n= the number of periods to maturity yield=YTM of the bond pvcf= the present value of cash flows discounted at the yield to maturity. The bracket part of the equation was developed by Frederick Macaulay in 1938 and is referred to as Macaulay Duration. So Modified duration = Macaulay's Duration/ (1 + yield/k) Macaulay's duration gives the analysis a short cut to measure modified duration. But because modified duration is flawed by not incorporating the change in cash flows due to an embedded option, so are Macaulay durations. When is Effective Duration a Better Measure? When a bond has an embedded option, the cash flows can change when interest rates change because of prepayments and the exercise of calls and puts.

Effective duration takes into consideration the changes in cash flows and values that can occur from these embedded options. Why is duration the best interpretation of a measure of the sensitivity of a bond or portfolio to changing interest rates? As expressed throughout this guide, duration gives an approximate percentage change for a 100 basis point change in rates. Once you understand duration, it is a quick way to calculate the change in a bond's value. It also allows an investor to get a "feel" for the price change. For example, you can tell a client that the duration of measure of 7 for their portfolio would equal roughly a 7% change in their portfolio's value if rates change, plus or minus 100 basis points. It also allows a manager or investor a way to compare bonds regarding the interest rate risk under certain assumptions. A portfolio's duration is equal to the weighted average of the durations of the bonds in the portfolio. The weight is proportional to how much of the portfolio consists of a certain bond. Formula 14.15

Portfolio Duration = w1D1 + w2D2 ...+ wkDk

Example: Let's take 3 bonds: $6,000,000 market value of Stone & Co 7% of 10 with duration of 5.5 $3,400,000 market value of Zack Stores 5% or 15 with duration of 7.8 $1,535,000 market value of Yankee Corp. 9% or 20 with duration of 12 Total market valve of $10,935,000 Answer: First let's find the weighted average of each bond Stone & Co. weighted average is 6,000,000 / 10,935,000 = .548 Zack Stores weighted average is 3,400,000 / 10,935,000 = .311 Yankee Corp. weighted average is 1,535,000 / 10935,000 = .14 So the portfolio duration = .548(5.5) + .311(7.8) + .14 (12) = 7.119 This means that if rates change by 100 bps the portfolio's value will change by approximately by 7.119%. Keep in mind that the individual bonds will not change by this much because each will have their own duration.

You can also use this to figure out the dollar amount of the change. This is done by using the dollar duration equation and adding up the change for all of the bonds in the portfolio. Going back to our example of those three bonds and a 50 bps yield change. Percentage price change = -duration * change in yield * market value Stone & Co = -5.5 * .005 * 6,000,000 = 165,000 Zack Stores = -7.8 * .005 * 3,400,000 = 132,600 Yankee Corp = -12 * .005 * 1,535,000 = 92,100 So the dollar change for a 50 bp change would be equal to approximately $389,700 Limitations of the Portfolio Duration Measure The primary limitation of this measure is that each of the bonds in the portfolio must change by the 100 or 50bps, or there must be a parallel shift in the yield curve for the duration measure to be useful. Fixed Income Investments - Convexity Convexity helps to approximate the change in price that is not explained by duration. If you go back to the third property of a bond's price volatility you will see that when there is a large change in rates, the duration measure can be way off because of the convex nature of the yield curve. To calculate convexity the formula is: Formula 14.16

Convexity adjustment to the percentage price change= C* change in yield squared * 100

To find the C in the equation, use this equation that has the same notation as duration: C = V3 +V2 - 2(V1) / 2V1(change in yield) squared Estimate a Bond's Price Given Duration, Convexity and Change in Yield This is done by simply adding the convexity adjustment and the percentage price change due to duration equations to achieve an estimate that is closer than just a duration measure. Formula 14.17

Total Price change = (-duration * change in yield * 100) + (C * change in yield squared * 100)

Example: Total Price Change Using the Stone & Co. bonds that had duration of 5.5, let's add a convexity of 93 and an increase of 150 bps in yield. Answer: Price Increase Total Price Change = (-5.5 * .0150 * 100) + (93 * .0150 squared * 100) = -8.25 + 2.0925 = 6.157 So if rates increase by 150 bps, the price will decrease by 6.157% Now let's look at a decrease of 150 bps in yield. Answer: Price Decrease Total Price Change = (-5.5 * -.0150* 100) + (93 * -.0150 squared * 100) = 8.25 + 2.0925 = 10.34 So if rates decrease by 150 bps, the price will increase by 10.34 % Again, if you refer to the properties of price volatility, you can see that as rates decrease, the price increase will be greater than the decrease in price when rates rise. Modified Convexity vs. Effective Convexity With modified convexity the cash flows do not change due to a change in interest rates. Effective Convexity, on the other hand, assumes that cash flow does change due to a change in interest rates. When bonds have options, it is best to use effective convexity just like you should use effective duration. For option-free bonds, either convexity measure will be a positive value, whereas when it comes to bonds with options, the effective convexity could be negative even if the modified convexity is positive.

Fixed Income Investments - Price Value of a Basis Point (PVBP)

This measure is the absolute value of the change in price of a bond for a one basis point change in yield. It is another way to measure interest-rate risk. It does not matter if it is an increase or decrease in rates, because such a small move in rates will be about the same in either direction according to the second property of a bond's price . This is also know as Dollar Value of an 01 (DV01). Formula 14.18 PVBP = initial price- price if yield is changed by 1 basis point

Example: Price Value of a Basis Point Assume that the initial price is 98 and the new price is 97.75.Because of a 1 bps increase in rates the PVBP would be .25 (98 - 97.75). DV01 is related to duration. It is just a special case of dollar duration. Instead of using a 100 basis point change you are simply using a 1 basis point change. An example using the Stone & Co. bonds with duration of 5.5 5.5 * 0.0001 * 100 = .055% change If the price was 98 the dollar price change would be: .055% * 98 = $ 0.53 Conclusion Congratulations! You just finished a section on one of the more complicated topics on your upcoming exam. Ensure you practice all examples presented in this section. We also recommend attempting several different practice exams on Fixed Income with Investopedia's CFA Level 1 Quizzer.