Fixed Income 2

Surendra Poddar CFA,FRM

Explain the sources of return from investing in a bond
Coupon interest payments
Capital gain or loss
Income from reinvestment of interim cash
flows
Refer illustration spreadsheet
Explain the importance of reinvestment income and
factors affecting reinvestment income
For given yield , and coupon rate, the
longer the maturity , greater the
reinvestment risk.
For given maturity and given yield, higher
the coupon rate ,higher the reinvestment
income.
Refer illustration spreadsheet.
Compute and interpret traditional yield measures for
fixed rate bonds and explain their limitations and
assumptions
Current Yield = Annual Dollar coupon interest
Price
Yield to maturity
Yield to call
Yield to put
Cash Flow yield = 2 X Effective Semiannual yield
Refer spreadsheet for illustration
Compute and interpret the bond equivalent yield of
an annual pay bond and annual pay yield of a
semiannual pay bond
Refer illustration spreadsheet.
Describe the methodology for computing Treasury
spot rate curve and compute the value of bond using
spot rates
The theoretical spot rates for treasury securities represent the
appropriate set of interest rates used to value default free cash
flows.
A default free spot rate curve can be constructed from observed
Treasury yield curve using bootstrapping.
Bootstrapping begins with the yield for on the run Treasury
issues (no credit and liquidity risk).
For maturities for which on the run Treasury yields are not
available, treasury yields are estimated using interpolation.
Basic principle for bootstrapping is that the value of treasury
coupon security should be equal to the value of the package of
zero coupon treasury securities that duplicates the coupon
bonds cash flows.
Refer spreadsheet and classroom illustration.
Differentiate between nominal spread, zero-volatility
spread and option adjusted spread
Issue Coupo Price Yield
n to
Maturi
ty
Treasur 6% 100.00 6.00%
y
Non- 8% 104.19 7.40%
treasur
y

Nominal Spread is
140 basis points.
Nominal Spread
It measures the compensation for the
additional credit risk, option risk, and liquidity
risk an investor is exposed to by investing in a
non treasury security rather than a treasury
security with the same maturity.
Drawbacks
For both bonds, yield fails to take into
consideration the term structure of spot rates
In case of bonds with embedded options ,
expected interest rate volatility may alter the
cash flows of the non-Treasury bond
Zero Volatility Spread (Z Spread)
Measure of the spread that the investor would
realize over the entire Treasury spot rate
curve if the bond is held till maturity.
The nominal spread is a spread off one point
on the Treasury yield curve while the Z spread
is spread over the entire theoretical Treasury
spot curve.
Divergence between Z spread and Nominal
Spread
Divergence is dependent on
Shape of the term structure of interest rates
( steeper the spot curve , larger the
divergence)
Characteristics of the security ( coupon rate,
time to maturity, non-amortizing versus
amortizing). Larger divergence for amortizing
securities.
 Z spread relative to any benchmark
When the benchmark is the spot rate curve
for the issuer, the Z spread measures the
liquidity risk of the issue and any option risk.
Option adjusted spreads
OAS removes from the Z spread , the spread that is due to
option risk.
OAS spread is model dependent. Higher the interest rate
volatility assumed, lower the OAS.
OAS is the spread over treasury spot curve or issuers
benchmark. The spot rate curve is a result of assumptions that
allow for changes in interest rates.
Z spread = OAS + option cost.
Option cost is the difference between the spread that would be
earned in a static interest rate environment (Z spread) and the
spread after adjusting for options.
For callable bonds and most MBS and ABS , option cost is
positive.
For putable bonds option cost is negative.
Explain a forward rate and compute spot rates from
forward rates and forward rates from spot rates
Forward rates are markets consensus of future rates.
There are two elements to the forward rate. First is when in
the future the rate begins and second is the length of time
for the rate.
A tfm , t is the length of time that rate applies, m is when
the forward rate begins.
1f12 is one period forward rate beginning 12 periods from
now
8f10 is 8 period forward rate beginning 10 periods from now.
Refer spreadsheet for illustrations.
 Introduction to
measurement of Interest
rate risk
Distinguish between full valuation approach and
duration/convexity approach for measuring interest
rate risk
Demonstrate the price volatility characteristics for
option free, callable, prepayable and putable bonds
when interest rates change