Sixth

Edition

BOND MARKETS,
ANALYSIS, ANO
STRATEGIES

Frank J. Fabozzi, CFA

Adjunct Professor of Finance and Becton Fellow
School of Management
Yale University

PEARSON
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To the memory of two wonderful mothers
Library of Congress Cataloging-in-Publication Data
Josephine Fabozzi and Patricia Marie Hieb~r
Fabozzi, Frank J.
Bond markets, analysis and strategies 1 Frank J. Fabozzi.-6th ed.
p. cm.
ISBN 0-13-198643-0
1. Bonds. 2. Investment analysis. 3. Portfolio management. 4. Bond market.
L Title.

HG4651.F28 2006
332.63'23-dc22
2006041617

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10987654
ISBN: 0-13-198643-0
Brief Contents

Preface XV
Chapter 1 Introduction 1
Chapter2 Pricing of Bonds 13
Chapter 3 Measuring Yield 34
Chapter4 Bond Price Volatility 58
Chapter 5 Factors Affecting Bond Yields and the Term Structure of
Interest Rates 94
Chapter6 Treasury and Agency Securities Markets 127
Chapter7 Corporate Debt Instruments 155
Chapter8 Municipal Securities 187
Chapter 9 Non-U.S. Bonds 206
Chapter 10 Residen tia! Mortgage Loans 225
Chapter 11 Mortgage Pass-Through Securities 243
Chapter 12 Collateralized Mortgage Obligations and Stripped
Mortgage-Backed Securities 273
Chapter13 Commercial Mortgage-Backed Securities 304
Chapter 14 Asset-Backed Securities 328
Chapter 15 Collateralized Debt Obligations 348
Chapter 16 Interest-Rate Models 362
Chapter 17 Analysis of Bonds with Embedded Options 377
Chapter 18 Analysis of Residen tia! Mortgage-Backed
Securities 407
Chapter 19 Analysis of Convertible Bonds 432
Chapter20 Corporate Bond Credit Analysis 444
Chapter21 Credit Risk Modeling 493
Chapter22 Active Bond Portfolio Management Strategies 510
Chapter23 Indexing 550
Chapter24 Liability Funding Strategies 560
Chapter25 Bond Performance Measurement and Evaluation 592
Chapter26 Interest-Rate Futures Contracts 609
Chapter27 Interest-Rate Options 640
Chapter28 Interest-Rate Swaps and Agreements 683
Chapter29 Credit Derivatives 719
Index 741
Contents

Preface xv
CHAPTER 1 Introduction 1
Sectors of the U.S. Bond Market 2
Overview of Bond Features 3
Risks Associated with Investing in Bonds 6
Secondary Market for Bonds 9
Financia! Innovation and the Bond Market 10
Overview of the Book 11

CHAPTER 2 Pricing of Bonds 13

Review ofTime Va!ue of Money 13
Pricing a Bond 20
Complications 28
Pricing Floating-Rate and Inverse-Floating-Rate
Securities 29
Price Quotes and Accrued Interest 31
Summary 32

CHAPTER 3 Measuring Yield 34

Computing the Yield or Interna! Rate of Return on Any
Investment 35
Conventional Yield Measures 38
Potentia! Sources of a Bond's Dollar Return 46
Total Return 49
Applications of the Total Return
(Horizon Analysis) 54
Caiculating Yield Changes 54
Summary 55
 CONTENTS ix
viii CONTENTS
CHAPTER 4 Bond Price Volatility 58 CHAPTER 8 Municipal Securities 187
Review of the Price-Yield Relationship for Types and Features of Municipal
Optlon-Free Bonds 59 Securities 188
Price Volatility Characteristics of Municipal Money Market Products 195
Option-Free Bonds 60 Municipal Derivative Securities 196
Measures of Bond Price Volatility 62 Credit Risk 199
Convexity 73 Risks Associated with Investing in Municipal
Additional Concerns When Using Duration 83 Securities 200
Don't Thlnk of Duration as a Measure Yields on Municipal Bonds 201
ofTime 83 Municipal Bond Market 202
Approximating a Bond's Duration and Convexity The Taxable Municipal Bond Market 203
Measure 84 Summary 204
Measuring a Bond Portfolio's Responsiveness
to Nonparallel Changes in Interest CHAPTER 9 Non-U.S. Bonds 206
Rates 86 Classification of Global Bond Markets 207
Summary 89 Foreign Exchange Risk and Bond Returns 209
Eurobond Market 210
CHAPTER 5 Factors Affecting Bond Yields and the Term
Strncture of Interest Rates 94 Non-U.S. Government Bond Markets 214
Base Interest Rate 95 The Pfandbriefe Market 221
Risk Premium 96 Emerging Market Bonds 221
Term Structure of Interest Rates 101 Summary 222
Summary 122
CHAPTER 10 Residential Mortgage Loans 225
CHAPTER 6 Treasury and Agency Securities What Is a Mortgage? 226
Markets 127 Participants in the Mortgage Market 226
Treasury Securities 127 Alternative Mortgage Instruments 229
Stripped Treasury Securities 146 Nonconforming Mortgages 235
Federal Agency Securities 147 Risks Associated with Investing in Mortgages 236
Summary 153 Surnmary 241

CHAPTER 7 Corporate Debt Instruments 155 CHAPTER 11 Mortgage Pass-Through Securities 243
Corporate Bonds 156 Cash F1ow Characteristics 244
Medium-Term Notes 174 WACandWAM 244
Commercial Paper 177 Agency Pass-Throughs 245
Bankrnptcy aud Creditor Rights 182 N onagency Pass-Throughs 246
Summary 184 Prepayment Conventions and Cash Flow 248
 CONTENTS XÍ
CONTENTS
Empírica! Evidence on Interest-Rate Changes 369
Factors Affecting Prepayments and
Prepayment Modeling 256 Selecting an Interest-Rate Model 371
Cash Flow for Nonagency Pass-Throughs 263 Estimating Interest-Rate Volatility Using
Historical Data 372
Cash Flow Yield 265
267 Summary 375
Prepayment Risk and Asset/Liability Management
Secondary Market Trading 269 CHAPTER 17 Analysis of Bonds witb Embedded
Summary 270 Options 377
Drawbacks ofTraditional Yield Spread Analysis 378
CHAPTER 12 Collateralized Mortgage Obligations and
Stripped Mortgage-Backed Securities 273 Static Spread: An Alternati ve to Yield Spread 378
Collateralized Mortgage Obligations 274 Callable Bonds and Their Investment
298 Characteristics 383
Stripped Mortgage-Backed Securities
Components of a Bond with an Embedded
Summary 300 Option 386
CHAPTER 13 Commercial Mortgage-Backed Valuation Model 387
Securities 304 Option-Adjusted Spread 400
Commercial Mortgage Loans 305 Effective Duration and Convexity 401
Commercial Mortgage-Backed Securities 307 Summary 403
Summary 326
CHAPTER 18 Analysis of Residential Mortgage-Backed
CHAPTER 14 Asset-Backed Securities 328 Secnrities 407
Creation of an ABS 329 Sta tic Cash Flow Yield Methodology 408
Ca !lateral Type and Securitization Structure 337 Monte Cario Simulation Methodology 417
Credit Risks Associated with Investing in ABS 338 Total Return Analysis 427
Review of Severa! Majar Types of ABS 341 Summary 428
Summary 345
CHAPTER 19 Analysis of Convertible Bonds 432
CHAPTER 15 Collateralized Debt Obligations 348
Convertible Bond Provisions 432
Structure of a CDO 349 Mínimum Value of a Convertible Bond 434
Arbitrage Transactions 350 Market Conversion Price 435
Cash FlowTransactions 353 Current Income of Convertible Bond
Market Value Transactions 356 Versus Stock 436
Synthetic CDOs 358 Downside Risk with a Convertible Bond 437
Summary 359 Investment Characteristics of a Convertible Bond 438
Pros and Cons of Investing in a Convertible Bond 438
CHAPTER 16 Interest-Rate Models 362
Types of Investors in Convertible Bonds 440
Mathematical Description of One-Factor Interest-Rate
Options Approach 441
Models 363
Arbitrage-Free Versus Equilibrium Models 366 Summary 442