CFA1 FI 2024 0501 Note

Student’s notes
Student’s notes
MODULE 1: FIXED-INCOME
INSTRUMENT FEATURES
INSTRUMENT FEATURES
2 Student’s notes
LEARNING OUTCOMES
1.a. Describe the features of a fixed-income security
1.b. Describe the contents of a bond indenture and contrast affirmative

and negative covenants
INSTRUMENT FEATURES
3 Student’s notes
[LOS 1.a] Describe the features of a fixed-income security
1. Introduction for fixed-income securities
Fixed-income securities allow governments, companies, and other issuers to

borrow from investors, promising future interest payments and the return of
principal, which are contractual (legal) obligations of the issuer.
The most common type of fixed-income security is a bond that promises to

make a series of interest payments in fixed amounts and to repay the
principal amount at maturity.
In comparision with equity, fixed-income security has some characteristics:
Fixed-income security Equity

Ownership rights No Yes
Priority of claim Higher Lower
Risk Lower Higher
INSTRUMENT FEATURES
4 Student’s notes
2. Overview of a Fixed-Income Security
A bond is a contractual agreement between the issuer and the bondholders
Three important elements that an investor needs to know about when

considering a fixed-income security are:
3. The bond’s features

(LOS 1.a)
Assign bond … Time

agreement
The contingency provisions that may affect

the bond’s scheduled cash flows
(LOS 1.b)
The legal, regulatory, and tax considerations (LOS 2.b)
Note: In this section, we focus on “traditional” or “non-securitized” bonds.

INSTRUMENT FEATURES
5 Student’s notes
3.1
Issuer
3.6
Contingency 3.2
provisions Maturity
The bond’s
features
3.3
3.5
Par value
Seniority
3.4
Coupon Rate
and Frequency
INSTRUMENT FEATURES
6 Student’s notes
3.1. Issuer
Issued by organizations that operate globally

Supranational such as the World Bank, the European
organizations Investment Bank, and the International
Monetary Fund (IMF).
The
government Sovereign United States gov, Japan gov,…
and (national) They usually represent the lowest risk and most
government- governments secure bonds in each market.
related Non-sovereign The State of Minnesota in the United States, the
sector (local) City of Edmonton in Alberta, Canada,..
governments
Quasi- Agencies that are owned or sponsored by
government governments (for example: postal services in
entities many countries,…)
The Often corporate bonds are divided into those
corporate Corporations issued by financial or non-financial
sector corporations.
The These are corporations set up to purchase
structured Special legal financial assets and issue asset-backed
finance entities securities, which are bonds backed by the cash
sector flows from those assets.
INSTRUMENT FEATURES
7 Student’s notes
3.2. Maturity
The maturity date of a bond refers to the date when the issuer is obligated
to redeem the bond by paying the outstanding principal amount
The tenor is the time remaining until the bond’s maturity date, it is an
important consideration in analyzing a bond’s risk and return (*)
Time remaining – Tenor

Assigned
bond …
agreement Time
Today The maturity date of a bond
(*) It indicates the period over which the bondholder can expect to receive
interest payments and the length of time until the principal is repaid in full.
INSTRUMENT FEATURES
8 Student’s notes
3.2. Maturity
Maturities typically range from overnight to 30 years or longer
Fixed-income securities, which, at the time of

issuance, are expected to mature in 1 year or less Money market
Example: commercial paper (CP) and certificates of securities
deposits, CDs,...
Fixed-income securities, which, at the time of

Capital market
issuance, are expected to mature in more than 1
securities
year
Fixed-income securities, which have no stated

Perpetual
maturity date, although very rare.
bonds
Example: issued by the U.K. government.
INSTRUMENT FEATURES
9 Student’s notes
3.3. Par value
Principal of a bond is the amount that the issuer agrees to repay the
bondholders on the maturity date. This amount refer to the par value, or
simply par, face value, nominal value, redemption value, or maturity value.
Bond prices are quoted as a percentage of their par value
Example:
A bond’s par value is $1,000. A quote of 95 means that the bond price is
$950 (95% × 1000).
The bond is trading at a

Bond’s price > par value
premium
Bond’s price = par value The bond is trading at par
Bond’s price < par value The bond is trading at a discount

INSTRUMENT FEATURES
10 Student’s notes
3.4. Coupon Rate and Frequency
The coupon rate or nominal rate of a bond is the interest rate that the issuer
agrees to pay each year until the maturity date.
The annual amount of interest payments made is called the coupon:

Coupon = Par value × Coupon rate
3.4.1. Frequency
Coupon interest payments of bonds are flexible, some bonds make annually,
semiannual, quarterly, or monthly payments.
Example:
If a bond has a coupon rate of 6% and a par value of $1,000, the periodic
interest payments will be $60 if coupon payments are made annually, $30 if
they are made semi-annually, $15 if they are made quarterly, and $5 if they
are made monthly.
INSTRUMENT FEATURES
3.4. Coupon Rate and Frequency
3.4.2. Coupon rate

Floating-rate notes (FRNs) or Plain vanilla bond or
floaters conventional bond
Pay a floating rate of interest Pay a fixed rate of interest
Zero-coupon, or pure discount bonds
Pay no interest prior to maturity

These bonds are sold at a discount to their par value and the interest is all
paid at maturity when bondholders receive the par value.
→ The interest earned on a zero-coupon bond is implied and equal to the
difference between the par value and the purchase price.
For example: A 10-year, $1,000, zero-coupon bond is purchased price is $950,
the implied interest is $50.
INSTRUMENT FEATURES
3.5. Seniority
A debt issue’s seniority or priority of repayment among all issuer obligations

is an important determinant of risk.
Senior secured debts

Priority of claim
Subordinated secured debt Senior debt has a

priority claim over
subordinated debt
Senior unsecured debts
or junior debt.
…
Subordinated unsecured
debt
INSTRUMENT FEATURES
3.6. Contingency Provisions

A contingency provision allows for some action given the occurrence of a
specified event in the future. Common contingency provisions found in a
bond's indenture come under the heading of embedded options*.
(*) Embedded options

The right, but not the obligation, to take some action are called “options”.
These options are not independent of the bond and cannot be traded
separately—hence the term “embedded”.
Some common types of bonds with embedded options include:
1. Callable bonds
2. Putable bonds
3. Convertible bonds
INSTRUMENT FEATURES
3.7. Yield Measures
Current yield Simple yield
Annual cash coupon payment Annual cash coupon payment + gain/loss (∗)
Bond price Bond price
(*) A bond’s simple yield takes a discount or premium into account by

assuming that any discount or premium declines evenly over the remaining
years to maturity.
Gain/loss = the straight-line amortization of a discount/premium
Example 10: Calculate the current yield and simple yield
A 3-year, 8% coupon, semiannual-pay bond is priced at 90.165.
Calculate the current and simple yield at the end of the first year.
Answer:
Annual cash coupon payment 8
Current yield = Bond price = 90.165 = 8.87%
The discount from par value is 100 – 90.165 = 9.835.
Gain = annual straight-line amortization of the discount is 9.835/3 = 3.278.
Annual cash coupon payment + gain/loss 8 + 3.278
Simple yield = Bond price = 90.165 =
12.51%
INSTRUMENT FEATURES
3.7. Yield Measures
Today Future cash flows
A given To equate to the given current price,

current price we must discount at YTM = ?
The yield-to-maturity (YTM) is the (uniform) interest rate that equates

the sum of the present values of the bond’s expected future cash flows
(when discount at that rate) to its current price.
PMT PMT PMT + Par
Current price of bond = + +...+
1
(1+YTM) (1+YTM)2 (1+YTM)n
The yield-to-maturity is the rate of return on the bond to an investor given

three critical assumptions:
• The investor holds the bond to maturity.
• The issuer makes all the coupon and principal payments in the full
amount on the scheduled dates
• The investor is able to reinvest coupon payments at that same yield.
This is a characteristic of an internal rate of return (IRR).
INSTRUMENT FEATURES
Example 3: Calculate the yield-to-maturity

1. Compute the YTM for a 10-year, $1,000 par bond that pays an 8%
annual coupon given that its current price is $925.
2. Compute the YTM of a 10-year, $1,000 par bond with an 8% coupon
rate that makes semiannual coupon payments given that its current price
is $925.
Answer:
1. Current price = $925, coupon payment = $1,000 × 8% = $80
80 80 80 + 1,000
925 = + +...+ → YTM = 9.18%
(1 + YTM)1 (1 + YTM)2 (1+YTM)10
(FV = -$1,000; PMT = -$80; N = 10; PV = $925, CPT → I/Y = 9.18)
2. Current price = $925, coupon payment = $1,000 × 8%/2 = $40
40 40 40 + 1,000
925 =
(1 + YTM)
+
1 (1 + YTM)2
+...+
(1 + YTM)20 → YTM = 9.16%
2 2 2
(FV = -$1,000; PMT = -$40; N = 20; PV = $925, CPT → I/Y = 4.58
→ YTM = 4.58 × 2 = 9.16)
INSTRUMENT FEATURES
3.8. Yield curves
A yield curve for coupon bonds shows the YTMs for coupon bonds at
various maturities.
YTM (%)
3
2.5
2
1.5
1
0.5
0 5 10 15 20 25 30
Time to maturity (Years)
A yield curve for coupon bonds
The bonds with longer maturities have higher YTMs

→ Investors are demanding higher expected returns to compensate for
higher risk associated with longer-maturity bonds of the same issuer.
INSTRUMENT FEATURES
Par value Issuer Currency
Issue date Maturity date Coupon Maturity

INSTRUMENT FEATURES
[LOS 1.b] Describe the contents of a bond indenture

and contrast affirmative
The trust deed is the legal contract that describes the form of the bond, the
obligations of the issuer, and the rights of the bondholders.
This legal contract is often referred to as the bond indenture
The indenture references both the issuer and the features of the bond issue
Basic features Further features
The principal value of the bond 1. Bond issuer

2. Funding sources for the interest
The coupon rate
payments and principal repayments
Dates when the interest payments 3. Collaterals
will be made
Covenants
The maturity date
Refer to LOS 1.a Will be detailed following

INSTRUMENT FEATURES

1. Legal Identity of the Bond Issuer and Its Legal Form
The bond indenture identifies the party that is obligated to make principal
and interest payments by its legal name.
The legal issuer is typically the institution responsible for

managing the national budget (the treasury of the issuing
Sovereign
country).
bonds
Example: Her Majesty's Treasury in the U.K, Viet Nam state
treasury,...
• The issuer is usually the corporate legal entity

• Bonds may be issued by the parent company or a subsidiary.
Corporate
→ Bondholders must consider the credit quality of the
bonds
specific entity issuing the bond (oftentimes, subsidiaries
carry a lower credit rating than the parent).
SPE is an entity is created solely for the purpose of owning

Special specific assets that supporting for issuing bonds in the
purpose securitization process → bankruptcy remoteness: the
entities payments to the holders of securitized bonds are sourced
(SPEs) from the cash flows from the assets owned by SPE even if the
company itself runs into financial trouble.
INSTRUMENT FEATURES

2. Source of Repayment Proceeds
The bond indenture usually specifies how the issuer plans to make debt
service payments (interest and principal).
2.1. Supranational bond
Bonds issued by supranational organizations are usually repaid through:

(1) Proceeds from repayments of previous loans made by these
organizations
(2) Paid-in capital from its members
Repayments
cash flows (1)
The Repayments
Supranational Supranational
borrowing
organizations bond holders
countries Loans
Paid-in
capital (2)
Members
INSTRUMENT FEATURES

2.2. Sovereign bond
Sovereign bonds are typically repaid by the tax receipts of the issuing
country.
Sovereign bonds are backed by the “full faith and credit” of the national
Government.
National governments have unique powers to ensure the ability to repay debt
Example: the authority to tax economic activity, print money,…
Sovereign bonds denominated in lower yields on sovereign bonds

local currency are considered the than for similar bonds from other
safest of all investments. local issuers
Government yields are often used as a “risk-free rate” for time value of
money calculations as well as a benchmark reference rate for pricing fixed-
income securities.
INSTRUMENT FEATURES

2.3. Non-sovereign bond

There are three major sources for repayment of non-sovereign bonds:
• The general taxing authority of the issuer
• Cash flows from the project that the bonds were issued to finance
• Special taxes or fees specifically set up to make interest and principal
payments
2.4. Corporate bond
The source of payment for corporate bonds is the issuer’s ability to generate
cash flows, primarily through its operations.
These cash flows depend on the issuer’s financial strength and integrity
Corporate bonds typically entail a higher level of credit risk than sovereign
bonds, and therefore carry a higher yield.
INSTRUMENT FEATURES

3. Asset or Collateral Backing
Collateral backing is a way to alleviate credit risk

Assets pledged as collateral and financial guarantees secure a bond issue
beyond the issuer's simple promise to pay
Investors should consider:
3.1. Seniority Ranking 3.2. Types of Collateral Backing

How the specific bonds they own The quality of the collateral
rank in the priority of claims in the backing the bond issue
event of default
INSTRUMENT FEATURES

3.1. Seniority Ranking
a. Secured bonds and unsecured bonds
Secured bonds are backed by assets Unsecured bonds are not protected
or financial guarantees pledged to by a pledge of any specific assets;
ensure debt repayment in the case bondholders have only a general
of default. claim on the issuer’s assets and
cash flows.
Unsecured bonds are paid after secured bonds in the event of default
Unsecured bonds are more risky, entailing a higher yield.
A bond’s collateral backing might not specify an identifiable asset but

instead may be described as the “general plant and infrastructure” of the
issuer → Investors rely on seniority ranking (Los 1.a).
INSTRUMENT FEATURES

b. Senior ranking
Seniority ranking is the systematic way in which lenders are repaid in case of
bankruptcy or liquidation
Senior secured debts

Priority of claim
Subordinated secured debt Senior debt has a

priority claim over
subordinated debt
Senior unsecured debts
or junior debt.
…
Subordinated unsecured
debt
INSTRUMENT FEATURES

c. Debentures – A type of bond
In many jurisdictions In the United Kingdom and other

Debentures are an unsecured Commonwealth Countries
loan, with no collateral backing Debentures are usually backed by
assigned to the bondholders an asset or pool of assets assigned
as collateral
Support for the bond obligations

and segregated from other
creditor claims
It is important for investors to review the indenture to determine whether a

debenture is secured or unsecured
INSTRUMENT FEATURES

3.2. Types of Collateral Backing

a. Collateral trust bonds are b. Equipment trust certificates are
secured by securities such as secured by specific types of
common stock, other bonds, or equipment or physical assets (e.g.,
other financial assets. aircraft, railroad cars, or oil rigs).
c. Mortgage-backed securities d. Covered bonds are backed by a

(MBS) are backed by a pool of segregated pool of assets (known
mortgage loans. Cash flows as the cover pool). (**)
generated by the pool are used to
make payments on MBS. (*)
(*) Refer to Module 19 – Mortgage-Backed Security (MBS) Instrument and

Market Features
(**) Refer to Module 18 – Asset-Backed Security (ABS) Instrument and
Market Features
INSTRUMENT FEATURES

4. Bond Covenants
Bond covenants are legally enforceable rules that borrowers and lenders
agree on at the time of a new bond issue.
4.1. Affirmative covernants (Positive covernants)
• Affirmative covenants are requirements placed on the issuer.

• Affirmative covenants are typically administrative in nature.
Do not lead to additional costs for the issuer, nor do they significantly
restrict the issuer's ability to make business decisions
Examples: Affirmative covenants include promises to:

• Make timely payments to bondholders,
• Comply with all laws and regulations,
• Maintain the issuer's current lines of business,
• Insure and maintain assets,
• Pay taxes.
INSTRUMENT FEATURES

4.2. Negative covenants
• Negative covenants are restrictions placed on the issuer.

• Negative covenants are frequently costly and materially constrain the
issuer’s potential business decisions.
Negative covenants ensure that the issuer will not take any actions that
would significantly reduce its ability to make interest payments and repay
the principal.
They protect bondholders from the dilution of their claims, asset

withdrawals or substitutions, and suboptimal investments by the issuer.
Restrictive covenants may not be in the bondholders’ best interest if they

force the issuer to default when default is avoidable
INSTRUMENT FEATURES

a. Restrictions on debt
b. Negative pledges
Negative covenants
c. Restrictions on prior claims
d. Restrictions on distributions to shareholders
e. Restrictions on asset disposals
f. Restrictions on investments
g. Restrictions on mergers and acquisitions

INSTRUMENT FEATURES

a. Restrictions on debt
Restrictions on debt regulate the issue of additional debt
Permitting new debt to be issued only when justified by the issuer’s financial
condition
Maximum acceptable
debt usage ratios
Specifying
Minimum acceptable
interest coverage ratios
b. Negative pledges
Negative pledges prevent the issuance of debt that would be senior to or
rank in priority ahead of the existing bondholders’ debt.
INSTRUMENT FEATURES

c. Restrictions on prior claims
Restrictions on prior claims protect unsecured bondholders by preventing

the issuer from using assets that are not collateralized to become
collateralized.
d. Restrictions on distributions to shareholders
Restrictions on distributions to shareholders restrict dividends and other

payments to shareholders, such as share buybacks (repurchases)
The covenant sets:

• A base date, usually at or near the time of the issue
• Limiting dividends
• Share buybacks to a percentage of earnings or cumulative earnings after
that date.
INSTRUMENT FEATURES

e. Restrictions on asset disposals
Restrictions on asset disposals limit the amount of assets that can be

disposed by the issuer during the bond’s life.
Preventing a break-up of the company
f. Restrictions on investments
Restrictions on investments constrain risky investments by blocking

speculative investments and ensuring an issuer devotes its capital to its
going-concern business.
g. Restrictions on mergers and acquisitions
Restrictions on mergers and acquisitions ensure that if the issuing company

is sold, the surviving company or the acquirer takes responsibility for debt
service payments.
Student’s notes
MODULE 2: FIXED-INCOME CASH

FLOWS AND TYPES
CASH FLOWS AND TYPES
LEARNING OUTCOMES
2.a. Describe common cash flow structures of fixed-income instruments

and contrast cash flow contingency provisions that benefit issuers
and investors
2.b. Describe how legal, regulatory, and tax considerations affect the
issuance and trading of fixed-income securities
[LOS 2.a] Describe common cash flow structures of fixed-income

instruments and contrast cash flow contingency provisions that
benefit issuers and investors
1. Principal repayment structures
How the bond issuer repays the amount borrowed is important to investors,
as it affects the level of credit risk faced by them
Credit risk is reduced if there are any provisions that periodically retires
some of the principal amount outstanding
1.1. Bullet, Fully Amortized, and Partially Amortized Bonds
1.2. Sinking Fund Arrangements


instruments and contrast cash flow contingency provisions
1.1. Bullet Bonds and Amortized Bonds
A bullet bond is one that only makes periodic interest payments, with the
entire principal amount paid back at maturity
Interest
Par
1 2 3 4 5 payment
t=0 Principal
No principal is paid until payment
maturity
An amortizing bond is one that makes periodic interest and principal

payments over the term of the bond.
A bond may be fully or partially amortized until maturity:
1.1.1. Fully amortized bond
1.1.2. Partially amortized bond



1.1.1. Fully amortized bond is characterized by a fixed periodic payment
schedule that reduces the bond’s outstanding principal amount to zero by
the maturity date
The bond’s outstanding
Par principal amount is
1 2 3 4 5 reduced to zero by the
t=0 maturity date.
1.1.2. Partially amortized bond makes fixed periodic payments until

maturity, but only a portion of the principal is repaid by the maturity date.
Only a portion of the

Par principal is repaid by the
1 2 3 4 5
t=0 maturity date.
Balloon
payment

Illustration for fully amortized bond and partially amortized bond

For the three bonds, the principal amount is $1,000, the maturity is five
years, the coupon rate is 6%, and interest payments are made annually. The
market interest rate used to discount the bonds’ expected cash flows until
maturity is assumed to be constant at 6%. The bonds are issued and
redeemed at par. For the partially amortized bond, the balloon payment is
$200 at maturity.
(continue in the next slide)


Illustration for Bullet Bonds and Amortized Bonds

Payment schedule for Bullet Bond
• Coupon payment = 6% x 1,000 = $60
• Last payment = Coupon + Bullet par repayment = 60 + 1,000 = $1,060
Investor Outstanding
Interest Principal
Year cash Principal at the
payment repayment
flows End of the Year
0 -$1,000 - - $1,000
1 $60 $60 $0 $1,000
2 $60 $60 $0 $1,000
3 $60 $60 $0 $1,000
4 $60 $60 $0 $1,000
5 $1,060 $60 $1,000 $0



Payment schedule for Fully Amortized Bond
•1 The annual payment is constant so it can be viewed as an annuity, and
calculated as: N = 5; PV = -$1,000; I/Y = 6; FV = 0; CPT PMT; Annual PMT =
$237.40
•2 Interest component of Year 2 payment = Coupon rate x Outstanding
principle = 0.06 x 822.60 = $49.36
•3 Principal repayment component of Year 2 payment = 237.40 - 49.36 =
$188.04
Investor cash Interest Principal Outstanding Principal
Year
flows payment repayment at the End of the Year
0 -$1,000 - - -
1 $237.40 $60 $177.40 $822.60
2 $237.40 2 $49.36 3 $188.04 $634.56
3 1 $237.40 $38.07 $199.32 $435.24
4 $237.40 $26.11 $211.28 $223.96
5 $237.40 $13.44 $223.96 $0


Payment schedule for Fully Amortized Bond
Comment: the annual payment is constant, but over time the interest
payment decreases (as the outstanding principal amount decreases each
year) and the principal repayment increases.
Par
1 2 3 4 5
t=0 $60 $49.36 $38.07 $26.11 $13.44
$177.40 $188.04 $199.32 $211.28 $223.96



Payment schedule for Partially Amortized Bond
This bond can be viewed as a combination of (1) a 5-year annuity (X) and (2)
a bullet payment at maturity. The sum of the present values of these two
elements is equal to the bond price of $ 1,000.
X X X X $200 + X
0 1 2 3 4 5
Timeline of payment
The PV of bullet payment is calculated as:

N = 5; FV = $200; I/Y = 6; PMT = 0; CPT PV → PV = $149.45
Therefore, PV of 5-year annuity is calculated as: 1,000 – 149.45 = $850.55

1• The annuity payment can be calculated as:
N = 5; PV = $850.55; I/Y = 6 ; FV = 0; CPT PMT → X = $201.92
Interest component of Year 2 payment = 0.06 x 858.08 = $51.48
Principal repayment component of Year 2 payment = 201.92 - 51.48 = $150.43
2• Investor’s cash flows at maturity year:
200 (balloon payment) + 201.92 = $401.92
Note: The methods applied to calculate interest rate and remaining principal
is similar to fully amortized bond

Illustraion for fully amortized bond and partially amortized bond

Investor Interest Principal Outstanding Principal
Year
cash flows payment repayment at the End of the Year
0 -$1,000 - - $1,000
1 $201.92 $60 $141.92 $858.08
2 $201.92 $51.48 $150.43 $707.65

1
3 $201.92 $42.46 $159.46 $548.19
4 $201.92 $32.89 $169.03 $379.17

5 $401.92 2 $22.75 $379.17 $0
Comment: the annual payment is constant, but over time the interest
payment decreases and the principal repayment increases. Since the
principal amount is not fully amortized, interest payments are higher for the
partially amortized bond than for the fully amortized bond except for Year 1
(when they are equal).


Par
1 2 3 4 5
t=0 $60 $51.48 $42.46 $32.89 $22.75
$141.92 $150.43 $159.46 $169.03 $179.17

Balloon
$200 payment

A sinking fund arrangement requires the issuer to repay a specified portion

of the principal amount every year throughout the bond's life or after a
specified date.
This repayment occurs whether or not an actual segregated cash reserve has
been created.
Example: a $10 million issue with a term of 5 years could require the issuer
to redeem bonds worth $2 million par each year. Coupon rate is 10%.
Principal
$10 mil
Annual
$8 mil coupon
$6 mil
$4 mil
$2 mil
$1 mil $0.8 mil $0.6 mil $0.4 mil $0 mil
$0.2 mil
0 1 2 3 4 5

Another type of sinking fund arrangement operates by redeeming a steadily

increasing amount of the bond’s notional principal (total amount) each year
Example: a $15 million issue with a term of 5 years and Coupon rate is 10%.
It requires the issuer to redeem bonds
Year 1: $1 mil Year 2: $2 mil Year 3: $3 mil
Year 4: $4 mil Year 5: $5 mil
Principal
$15 mil
Annual
$14 mil coupon
$12 mil
$9 mil
$5 mil
$1.5 mil
$1.4 mil $1.2 mil $0.9 mil $0.5 mil $0 mil
0 1 2 3 4 5


Sinking fund arrangements have several benefits and drawbacks
Benefits Drawbacks
• Ensures a formal plan exists for • Reinvestment risk, which is the

debt retirement. risk associated with having to
• Reduces credit risk due to a reinvest cash flows at an interest
reduction of default risk at rate below the current yield-to-
maturity. maturity.
• If the issue has an embedded call
option, the issuer may be able to
repurchase bonds at a price
lower than the current market
price, resulting in bondholders
losing out.

1.3. Waterfall structure

The bond classes differ as to how they will share any losses resulting from
defaults of the borrowers whose loans are in the collateral
→ Ordering the claim priorities for interest in an asset between the tranches
→ “Waterfall” structure
The most senior tranche is unaffected unless losses
exceed the amount of the subordinated tranches
In the event of default
The proceeds from
Senior tranche liquidating assets will
Provide credit first be used to repay
protection to Subordinated tranche the most senior
the senior (junior tranches) creditors
classes
Subordinated tranche Losses are allocated
(junior tranches) from the bottom up
This structure redistribute the credit risk associated with the collateral
Allow investors to choose the level of credit risk that they prefer to bear.

2. Coupon payment structures
A coupon is the interest payment that the bond issuer makes to the
bondholder
A conventional bond pays a fixed periodic coupon over a specified time to

maturity (annually, semi-annually, quarterly,…)
Various other coupon-payment structures are described below:
2.1. Floating-Rate Notes (FRN)
2.2. Step-Up Coupon Bonds
2.3. Credit-Linked Coupon Bonds
2.4. Payment-in- Kind Coupon Bonds
2.5. Deferred Coupon Bonds
2.6. Index-Linked Bonds


Floating-rate notes (FRN) do not have a fixed coupon; instead, their coupon
rate is linked to an external reference rate (Euribor, Libor,…).
The coupon rate of an FRN has two components:

Coupon rate = Reference rate + a spread (Margin)
For example, the three-month Libor + 20 bps for a euro-denominated FRN
The reference rate resets periodically based on market conditions.
• The spread is typically fixed and expressed in basis points (bps). 1 bps =
0.01%
• The spread on an FRN is determined at issuance and is based on the
issuer's credit rating at issuance. The higher the issuer's
creditworthiness, the lower the spread.

FRNs have less interest rate risk than fixed-rate bonds

This is because the coupon rate on an FRN is reset periodically and brought in
line with current market interest rates (Reference rate).
Market interest rates rise → The coupon rate on FRN increases

If market interest rates fall → The coupon rate on FRN decreases
When market interest rates (discount rate) increases, coupon payment also
increases → the bond’s value would not decline
FRNs are preferred by investors who expect interest rates to increase


2.1.1. Floor or cap
Floating-Rate Notes (FRNs) may be structured to include a floor or a cap on

the periodic coupon rate.
A cap prevents the periodic coupon rate on the FRN from rising above a
prespecified maximum rate, so it benefits the issuer
Floating
Interest Cap
rate
(%)
Floor
0 Time
A floor prevents the periodic coupon rate on the FRN from falling below a
prespecified minimum rate, so it benefits investors.

2.1.2. Inverse floater - Inverse FRN
Inverse floater is a bond whose coupon rate has an inverse relationship to

the reference rate.
Coupon rate = Maximum coupon rate – (Leverage × Reference rate)
If market interest rates fall → The coupon rate on FRN increases
Inverse FRNs are favored by investors who expect interest rates to decline

2.2. Step-Up Coupon Bonds
• A step-up coupon bond (which can be fixed or floating) is one where the
periodic coupon rate increases by specified margins at specified dates.
• Step-up coupon bonds have a call feature that allows the firm to redeem
the bond issue at a set price at each step-up date.
Coupon rate
(%)
4%
3.5%
3%
2.5%
2016 2017 2018 2019 2020 2016 Year
• Like floating rate notes, bonds with step-up coupons offer bondholders
some protection against rising interest rates.

A credit-linked coupon bond has a coupon that changes when the bond’s
credit rating changes
Example: a bond's coupon rate may be structured to increase (decrease) by

a specified margin for every credit rating downgrade (upgrade) below
(above) the bond’s credit rating at issuance.
Credit-linked coupon bonds protect investors against a decline in the credit

quality
Be more attractive to investors who are concerned about the future

creditworthiness of the issuer

There is a problem with credit-linked coupon bonds is that since a rating

downgrade results in higher interest payments for the issuer, it can
contribute to further downgrades or even an eventual default.
Rating Higher interest

downgrades payments
Default risk
Further Higher debt

downgrades burden
Eventual
default

2.4. Payment-in- Kind Coupon Bonds
A payment-in-Kind (PIK) coupon bond typically allows the issuer to pay

interest in the form of additional amounts of the bond issue rather than as a
cash payment.
Issuer’s perspective Investor’s perspective

PIK coupon bond are preferred by Demand a higher yield on these
issuers may face potential cash bonds to compensate them for the
flow problems in the future. higher credit risk
Other forms of PIK arrangements

• A PIK toggle note: issuers pay interest in cash, in kind, or a combination
of the two.
• Pay common shares worth the amount of coupon due

A deferred coupon bond (a split coupon bond) pays no coupons for its first
few years but then pays a higher coupon than it otherwise normally would
for the remainder of its life.
Cash flows
High dividends to
No compensate for no dividend
dividend in the first 2 years
0
1 2 3 … Maturity date
Issuers are usually seeking ways to conserve cash in the years immediately
following the bond issue. → A deferred coupon bond allows them to delay
interest payments until the project is completed

A zero-coupon bond can be viewed as an extreme form of a deferred

coupon bond
Par Deep discount to par
value (compensate for no
interest payment)
1 2 3 4 5
t=0
Redeem at par
Note: in certain jurisdictions, the deferred coupon structure may help
investors manage their tax liability by delaying taxes due on interest income

An index-linked bond has its coupon payments and/or principal repayment

linked to a specified index (such as a commodity or equity index).
Tạke inflation-linked bond as a common example of index-linked bond
• Inflation-linked bonds offer investors protection against inflation by

linking a bond’s coupon payments and/or the principal repayment to an
index of consumer prices.
• Their payments are based on the change in an inflation index, such as the
Consumer Price Index (CPI) in the United States.

Example:
US Treasury introduced Treasury Inflation-Protected Securities (TIPS) linked
to the US Consumer Price Index (CPI). An inflation-linked bond is the 1% US
TIPS. The coupon rate remains fixed at 1%, but the principal is adjusted every
six months for changes in the CPI.
 While traditional bonds fix both coupon and principal, inflation-linked
bonds fix coupon rate (at 1%) and adjust the principal to compensate the
change in inflation
Traditional
bonds Coupon = $1
Coupon 1% Principal Principal
$100 $100
…
Inflation rate = 10% Year
Year 0 After one year
Inflation-
linked bonds Principal Principal Coupon = $1.1
Coupon 1% $100 $110 Higher coupon payment

Structure of index-linked bond
Type of structure Coupon Principal
Zero-coupon-indexed No coupon Linked to a specified

bonds index
Interest-indexed Linked to a specified Fixed amount

bonds index
Capital-indexed Fixed rate Linked to a specified

bonds index
Indexed-annuity Linked to a specified Linked to a specified

bonds index index

3. Overview for contingency provisions
A contingency provision allows for some action given the occurrence of a

specified event in the future. Common contingency provisions found in a
bond's indenture come under the heading of embedded options*.
(*) Embedded options

The right, but not the obligation, to take some action are called “options”.
These options are not independent of the bond and cannot be traded
separately—hence the term “embedded”.
Some common types of bonds with embedded options include:
3.1. Callable bonds
3.2. Putable bonds
3.3. Convertible bonds
Note: Bonds that do not have contingency provisions are referred to as

straight bond or option-free bonds.

3.1. Callable bonds
A callable bond gives the issuer the right to redeem all or part of the bond
before the specified maturity date.
Under issuer’s perspective
Market interest rates falling The issuer’s credit quality improving
A decline in required interest rates
The issuer would call the outstanding issue and replace this old (expensive
to pay interest on) issue with a new issue that carries a lower interest rate.
Callable bonds are advantageous to the issuer of the security
Non-callable
bonds
Value of call
Right to redeem option
bond at a specified = Value of
Callable bonds price noncallable bond
- Value of callable
bond

3.1. Callable bonds
Under investor’s perspective

Callable bonds expose investors to a higher level of reinvestment risk than
noncallable bonds.
If the bonds are called, bondholders must reinvest funds in a lower interest
rate environment.
Callable bonds have to offer a higher yield and sell at a lower price
To compensate investors for

Granting the option to call the bond Accepting potentially higher
to the issuer reinvestment risk

3.1. Callable bonds
The following details are specified:
Call price: the price paid to bondholders when the bond is called
Call premium: the excess over par paid by the issuer to call the bond
Call schedule: specifies the dates and prices at which the bond may be called

3.1. Callable bonds
Make-whole call provisions
With a make-whole bond, the call price is not fixed but includes a lump-sum
payment:
Lump-sum payment = PV of (the future payments the bondholder will not
receive if the bond is called early)
• The calculated call price is unlikely to be lower than the market value of
the bond
• Issuer is unlikely to call the bond except when corporate circumstances,
require it
The make-whole provision actually restricts the the probability that the bond
would be called
The net effect is that the bond can be called if necessary, but it can
also be issued at a lower yield than a bond with a traditional call provision.

3.1. Callable bonds
Available exercise styles on callable bonds

American-style call (continuously
callable)
The issuer has the right to call a
bond at any time starting on the Call at
first call date. anytime
European-style call
The issuer has the right to call a
bond only once on the call date. One specified
Bermuda-style call date
The issuer has the right to call bonds
on specified dates following the call
protection period. These dates
Some specified
frequently correspond to coupon
Lockout period dates
payment dates.
During lockout period (initial call protection period), the issuer is prohibited
from calling the bond.

3.1. Callable bonds
Example:
A hypothetical $1,000 par 20-year bond is issued on January 21, 2013 at a
price of 98.515. The issuer can call the bond in whole or in part every January
21, from 2019. Call prices at different call dates are listed below:
Year Call Price (%) Year Call Price (%)
2019 102.00 2023 100.824
2020 101.655 2023 100.548
2021 101.371 2024 100.273
2022 101.095 2025 and thereafter 100.00
Required:
1. What is the length of the call protection period?
2. What is the call premium (per bond) for the 2022 call date?

3.1. Callable bonds
Answer:
1. The bonds were issued in 2013 and are first callable in 2019. Therefore,
the call protection period is 2019 - 2013 = 6 years.
2. Call prices are stated as a percentage of par, so the call price in 2022 is
$1,010.95 (= 101.095% x 1,000). The call premium is the amount paid
above par by the issuer. Therefore, the call premium in 2022 is $10.95
(= 1,010.95 - 1,000).

3.2. Putable bonds
A put provision gives the bondholders the right to sell the bond back to the
issuer at a pre-determined price on specified dates

Putable bonds are beneficial for the bondholder by guaranteeing a pre-
specified selling price at the redemption dates
An increase in interest rates
Investor can put the bond back to the issuer and reinvest the proceeds in
bonds that offer higher yields, in line with higher market interest rates.
Putable bonds are advantageous to the investor
Non-
putable Value of put option
bonds = Value of putable
bond - Value of
nonputable bond
Putable
bonds
Right to sell the Maturity
bond back

3.2. Putable bonds
Under issuer’s perspective

As the bond is put, the issuer would have to reissue new bonds at a higher
interest rate → the issuer face higher risk

A convertible bond gives the bondholder the right to convert the bond into a
prespecified number of common shares of the issuer.
• A convertible bond is a hybrid security with both debt and equity features
• Additionally, a convertible bond can be viewed as the combination of a
straight bond (option-free bond) plus an embedded equity call option.

Non-
convertible
bonds
Right to
convert the
Convertible bond to equity
bonds
Maturity
Value of convertible right

= Value of convertible bond - Value of nonconvertible bond

Convertible bond offers several advantages relative to a non-convertible bond
• It gives the bondholder the ability to convert into equity in case of share
price appreciation, and thus participate in the equity upside;
• The bondholder receives downside protection
If the share price The convertible bond offers the regular coupon
does not appreciate payments and principal repayment at maturity
Convertible bonds are attractive to investors
Convertible bonds offer a lower yield and sell at higher prices than similar
bonds without the conversion option.

Key terms regarding the conversion provision include the following:
a. The conversion price is the price per share at which the convertible bond
can be converted into shares.
b. The conversion ratio is the number of common shares that each bond can
be converted into.
Par value
Conversion ratio =
Conversion price
c. The conversion value, sometimes called the parity value, is the current
share price multiplied by the conversion ratio.
d. The conversion premium is the difference between the convertible bond’s

price and its conversion value.

Key terms regarding the conversion provision include the following:
e. Conversion parity occurs if the conversion value equals the convertible

bond’s price.
Example: Assume that the bond price is $1,000 and the conversion ratio is
40 shares per bond.
• If the current share price is $25 → the conversion value = 25 × 40 = $1,000

→ both the convertible bond’s price and the conversion value are equal
to $1,000 → a conversion premium equal to 0 → this condition is referred
to as parity.
• If the common share is selling for less than $25, the condition is below
parity.
• If the common share is selling for more than $25, the condition is above
parity.
Note: Although it is common for convertible bonds to reach conversion

parity before they mature, bondholders rarely exercise the conversion
option, choosing to retain their bonds and receive (higher) coupon payments
instead of (lower) dividend payments.

a. Warrants
A warrant offers the holder the right to purchase the issuer's stock at a fixed
exercise price until the expiration date.
Allowing investors to participate in the upside from an increase in share prices
A warrant is somewhat similar to a conversion option, but it is not

embedded in the bond’s structure.

b. Contingent Convertible Bonds

Several European banks have issued a type of convertible bond called
contingent convertible bonds.
Contingent convertible bonds (CoCos) are bonds that convert from debt to
common equity automatically if a specific event occurs.
They differ from traditional convertible bonds in two ways:
Traditional convertible bonds Contingent Convertible Bonds
Convertible at the option of the Cocos convert automatically upon the

bondholder occurrence of a prespecified event.
Conversion occurs on the upside— Contingent write-down provisions are

that is, if the issuer’s share price convertible on the downside.
increases

b. Contingent Convertible Bonds
To understand the application of CoCos, consider a bank that is required to

maintain its core equity capital above a minimum level.
CoCos automatically convert into They may force holders to take

equity if the bank suffers losses losses
• Lightening the debt burden Offer investors a higher yield

• Increasing its equity capital than otherwise similar bonds
Ensure that it continues to adhere

to capital requirements in the event
of significant losses
[LOS 2.b] Describe how legal, regulatory, and tax considerations

affect the issuance and trading of fixed-income securities
1. Legal and regulatory consideration
Fixed-income securities are subject to different legal and regulatory

requirements across jurisdictions, depending on where they are issued,
traded and who holds them.
An important consideration for investors is where the bonds are issued and
traded because it affects the laws and regulations that apply
The global bond market
1.1. National bond markets 1.2. Eurobond market
Domestic
Foreign bonds Eurobonds
bonds

1.1. National bond market includes all the bonds that are issued and traded in a
particular country and denominated in that country's local currency.
1.2. Eurobond market is the market where Eurobonds are issued and traded.
• Eurobonds refer to bonds that are denominated in a currency other than the
local currency where they are issued.
Types Domestic bond Foreign bond Eurobond

Currency
Domestic Foreign Any
denominated
Market issued and
Domestic Foreign International
traded
Issuer incorporated Domestic Domestic Any
Legal and Under the jurisdiction of the Not under the jurisdiction
regulatory country they are issued. of any single country
Registered bonds
Ownership record
(the trustee keeps a record of bond ownership)*
*In the past, Eurobonds typically were bearer bonds (the trustee keeps no records
of bond ownership)

Example:
• Domestic bonds: bonds issued by Google Inc. (U.S. firm) in U.S. dollars and
traded in the U.S. bond market.
• Foreign bonds: bonds issued by Toyota Motor Company (Japanese firm) in
U.S. dollars and traded in the U.S.bond market.
• Eurobond: bonds issued by a Chinese firm in U.S.dollars and traded in
markets outside the U.S.
1.3. Global bonds are bonds that are issued simultaneously in the Eurobond
market and in at least one domestic bond market.
Ensuring sufficient demand for large bond issues and access to all fixed-
income investors regardless of location

2. Tax consideration
We discuss some aspects of bond that are through to tax considerations
2.1. Coupon/Interest of bond
2.2. Capital gain/loss from bond trading
2.3. Discounted issues
2.4. Premium issues


2.1. Coupon/Interest of bond
For Investor
• Bond interest receipt (coupon receipt) is taxed at the ordinary income tax
rate, which is the same rate as wage and salary income.
• However, the interest income from national bonds (tax-exempt
securities) issued by municipal governments in the United States is most
often exempt from national income tax and often from any state income
tax in the state of issue.
For Issuer
• Bond interest payments are usually allowed to deduct taxable income

→ Some domestic bonds pay their interest net of income tax (interest
received is the amount after deducting income tax).
• Other bonds make interest payments in gross (interest receipt still includes
tax, investors subjects to tax purpose).

2.2. Capital gain/loss from bond trading
A bond investment will generate a capital gain or loss if sold prior to maturity
at a price different from the purchase price
If the bond price has increased If the bond price has decreased
Capital gain Capital loss
Be taxed at specific tax rate

May be deductible or not
that may be lower than ordinary
Depend on national tax legislations
income tax rate
• Capital gains recognized over a year after the original bond purchase may
be classified as long-term capital gains and taxed at an even lower rate.
• Capital gains recognized within a year of bond purchase may be classified
as short-term capital gains and taxed at the ordinary income tax rate.

Bonds issued at a discount (including pure discount bonds) are termed the
original issue discount (OID) bonds.
→ the tax status of the original issue discount is an additional tax
consideration.
→ A prorated portion of the discount increases the investor’s taxable income
(coupon payments) each year until maturity.
2.4. Premium issues
In contrast, a prorated portion of the premium may deduct the investor’s

taxable income each year until maturity.

Illustration of tax treatment for discount bonds

Assume that a company issues bonds in the hypothetical country of Zinland,
where the local currency is the zini (Z). There is an original issue discount tax
provision in Zinland’s tax code. The company issues a 10-year zero-coupon
bond with a par value of Z1,000 and sells it for Z800.
Original issue discount

=Z1,000 – Z800 = Z200
1,000
A prorated portion of the discount
each year = Z200/10 = Z20
800 → Increase the taxable income by
Z20 each year.
Par value Original issue price

Student’s notes
ISSUANCE AND TRADING
LEARNING OUTCOMES
3.a. Describe fixed-income market segments and their issuer and investor
participants
3.b. Describe types of fixed-income indexes
3.c. Compare primary and secondary fixed-income markets to equity

markets
[LOS 3.a] Describe fixed-income market segments and their issuer

and investor participants
1. Classification of Fixed-Income Markets
d. Currency a. Issuers
Classification of global
e. Geography b. Maturity
fixed-income markets
ESG
c. Credit quality
Characteristics

a&b. Issuers and Maturities
Major classifications of bond issuers are governments (sovereign and non-

sovereign), corporates, and special purpose entities issuing asset-backed
securities (ABSs).
Years to maturity
< 1y 1y – 10y > 10y

Short-term Intermediate-term Long-term
“Default
Treasury bills Treasury notes Treasury bonds
risk free”
Repo commercial Unsecured Unsecured
Investment paper* corporate bonds corporate bonds
grade Asset-backed Asset-backed Mortgage-backed
commercial paper** securities (ABS)** securities (MBS)**
Secured corporate
High yield bonds (new issuers)
Leveraged loans
Credit quality
(*) Refer to Module 4
(**) Refer to Module 17 – 19

c. Credit quality
A common measure of credit quality is a credit rating. Credit ratings

qualitative measures of an issuer’s ability to meet its debt obligations based
on both the probability of default and the expected loss under a default
scenario.
Credit rating agencies Moody’s Fitch and S&P

Aaa AAA
Aa AA
Investment grade
A A
Credit rating
Baa BBB
Ba BB
B B
Non-investment
grade Caa CCC
(high yield or junk)
Ca CC
C C, D

c. Credit quality
Investment grade
• More stable cash flows
Risk and Return
• Relative rare defaults among issuers
Non-investment grade
• Less stable cash flows
• Higher probability of default
Non-investment grade (high yield or junk) include
New issuers Fallen angels

New issuers for which investors Formerly investment-grade
are more likely to require issuers whose credit quality has
collateral due to less stable deteriorated since the time of
operating cash flows. issuance.

d. Currency denomination
Fixed-income securities can also be classified based on the currency in

which they are issued. The currency in which a bond is issued determines
which country's interest rates affect its price.

e. Geography
Bonds may be classified on the basis of where they are issued and traded.
Types Domestic bond Foreign bond Eurobond
Currency
Domestic Foreign Any
denominated
Market issued and
Domestic Foreign International
traded
Issuer incorporated Domestic Domestic Any
Legal and Under the jurisdiction of the Not under the jurisdiction
regulatory country they are issued. of any single country
Investors also often distinguish between developed bond markets or

emerging bond markets.
Emerging bond markets Developed bond markets
Scale Smaller Higher
Riskiness More risky Less risky
Return Higher return Lower return


2. Investors in Fixed-Income Securities
Fixed-income investors have corresponding positions along the credit and

maturity spectrums as they seek to gain exposures to certain risks and to
match the cash flows of known future obligations.
Years to maturity
< 1y 1y – 10y > 10y

Short-term Intermediate-term Long-term
Financial intermediaries
“Default
risk free”
Money market funds Central banks Pension funds
Investment Money market funds Bond funds and ETFs

Insurance companies
grade Corporate issuers Asset managers
Asset managers
Hedge funds
High yield
Distressed debt
funds
Credit quality

2. Investors in Fixed-Income Securities
Bond investors Invest in Purpose

Financial Treasuries across the
Manage interest rate and liquidity risks
intermediaries whole maturity
As a monetary policy tool to increase
Intermediate-term
Central banks or decrease the monetary reserves of
Treasury notes
commercial banks.
• Match their long-term liabilities
Pension funds (paying pensions and claims on
Long-term, investment-
and insurance insurance policies).
grade securities
companies • Are often prohibited by regulations
from owning high-yield securities.
Corporation Commercial paper, repos Seek to earn returns on excess
issuers and ABCP liquidity.
Bond funds and Investment-grade Position according to their stated
ETFs intermediate securities mandate
Intermediate securities,
Asset managers between investment- Earn high returns
grade and high-yield
Hedge funds
High-yield intermediate
and Distressed Earn high returns
securities
debt funds
[LOS 3.b] Describe types of fixed-income indexes
Recall from Equity Investments topic

The role of market indexes involve:
• Tracking the broad risk and return of different security markets, which
enable the evaluation of market performance.
• Benchmarking the performance of investments and investment managers.
• Forming the basis for indexed investment strategies.
Contrast Equity indexes versus Fixed-income indexes

Categories Equity indexes Fixed-income indexes
More constituents
Amount of Corporate bond issuers can
Less constituents
constituents have many different bonds
outstanding.
• Infinite maturity • Finite maturity
• Less frequency of new • Higher frequency of new
Probability
issuance issuance
of turnover
→ Less changes in constituents → More changes in
→ less turnover constituents → more turnover
• Diversify weighting method.
More common use is weighting
Weighting • More common use is
by market value of debt
method weighting by issuers’ market
outstanding.
capitalization.
Despite of the complexity of bond indexes, a bond fund aims to match the returns
of a specific index will hold a representative sample of constituent securities.
Fixed-income indexes classification
1. Aggregate indexes 2. Narrowed indexes

Contain a broad selection of Focus on criteria such as sector,
constituent bonds credit quality, maturity, ESG…
Example: Bloomberg Barclays Example: J.P. Morgan Emerging

Global Aggregate Index Markets Bond Index Plus (EMBI+),
Bloomberg Barclays MSCI Euro
Corporate Sustainable SRI Index.
The index chosen to evaluate an investment manager or fund should

correspond to that manager’s or fund’s investment strategy.
1. Aggregate indexes example
Bloomberg Barclays Global Aggregate Index
Extract of Brief summary of inclusion criteria
Fixed-rate bonds from sovereign, government, corporate, and

Issuers:
securitized issuers based in DM and EM markets
Currencies: 28 eligible currencies across the Americas, EMEA, and Asia Pacific
Credit quality: Investment-grade rating or equivalent
Fixed rate, zero coupon, and step-up coupon (if step-up dates are
Coupon:
predetermined)
Minimum issuance size by market, for example:

—CAD150 m
Amount —USD300 m, EUR300 m, CHF300 m, AUD300 m
outstanding: —CNY 5 bn (Treasury and bank debt)
—RUB20 bn
—JPY35 bn
Maturity: At least one year to final maturity or average weighted maturity
Include fixed-coupon capital market Exclude high-yield and unrated debt

securities from all major issuer types in instruments and those that do not meet
28 developed and emerging markets minimum issuance size.
that meet the above inclusion criteria.
2. Narrowed indexes example
J.P. Morgan Emerging Markets Bond Index Plus (EMBI+)
Issuers: Emerging market sovereign issuers of US dollar debt
Only US dollar–denominated bonds are included. Bonds with a

Currencies: coupon or redemption payment linked to an exchange rate are
not eligible
Sovereign rating of Baa1/BBB+/BBB+ or below by

Credit quality:
Moody’s/S&P/Fitch Ratings
Fixed rate, zero coupon, and step-up coupon (if step-up dates are
Coupon:
predetermined)
Amount Issues with a current face amount outstanding of USD500 million

outstanding: or more
Only instruments with at least 2.5 years until maturity are

considered. At each month-end, instruments that will fall below
Maturity:
12 months to maturity during the upcoming month will be
excluded.
Include US dollar–denominated emerging market sovereign debt with a rating of

Baa1/BBB+ or below, with minimum size and maturity limits.
2. Narrowed indexes example
Bloomberg Barclays MSCI Euro Corporate Sustainable SRI Index
Issuers: Corporate (industrial, utility, and financial institution) issuers
Currencies: Only euro-denominated bonds are included
Security rating of Baa3/BBB-/BBB- or above by Moody’s/S&P/Fitch

Credit quality:
or equivalent
Amount
EUR300 million minimum par amount outstanding
outstanding:
At least one year to final maturity, with fixed-to-floating perpetual
Maturity: bonds excluded one year prior to conversion. Fixed-rate perpetual
bonds are excluded.
• Must have an MSCI ESG rating of BBB or higher

• Excludes issuers involved in the following business
lines/activities, such as: alcohol, tobacco, gambling…
ESG rules:
• Excludes issuers with a “Red” MSCI Controversies score
measuring issuer involvement in major ESG controversies and
adherence to international norms and principles
Indexes can also incorporate ESG factors in their

construction that regularly screen for and exclude
issuers that fail to meet certain minimum ESG criteria.
[LOS 3.c] Compare primary and secondary fixed-income markets to

equity markets
Primary bond markets Secondary bond markets

are markets in which are markets in which
issuers initially sell existing bonds are
bonds to investors to subsequently traded
raise capital. among investors.
Sell Trade
bonds bonds
Issuers Investors Investors
1. Primary bond markets 2. Secondary bond markets
Mechanism for issuing and trading bond in each market
Underwritten offering Quote-driven market
Best-efforts offering Over-the-counter (OTC)

Public
offerings
Shelf registration
Auction
Private placement

equity markets
1. Primary bond markets
Before IPO IPO After IPO
Private debt Public debt
• Public offering
• Private placement
Debut issuers Repeat issuers
Reopening of an
existing bond:
increase the size of
an existing bond
with a price
significantly
different from par

equity markets
1. Public offerings
a. Underwritten offering (Firm commitment offering)
The investment bank guarantees the sale of the bond issue at an offering
price that is negotiated with the issuer.
→ The investment bank, called the underwriter, takes the risk associated
with selling the bonds.
Illustration of Underwritten offering
Sell Resell
Issuers bonds Investment bank bonds Investors
2 types
Small issues Large issues
Lead underwriter
Single investment bank Syndicate of investment bank

equity markets
1. Public offerings
b. Best-efforts offering
Contrast Underwritten offering and Best-efforts offering:
Best-efforts offering Underwritten offering
The investment bank only acts as a The investment bank guarantees

broker and tries its best to sell the the sale of the bond issue at an
bond at the negotiated offering offering price that is negotiated
price for a commission. with the issuer.
The investment bank bears less

The investment bank takes the risk
risk and has less of an incentive to
associated with selling the bonds.
sell in a best efforts offering.
This offering is more common for bonds of lower credit quality, the financial
intermediary does not guarantee the sale and may serve only as a broker.

equity markets
1. Public offerings
c. Shelf registration
Shelf registration allows certain authorized issuers to

Mechanism offer additional bonds to the public without a new and
separate offering circular.
• The issuer prepares a single, all-encompassing offering
circular that describes a range of future bond issuances,
all under the same document called master
prospectus.
Requirements
• Each issue must be accompanied by an announcement
document describing changes to the issuer's financial
condition (if any) since the filing of the master
prospectus.
• Only used by well-established issuers with proven

financial strength.
Limitation
• In some jurisdictions, only qualified investors can
purchase.

equity markets
1. Public offerings
c. Auction
• Bonds are sold to investors through a bidding process, which helps in

price discovery and allocation of securities.
• Primary market issuance of sovereign debt usually takes the form of a
public auction led by the national treasury or finance ministry.
(Auction is further discussed in Module 5)

equity markets
2. Private placement
Contrast Private placement and Public offering
Private placement Public offering
Only a selected group of Any member of the public

qualified investors (typically may purchase the bonds
Member
large institutional investors)
are allowed
Either: Investment banks, which

• Directly between the provide a wide range of
Intermediary issuer and the investors financial services
• Through an investment
bank
Liquidity Less liquid More liquid
Have customized and Have standardized and less

Restriction
restrictive covenants restrictive covenant

equity markets
2. Secondary bond markets
Trading platforms
Quote-driven market Over-the-counter (OTC)

Investors trade with dealers Orders are matched through a
communications network.
Dealers post quotes comprising bid (purchase) prices and ask or offer
(selling) prices for various bond issues.
Bid price Spread Ask price

The price a buyer The price a seller is
is willing to pay willing to accept
The spread varies across individual bonds according to their liquidity:

• < 10 – 20 basic points: Bond of the most recently issued (on-the-run
bonds), developed market sovereign bonds.
• ≥ 10 – 20 basic points: Bonds of less frequent corporate issuers or more
seasoned bonds of frequent issuers are rarely traded.

equity markets
2. Secondary bond markets
Distressed debt is a name given to the bonds of issuers that are in, or
expected to file for, bankruptcy.
Trading platform: Secondary market at a price well below par.
Investors: Hedge funds and other opportunistic investors seeking more
equity-like returns.
Features:
• Distressed debt is traded until either the corporate issuer has liquidated
its assets or its outstanding bonds have been restructured.
• By the time an issuer’s debt has become distressed, its equity securities
will likely have already been delisted.
Student’s notes
MARKETS FOR CORPORATE
ISSUERS
MARKETS FOR CORPORATE ISSUERS
LEARNING OUTCOMES
4.a. Compare short-term funding alternatives available to corporations

and financial institutions
4.b. Describe repurchase agreements (repos), their uses, and their

benefits and risks
4.c. Contrast the long-term funding of investment-grade versus high-yield

corporate issuers
[LOS 4.a] Compare short-term funding alternatives available to

corporations and financial institutions
Short-term funding alternatives
1. For non-financial corporations 2. For financial institutions
1.2. External
1.1. External Interbank
security-based Deposits
loan financing markets
financing
Bank lines of
Commercial paper
credit Repurchase
(issued by both Non-financial
agreements
corporations and Financial
Secured loans (repos)
institutions)
and factoring

1. Short-term funding for non-financial corporations
Cash Working capital

Accounts
Short-term payable
Short-term
investments Short-term liabilities
Short-term
assets Long-term Borrowing
Accounts
obligations
receivable
Long-term Ownership
Inventory assets capital (equity)
Internal financing – come from External financing – come from

business outsider investors
• Cash Short-term borrowing including:
• Short-term investments • Uncommitted or Committed lines
• Accounts receivable of credit
• Inventory • Revolving credit
• Accounts payable • Secured loans
… • Factoring

1.1. External loan financing
a. Lines of credit (LOC)
A line of credit is a preset borrowing limit that a borrower can draw on at

any time.
Pays interest
Company Bank
Lends money up to a limit
Uncommitted Committed Revolving
Reliability

Committed or
Types Definition Period
not?
Uncommitted
Form of bank borrowing in which a bank

extends an offer of credit for an extended
Uncommitted N/A
period of time but may refuse to lend if
circumstances change.
A formal written commitment outlining the

Committed
conditions of the credit line between a Less than 365

Committed
bank & the borrower and cannot be days
suspended without notifying the borrower.
Agreement that permits an account holder

Revolving
to borrow money repeatedly up to a set

Multiple
money limit while repaying a portion of Committed
years
the current balance due in regular
payments.

Unsecured or
Types Cost Risk
secured?
Can be unsecured
Uncommitted
if borrower
Do not require any compensation other Banks may refuse
maintains stable
than interest to lend
cash balances
with bank
• Require compensation, usually in the Renewal risk at
form of a commitment fee to the maturity – bank
Committed
(Regular)
lender withdraw the

• A commitment fee is charged Unsecured agreement for
(typically 50 basic points) on either borrowers with
the full or unused amount of over the credit condition
period. worsen
• Similar to committed LOC with

Revolving
respect to borrowing rates and

commitment fee. Unsecured Not mentioned
• Banks typically place restrictive
covenants on borrowers.

b. Secured loans and factoring
Secured loans are loans in which the lender requires the company to
provide collateral in the form of an asset.
Lend money
Company Bank
Provide collateral
• Collateral is usually a fixed asset owned by the company or high-quality

receivables and inventory.
• Assignment of accounts receivable is the use of cash-flow-generating
accounts receivable as collateral for a loan
• These assets are pledged against the loan, and the lender files a lien (*)
against them.
(*) A lien is a claim or legal right against assets that are typically used as
collateral to satisfy a debt.

b. Secured loans and factoring
Factoring refers to the actual sale of receivables at a discount from their

face value. Debt factoring involves three parties: a business, a client, and a
debt factoring company.
(1) The company sells goods on credit to

Company the customer in 30 days Customer
(3) Money
(2) The company sells (4) The customer pays
the debt to the factor the factor after 30 days
Factor
In a factoring arrangement, the company shifts the credit granting and

collection process to the factor. The cost of this credit (i.e., the amount of
the discount) depends on the credit quality of the accounts and the costs of
collection.

1.2. External security-based financing
Commercial paper is a short-term, unsecured notes issued in the public

market or via a private placement.
Issuing commercial paper

Issuer Holder
Lending money
a. Characteristics of Commercial paper

• It is a valuable source of flexible, readily available, and relatively low-cost
short-term financing.
• It can be used to meet seasonal demands for cash and is also commonly
used to provide bridge financing (i.e., interim financing until long-term
financing can be arranged).
Unfavorable conditions Favorable conditions

Bridge financing
Issuing long-term bonds Issuing long-term bonds
Issuing commercial paper


b. Credit quality of Commercial paper

Rolling over the paper (or “rolled over”) is the practice of paying maturing
commercial paper with the proceeds of new issuances.
Begin the Company obtain the funds to pay off maturing paper End the
project by issuing more commercial paper project
…
1st issue 2nd issue 3rd issue 4th issue
Rollover risk: the risk
Success Success Success Fail that issuer will be unable
to issue new at maturity.
Commercial paper issuers secure a backup line of credit from banks.
The purpose of the backup lines of credit is to ensure that the issuer will
have access to sufficient liquidity to repay maturing commercial paper if a
rollover is not possible.
Given their short maturity, commercial paper markets adapt quickly to

adverse credit events and defaults are relatively rare.

c. Yield on Commercial paper
Short-term Short-term Commercial

sovereign bonds municipal bonds paper
• Lowest credit risk • Higher credit risk • Highest credit risk
• Most liquid • Less liquid • Least liquid
• Income can be tax • Income is subject to
exempt income taxes
d. US Commercial Paper vs. Euro commercial Paper
Feature US Commercial Paper Euro commercial Paper

Market United States International market
Currency US dollar Any currency

Transaction
Larger Smaller
size
Liquidity More liquid Less liquid

2. Short-term funding for financial corporations
Cash Deposits
Central bank Short-term Certificates

reserves liabilities of deposit
Short-term
Short-term assets Long-term Securities
loans obligations sold via Repos
Securities Long-term Ownership Short-term

purchased assets capital (equity) borrowing
via Repos
External financing – come from outsider investors

In this section, we further discuss about:
• Deposits – refer to 2.a
• Interbank markets – refer to 2.b
• Commercial paper – refer to 2.c
• Repurchase agreements (repos) – refer to LOS 4.b

a. Deposits
One of the primary sources of funding for deposit-taking banks is their

deposit base, which includes funds from both retail (household) and
commercial depositors.
Types of deposit accounts
Checking accounts Operational deposits Savings deposits
• Pay no interest Made by larger • Pay periodic interest

• Provide full of depositors who require • Provide less
transaction services cash management, transaction services
• Offer immediate custody, and clearing • Less liquidity
access to funds. services • Stated maturity
• No stated maturity
Example: Certificate of
deposit (CD).
(see more in next slide)

a. Deposits
Certificate of deposit (CD)
A certificate of deposit (CD) is an instrument that represents a specified

amount of funds on deposit for a specified maturity and interest rate.
Fund
Banks CDs Investors
• Usually < 1 year.

Maturity
• CDs with longer maturities are called “term CDs”.
Large-denomination CDs (≥ $1 million) are important

Denomination
funding sources for banks from institutional investors.
Non-negotiable CD Negotiable CD
Initial depositor at
Negotiable and Pay to Holder of CD
maturity
Nonnegotiable
CD Yes
Can be
No It can be sold in the open
sold?
market prior to maturity

b. Interbank market
• Periods of one day to a year.

Interbank market • Either on secured or unsecured basis. Most
Funds are loaned common type of secured is Repos (LOS 4.b)
by one bank to Borrowing at market reference rate (MRR)
another.
Bank A Funding Bank B
Borrowing at
Central bank Central bank
funds rate
funds market
Funds are loaned minimum
reserve
by excess reserves
requirement
from other banks Bank A Bank B Bank C
Reserves of banks at Central Bank
Discount window Extra scrutiny and restrictions on the activities of

lending the bank to address the liquidity issues.
Borrowing at higher rate than CB fund rates
Funds are loaned
by central bank Bank A Central
Funding
bank

c. Commercial paper
Asset-backed commercial paper

Commercial paper
(ABCP)
Unsecured notes
(Refer to Commercial paper in • Secured form of commercial
External security-based financing paper.
for Short-term funding for non- • A liquid, short-term note.
financial corporations) • Is recorded off-balance-sheet.
Asset-backed commercial paper creation process

Step 1
Short-term
loans A bank agrees to transfer short-term loans
Bank SPE to a Special purpose entity (SPE)
Cash
Step 2
Backup credit ABCP Investor The SPE issues ABCP
liquidity line to investors with a
Bank SPE Investor backup credit liquidity
line provided by the
Investor bank
[LOS 4.b] Describe repurchase agreements (repos), their uses, and

their benefits and risks
An important source of secured short-term lending and borrowing is the

repurchase agreement (repo) market.
A repurchase agreement or repo is the sale of a security with a simultaneous

agreement by the seller to buy the same security back from the purchaser at
an agreed-on repurchase price and repurchase date.
Understanding in alternative way, a repurchase agreement can be viewed as
a collateralized loan in which the security sold and subsequently
repurchased represents the collateral posted.
Illustration of Repo transaction

t=0 t=T
Initial sale At repurchase date

Security
Cash (Collateral)
Lender Borrower Lender Borrower
(Buyer) (Seller) (Buyer) (Seller)
Security Cash
(Collateral) + Interest
From borrower perspective, transaction From lender perspective, transaction

would be referred to as a repo. would be referred to as a reverse repo.

1. Structure of repurchase and reverse repo
Introduction some terms of Repos
Overnight repo An agreement for one day.
Term repo An agreement for a longer than one day.
The collateral used in the repo may involve a specific

General
security or a general type of security (e.g., Treasury bonds
collateral repo
of a certain range of maturities).
Master
The details of the contractual terms of the repo between
repurchase
the counterparties.
agreement
• The annualized interest rate of the loan.

• Repurchase price = Loan × (1 + annualized repo rate)
Repo rate repo term
where: annualized repo rate = repo rate ×
360
Repurchase price – Loan 360
→ Repo rate = ×
Loan repo term

• The borrower typically must post extra collateral above the

loan amount (or can be called the purchase price) by an
amount known as the initial margin → To protect the lender
Initial against a potential decrease in the value of the securities
margin posted as collateral.
Security price
• Initial margin = Loan amount 0
0
• The percentage difference between the market value of the
security and the value of the loan.
• The margin serves to protect the lender against a decline in
Haircut the value of the collateral over the term of the repo.
(Repo Security price0 – Loan amount0
margin) • Haircut = Security price0
• Haircut can also be calculated quickly as:
1
1 – Initial margin

• During the period, the loan value increases at the repo rate
and the market value of collateral fall → Variation margin is
the amount ensure maintaining security interest equal to
origin initial margin terms.
Variation • Variation margin = (Initial margin × Loan amountt ) –
margin Security pricet
o Variation margin > 0: Borrower is asked to post additional
collateral.
o Variation margin < 0 (Overcollateralized): Borrower can
request a release of collateral.

Example: Consider party A that wishes to borrow by entering into a repo

agreement to sell a bond today with a market value of $1 million and
repurchase it 90 days later (the repurchase date). The lender requires a
repo rate of 2% and initial margin of 103%. Assuming a 360-day count
convention.
t=0 t = 90
Bond
Cash (Collateral)
Party B Party A Party B Party A
(Lender) (Borrower) (Lender) (Borrower)
Bond Cash

Determine the following factors:
Initial purchase price (loan amount) ...
Repurchase price …
Haircut (repo margin) …
Step 1: Determine Loan amount

after 30 days
…
Variation margin
Assuming that after 30 days the
market value of bond has fallen to
Step 2: Determine Variation margin
$990,000
…
Is variation margin negative or

…
positive? What will borrower do?


convention
t=0 t = 90
Bond
Cash (Collateral)
Bond Cash
1. Determine purchase price (loan amount) at t = 0.

Given Initial margin = 103% and Security price0 = $1 million, the initial
purchase price is calculated as:
Security price0 1,000,000
Purchase price0 = = = $970,874
Initial margin 103%
Note that Party A must finance the remaining $29,126 from other sources.


convention
t=0 t = 90
Bond
Cash (Collateral)
Bond Cash
2. Determine repurchase price using repo term and repo rate.

Given Initial loan amount = $970,874, repo rate = 2% and 90-day repo term,
the repurchase price is calculated as:
repo term
Repurchase price = Loan × 1 + repo rate ×
360
90
= 970,874 × 1 + 2% × = $975,728
360


convention
t=0 t = 90
Bond
Cash (Collateral)
Bond Cash
3. Determine repo haircut.

Given Initial loan amount = $970,874 and Security price0 = $1 million, the
haircut is calculated as:
Security price0 – Loan amount0 1,000,000 – 970,874
Haircut = = = 2.91%
Security price0 1,000,000

You are standing here
t=0 t = 30 t = 90
Bond = $1,000,000 Bond = $990,000

Loan = $970,874 Loan = ?
4. Assuming that after 30 days the market value of bond has fallen to
$990,000. Determine variation margin.
Step 1: Determine Loan amount after 30 days
t
Loan amountt = 30 = Loan amount0 × 1 + repo rate ×
360
30
= 970,874 × 1 + 2% × = $972,492
360
Step 2: Determine Variation margin
Variation margin = (Initial margin × Loan amountt ) – Security pricet
= (103% × 972,492) – 990,000 = $11,667
Implication: After 30 days, the loan amount rises to $972,492 leading to the
increase of the current margin. Since the market value of the bond
($990,000) is less than this amount, the borrower must provide an additional
$11,667 of securities as collateral.

2. Repo applications and benefits
Participants use the repo market for three specific purposes:
Finance the Financial institutions enter repos as security sellers or cash

ownership of borrowers to finance positions in securities held in their
a security trading activities.
• Banks and institutional investors, such as mutual funds

Earn short-
and pension funds, enter repos as security buyers/lenders
term income
to earn the repo rate on excess short-term funds.
by lending
• Central banks may use repos to enact monetary policy,
funds on a
buying securities/lending to increase the money supply
secured
and selling securities/borrowing to decrease the money
basis
supply.
• Hedge fund may take a short position in a security, with a

view that its price will decline.
• Short sale process (recall from Equity investments topic)
Borrow a
1 2
security in
order to sell Simultaneously borrow Simultaneously buy
security in repo market security in cash market
it short and sell in cash market and repay in repo market
Wait for decrease
in securities price
Open the position Close the position

3. Factors affecting repo rate
Factors Change in factor Change in repo rate
Money market interest rates Higher Higher

Collateral quality Higher Lower
Repo term (Length of repo) Longer Higher
Supply and Supply Lower
demand
Lower
conditions Demand Higher
of collateral
Undercollateralized
Collateral delivery or Higher
no collateral is provided

4. Repo risks
Relating to the lender fails to make the repurchase

Default risk
payment at the end of the repo.
Relating to the value that can be generated for collateral

Collateral risk
in event of default.
Relating to the timely and accurate calculation and

Margining risk
payment of margin.
Legal risk Relating to the contracts cannot be legally enforced.
Relating to the ability to net off payments across different

Netting and contracts with the same non-defaulting counterparty,
settlement risk and the ability to settle the cash and collateral
transactions underlying the repo.
In many cases, repo market participants manage these risks by engaging a

third party. Under a triparty repo, both parties agree to use a third-party
agent (usually a custodian bank or clearinghouse) for the transaction.
[LOS 4.c] Contrast the long-term funding of investment-grade versus

high-yield corporate issuers
1. Similarity between investment-grade versus high-yield bond
Yield-to-maturity (%)
High-yield issuer
Investment-grade
3.2% issuer
2.3%
Maturity
3y 5y 7y
Under normal market conditions, bond yields are higher for longer-dated
maturities, reflecting higher risk-free rates and credit spreads over longer
time frames.
In this environment, both investment-grade and high-yield corporate issuers
must offer higher yields on longer-maturity bond issues.
[LOS 4.c] Contrast the long-term funding of investment-grade versus

high-yield corporate issuers
2. Differences between investment-grade versus high-yield bond
Bond features Analytical approach
AAA
Bond-like cash flows Use financial ratios
AA • Lower YTM proportion and credit ratings to
Investment
due to credit spreads determine if/when IG
grade
A • Fewer issuer restrictions issuer’s likelihood of
• Unlikely to default default will change
BBB
BB
Equity-like cash flows
Consider likelihood of
B • Higher YTM proportion
Non-investment default and potential
due to credit spreads
grade loss given default
CCC • Issuer restrictions
(high yield or given covenants,
and/or bonds secured
junk) CC restrictions and/or
by assets
security
• More likely to default
C, D
Student’s notes
MARKETS FOR GOVERNMENT
ISSUERS
MODULE 5: FIXED-INCOME MARKETS
FOR GOVERNMENT ISSUERS
LEARNING OUTCOMES
5.a. Describe funding choices by sovereign and non-sovereign

governments, quasi-government entities, and supranational agencies
5.b. Contrast the issuance and trading of government and corporate

fixed-income instruments
[LOS 5.a] Describe funding choices by sovereign and non-sovereign

Public sector issuers
1. Sovereign governments 2. Non-sovereign governments
Non- Quasi-
Supranational
Sovereign debt sovereign government
debt
debt debt

1. Issued by
Issued by
Sovereign debt National governments
Levels of government that lie below the national level

Non-sovereign debt
(e.g., provinces, regions, states, and cities).
Organizations that perform various functions for the

national government, but are not actual
governmental entities.
Quasi-government Example of Quasi-government organizations:
debt • In USA: Ginnie Mae (Government National Mortgage
Association).
• In VN: Vietnam bank for social policies (VBSP),
Vietnam development bank (VDB),…
Supranational (or multilateral) agencies such as the

Supranational debt World Bank, International Monetary Fund (IMF) and
the Asian Development Bank (ADB).

2. Purpose
Purpose
Fund spending on public goods and services and

Sovereign debt
investment in public infrastructure.
Finance public projects, such as construction of

Non-sovereign debt
hospitals, airports…
Fund specific purposes, such as financing

Quasi-government
infrastructure investment or providing mortgage
debt
financing.
Pursuit common objective, such as fostering economic

cooperation and development, promoting trade, or
Supranational debt
providing financing to emerging economies in pursuit
of sustainable growth.

3. Sources of repayment
Sources of repayment
Tariffs, usage fees, and cash flows from government-

Sovereign debt
owned enterprises.
• Taxes
Non-sovereign debt • Sovereign government backing
• User fees
• Taxes
Quasi-government
• Sovereign government backing
debt
• User fees or Cash flows from project operation
Supranational debt Sovereign government backing


4. Characteristics
a. Sovereign debt
1. In preparing financial reports
Sovereign debt Private debt
Are based more on cash In accordance with generally

transactions and less on accruals accepted accounting principles
(e.g., depreciation, unfunded (GAAP).
liabilities).
When assessing the financial statements of a government, an analyst

should consider the issuer to have an “economic balance sheet” that
includes implied assets (e.g., expected future tax revenues) and implied
liabilities (e.g., promised future expenditures) in addition to the financial
assets and liabilities reported in the public accounts.

4. Characteristics
a. Sovereign debt
2. National government issuers are distinguished between
Developed market Emerging market

sovereign issuers sovereign issuers
Strong, stable, well- Faster growing, less stable,

diversified economies with and more concentrated
Features
consistent and transparent economies with less stable
fiscal policy tax revenues
• Domestic currency
Currency
Reserve currency* • Foreign currency
denomination
Reserve currency: A currency held by global central banks in significant

quantities and widely used to conduct international trade and financial
transactions.
Reserve currencies
Possesses Used for
Central bank International

trade

4. Characteristics
a. Sovereign debt
Emerging market sovereign issuers – Currency denomination
Domestic debt External debt
• Domestic investors • Foreign private investors

• Domestic currency • Currency can be denominated
either:
o Government’s home currency
o Reserve currency
Illustration: When external debt is denominated in a reserve currency

Issue Issue
Thailand sovereign US dollar–denominated US-based

issuer external sovereign debt investors
Investors faces indirect

Investors avoid the direct
exposure to currency fluctuations,
currency risk of the issuer’s
related to ability to generate
currency weakening.
revenue for repayments.

4. Characteristics
a. Sovereign debt
3. Debt management policy
A government’s debt management policy sets out the amount and type of
securities the government intends to issue:
Short-term securities (with maturities ranging from 1 to

Treasury bills 12 months), which are usually zero-coupon
instruments sold at a discount to par.
• Medium- and long-term securities

Treasury notes • Coupon instruments can be fixed-rate, floating-rate,
inflation-linked, and foreign currency instruments.
Some sovereign governments guarantee certain other

Other types of
instruments that make them a type of sovereign debt.
bonds
For example: Mortgage-backed securities

4. Characteristics
a. Sovereign debt
4. Government’s choice of debt maturity
Recall from Economics topic: The Ricardian equivalence theorem based on

similar simplified assumptions, gives an analogous result:
A government’s choice of debt maturity is irrelevant in determining the
present value of future tax cash flows
This would imply that a government should be indifferent among the

possible maturities of its debt, but only under all of the following
assumptions about taxpayer behavior:
• They will increase savings when they expect higher future taxes.
• They have rational expectations, expecting tax decreases in the present to
be offset by tax increases in the future.
• They can borrow and lend in capital markets that have no transactions
costs.
• They can and will pass tax savings on to future generations.
Because these assumptions do not hold in practice, governments must

manage how much of their debt is short-term or longer-term.

4. Characteristics
a. Sovereign debt
4. Government’s choice of debt maturity
Different maturity sectors for sovereign debt have some benefits and
drawbacks for market participants:
Benefits Drawbacks
Safe and highly liquid, and it • Lower yield

Short-term
may function as an alternative • Relying too heavily on it
securities
to bank deposits creates rollover risk
• Establishment of a risk-free
benchmark for all debt of
specific maturities
• Use in managing and
Medium-
hedging market interest
and long- • Lower of flexibility
rate risk
term • Less liquid
• Preferred use as collateral in
securities
repo and derivative
transactions
• Use in monetary policy and
foreign exchange reserves

4. Characteristics
b. Non-sovereign debt
General obligation bonds Revenue bonds

(GO bonds)
• Fund for general purposes. • Fund for specific projections.
• Repaid from local tax cash flows. • Repaid from user fees or cash
flows directly from the project.
• The maturity of bond often
matches the expected life of
matching project cash flows.
• Non-sovereign bonds are of high credit quality, but they still trade at
higher yields than sovereign bonds.
• The lower the credit quality and the liquidity of a non-sovereign bond
relative to a sovereign bond, the greater the additional yield.

4. Characteristics
c. Quasi-government debt
Illustration of agency issuers
Airport authority of Hong Kong Ginnie Mae

• Statutory agency for operating • Securitizes and guarantees
and developing the Hong Kong certain mortgage loans in the U.S
International Airport. to facilitate home ownership.
• Fund spending on airport’s • Fund spending on its operations
specific working capital and with maturities matching the
capital investment needs. cash flows of mortgages.
• Source of repayment: • Source of repayment:
o Primary: cash flows from o Primary: mortgage-based
airport operations. guaranty fees.
o Secondary: sovereign o Secondary: sovereign
government backing. government backing.
When they are backed by the sovereign entity, agency bonds typically have
yields and credit ratings closely aligned with those of the government.

4. Characteristics
d. Supranational debt
Member states typically share decision-making authority and provide

implicit and explicit financial support to these organizations, resulting in the
highest credit quality among these issuers and a strong ability to access
capital markets across maturities.
[LOS 5.b] Contrast the issuance and trading of government and

corporate fixed-income instruments
1. Issuance of sovereign debt
In contrast to the opportunistic nature of corporate debt issuance managed

by investment bank underwriters on behalf of issuers, issuance of sovereign
debt usually takes the form of a public auction led by the national Treasury
or finance ministry.
Auction process
Auction announcement by
the government debt 1
management office
Dealers, institutional
2 investors, and individuals
make bids.
Bids can be competitive or
non-competitive, leading
3
to different results
Securities are delivered to:
• 1st: non-competitive
4
• 2nd: winning competitive
bidders

Competitive bidder Non-competitive bidder
• Competitive bidder specifies an Non-competitive bidder agrees to

acceptable price and number of accept the price determined at
securities to be purchased. auction and always receives
• If the price determined at auction securities.
is above the bid, a competitive
bidder will not be offered any
securities.
$100 $100
$150 $90 $85 $100 $100 $100


The issuer ranks bids by prices, choosing bids from highest to lowest until the desired
issuance amount is reached.
Cut off price is the minimum price for acceptance of bids as determined in an auction
→ All bids received below the cut off price is rejected.
Illustration:
In this auction, the cut-off price was Bidder Bid price ($)
determined at $110.
Ranking
A 120
→ Bids offered by A, B, C was accepted
because the bid price is higher than the B 115
cut-off price and bid offered by D was C 110
rejected.
D 100
There are two types of public auction
Single-price auction Multiple-price auction
All the winning bidders pay the same Each successful bidder pay at the bid
price and receive the same coupon rate price and yield they had offered for the
for the bonds. same bond issue.
• Lower cost of funds. • Higher cost of funds.
• Broader distribution among investors. • Narrower distribution of large bids.
A A 120
B 110 B 115
C C 110

Participants in issuance
A group of financial intermediaries
Sovereign Investors
issuers
Primary dealers
Purpose:
• Make competitive bids in auctions.
• Submit bids in auctions on behalf
of third parties.
• Act as counterparty to the central
bank when it buys and sells
securities to carry out monetary
policy.

2. Trading of sovereign debt
Sovereign debt is usually traded in a manner similar to that of private sector

debt securities primarily on OTC markets by financial intermediary
broker/dealers.
Now
Liquidity
… Issued Issued Issued Issued
bonds bonds bonds bonds
Off-the-run On-the-run
securities securities
Previously Most recently
issued bonds issued bonds
Types of investors and their “non-economic” objects on trading sovereign

bonds:
• Central banks use sovereign bonds to conduct monetary policy.
• Foreign governments purchase sovereign bonds of other nations as
reserves.
• Some financial institutions are required to hold government bonds to
comply with regulations.
Student’s notes
BOND VALUATION: PRICES AND
YIELDS
MODULE 6: FIXED-INCOME BOND
VALUATION: PRICES AND YIELDS
LEARNING OUTCOMES
6.a. Calculate a bond’s price given a yield-to-maturity on or between

coupon dates
6.b. Identify the relationships among a bond’s price, coupon rate,

maturity, and yield-to-maturity
6.c. Describe matrix pricing

OVERVIEW
Difference between two bonds’ yield
Yield curve
Module 9
Required rate of returns (bond yields)

Bond valuation
Yield measures
Module 7 + 8
Yield spreads
Module 7 + 8
Module 6
Bond pricing Matrix pricing Benchmark rate

[LOS 6.a] Calculate a bond’s price given a yield-to-maturity on or

between coupon dates
1. Bond pricing with a Market discount rate
The value or price of a bond is computed as the present value of

expected future cash flows from the bond.
Value/Price Discounted at market discount rate

of bond = ? to estimate the price of bond
The market discount rate (also known as the required yield or the
required rate of return) represents the rate of return required by
investors to compensate them for the perceived riskiness of the bond.

General formula of bond pricing:

PMT PMT PMT PMT + Par
PV = + + +...+
(1+r)1 (1+r)2 (1+r)3 (1+r)n
where:
PV = present value, or the price of the bond
PMT = coupon payment per period
Par = the par value of the bond
r = market discount rate, or required rate of return per period
n = number of evenly spaced periods to maturity
As explained in Module - FSA topic: the market rate can be the same as or
different from the coupon rate
Market rate > coupon Market rate = coupon Market rate < coupon
rate rate rate
the bond is trading at a the bond is trading at the bond is trading at a

discount (PV < Par) Par (PV = Par) premium (PV > Par)

Example 1: Calculate the price of bond: at discount, at premium and at Par

A 4-year, 10% annual coupon bond with a par value of $1,000. Calculate
the price of the bond at the market discount rate of:
a. 10% b. 9% c. 11%
Answer:
0 1 2 3 4
PV = ? $100 $100 $100 $100 + $1,000 = $1,100
Coupon payment each period (PMT) = 10% × $1,000 = $100

a. r = 10% = coupon rate
100 100 100 100 + 1,000
PV = + + + = $1,000 = Par
(1+ 10%)1 (1+ 10%)2 (1+ 10%)3 (1+10%)4
→ trading at Par
(FV = $1,000; PMT = $100; N = 4; I/Y = 10; CPT PV; PV = -$1,000)
(Continue in the next slide)


Example 1: Calculate the price of bond: at discount, at premium and at Par

A 4-year, 10% annual coupon bond with a par value of $1,000. Calculate
the price of the bond at the market discount rate of:
a. 10% b. 9% c. 11%
Answer:
b. r = 9% < 10% (coupon rate)

100 100 100 100 + 1,000
PV = + + + = $1,032.4 > Par
(1 + 9%)1 (1 + 9%)2 (1 + 9%)3 (1+9%)4
→ trading at Premium
(FV = $1,000; PMT = $100; N = 4; I/Y = 9; CPT PV; PV = -$1,032.4)
c. r = 11% > 10% (coupon rate)

100 100 100 100 + 1,000
PV = + + + = $968.98 < Par
(1 + 11%)1 (1 + 11%)2 (1 + 11%)3 (1+11%)4
→ trading at Discount
(FV = $1,000; PMT = $100; N = 4; I/Y = 11; CPT PV; PV = -$968.98)

Conclusions:
• The higher the discount rate, the lower the present value of each
individual cash flow, and the lower the value of the fixed-income
security.
• The lower the discount rate, the higher the present value of each
individual cash flow, and the higher the value of the fixed-income
security.

Example 2: Calculate the price of bond with semiannual coupon payment

Calculate the price of the bond in the Example 1.b, but with semiannual
coupon payment instead.
Answer:
There will be 8 (= 4 × 2) semiannual coupon payments on this bond and
each coupon payment will be worth $50 (= 10%/2 × $1,000). Given a
semiannual yield-to-maturity of 4.5% (= 9%/2), the value of the bond
today can be computed as:
50 50 50 50 + 1,000
PV = 1 + 2 +... + 7 + = $1,032.98
(1 + 4.5%) (1 + 4.5%) (1 + 4.5%) (1+4.5%)8
(FV = -$1,000; PMT = -$50; N = 8; I/Y = 4.5; CPT PV; PV = $1,032.98)

Discussion: The value of the bond here is slightly greater than the value of
the bond in the Example 1.b ($1,032.98 > $1,032.40).

2. Yield to maturity

A given To equate to the given current
current price price, we must discount at YTM = ?
The yield-to-maturity (YTM) is the (uniform) interest rate that equates the
sum of the present values of the bond’s expected future cash flows (when
discount at that rate) to its current price.
PMT PMT PMT + Par
Current price of bond = + +...+
(1+YTM)1 (1+YTM)2 (1+YTM)n
The yield-to-maturity is the rate of return on the bond to an investor given

three critical assumptions:
• The investor holds the bond to maturity.
• The issuer makes all the coupon and principal payments in the full
amount on the scheduled dates
• The investor is able to reinvest coupon payments at that same yield.
This is a characteristic of an internal rate of return (IRR).

2. Yield to maturity
Example 3: Calculate the yield-to-maturity

1. Compute the YTM for a 10-year, $1,000 par bond that pays an 8%
annual coupon given that its current price is $925.
2. Compute the YTM of a 10-year, $1,000 par bond with an 8% coupon
rate that makes semiannual coupon payments given that its current price
is $925.
Answer:
1. Current price = $925, coupon payment = $1,000 × 8% = $80
80 80 80 + 1,000
925 = + +...+ → YTM = 9.18%
(1 + YTM)1 (1 + YTM)2 (1+YTM)10
(FV = -$1,000; PMT = -$80; N = 10; PV = $925, CPT → I/Y = 9.18)
2. Current price = $925, coupon payment = $1,000 × 8%/2 = $40
40 40 40 + 1,000
925 = + +...+ → YTM = 9.16%
(1 + YTM)1 (1 + YTM)2 (1 + YTM)20
2 2 2
(FV = -$1,000; PMT = -$40; N = 20; PV = $925, CPT → I/Y = 4.58
→ YTM = 4.58 × 2 = 9.16)

In the LOS 6.a: it is assumed that the bond is priced on a coupon payment date.
→ If a coupon bond is sold between coupon payment dates, we must account for
the accrued interest (AI) that the seller has earned, but not yet received.
→ We need to consider 2 types of bond price at that settlement date: Full and
Flat price
• Full price/Dirty price is the value of the bond at the settlement date, or the
total amount that the buyer pays the seller, including accrued interest (AI)
• Flat price/Clean price is usually quoted by bond dealers
• Accrued interest (AI)/Interest earned by seller is the seller’s proportional
share of the next coupon payment.
T days
AI = PMT × t/T ...
Last coupon t days Next coupon

Settlement date
payment date payment date
PV – price of the Price paid Price quoted

bond at the last Full price (Dirty price) Flat price (Clean price)
coupon payment = =
date PV × (1+r)t/T Full price - AI
Where: PMT = coupon payment r = discount rate per period


Example 4: Calculate the flat price, accrued interest and the full price
A 5% U.S. corporate bond is priced for settlement on July 20, 2015. The
bond makes semiannual coupon payments on April 21 and October 21 of
each year and matures on October 21, 2021. The bond uses the 30/360
day-count convention for accrued interest.
Required: Calculate the full price, the accrued interest, and the flat price
per USD 100 of par value for annual yields-to-maturity of 4.7%.
Answer:
T = 180 days
21/4/15 20/7/15 21/10/15 … 21/10/21
$2.5 t = 89 days $2.5 $102.5
1 2
PV = $101.6636 Flat price = $101.60
Full price = $102.84
1
Coupon payment each period = 5%/2 × $100 = $2.5
• The bond price at the last coupon day (21/4/15): PV = $101.66
(N = 13; PMT = -$2.50; FV = -$100; I/Y = 2.35%; CPT→ PV = $101.66)

Example 4: Calculate the flat price, accrued interest and the full price
Answer: T = 180 days

21/4/15 20/7/15 21/10/15 … 21/10/2
1
$2.5 t = 89 days $2.5 $102.5
1 2
PV = $101.6636 Flat price = $101.60
Full price = $102.84
2
• Given the 30/360 day-count convention:
o There are 89 days between the last coupon on 21/4/15 and the
settlement date on 20/7/15 → t = 89

o There are 360/2 = 180 days from the last coupon payment date on
21/4/15 to the next coupon payment date on 21/10/15 → T = 180

• Full price = PV × (1+r)t/T = $101.66 × (1+2.35%)89/180 = $102.84
• Accrued interest (AI) = PMT × t/T = 2.5 × 89/180 = $1.24
• Flat price = Full price – AI = $102.84 - $1.24 = $101.60
[LOS 6.b] Identify the relationships among a bond’s price, coupon

rate, maturity, and yield-to-maturity
1. Bond’s price and market discount rate (YTM)
a.The inverse effect
As explained above, the bond price is inversely related to the market

discount rate:
Market discount rate Price of the bond
increases (decreases) decreases (increases)
b.The convexity effect
Consider the bond’s price calculated in the Example 1:
Discount rates go down Discount rates go up
Price at 10% Price at 9% % Change Price at 11% % Change
$1,000 $1,032.4 +3.24% $968.98 -3.10%


Discount rate falls by 100 bps Discount rate rises by 100 bps
( 10% → 9%) ( 10% → 11%)
Bond price increases 3.24% > Bond price decreases 3.10%
For the same coupon rate and term to maturity, the percentage change in
price is greater in absolute value when the discount rate decreases than
when it increases
→ the relationship between bond prices and the market discount rate is
not linear; instead, it is curved on a graph
→ “convex curve” or “price-yield profile” of a bond

Bond price
Premium
$1,032.4 Discount
+3.24%
$1,000
-3.10%
$968.98
1% 1%
9% 10% 11% Discount rate

Price-yield profile

2. Bond’s price and coupon rate
c. The coupon effect
Consider the bond’s price calculated in the Example 1, assume that the
coupon rate has raised up to 15% (case C) and falled down to 5% (case A)
Discount rates go Discount rates go
down up
Coupon Price at Price at % Price at %

rate 10% 9% Change 11% Change
A 5% $841.5 $870.4 +3.43% $813.9 -3.28%
B 10% $1,000 $1,032.4 +3.24% $968.98 -3.10%
C 15% $1,158.5 $1,194.4 +3.10% $1,124.1 -2.97%
For the same term to maturity, a lower coupon bond is more sensitive to
changes in the market discount rate than a higher coupon bond

3. Bond’s price and maturity
d. The maturity effect
Consider the bond’s price calculated in the Example 1, assume that the
maturity has raised up to 6 years (case C) and falled down to 2 years (case A)
Discount rates go Discount rates go
down up
Maturit Price at Price at % Price at %

y 10% 9% Change 11% Change
A 2y $1,000 $1,017.6 +1.76% $982.9 -1.71%
B 4y $1,000 $1,032.4 +3.24% $968.98 -3.10%
C 6y $1,000 $1,044.9 +4.49% $957.7 -4.23%
Generally, for the same coupon rate, a longer-term bond is more

densitive to changes in the market discount rate than a shorter term
bond.

e. The constant-yield price trajectory
As time passes, bond prices change even if the market discount rate
remains the same.
→ the price of a bond approaches par value as its time-to-maturity
approaches zero – “pull to par” effect
→ illustrated by the constant-yield price trajectory
Consider the bond’s price calculated in the Example 1:

Bond price (PV of remaining CF)
Tenor
At 9% At 10% At 11%
4 +$1,032.4 $1,000 -$968.98
3 +$1,025.3 $1,000 -$975.6
2 +$1,017.6 $1,000 -$982.9
1 +$1,009.2 $1,000 -$991
0 +$1,000 $1,000 -$1,000
Bond value decreases over time Bond value increases over time
and reaches Par at maturity and reaches Par at maturity

e. The constant-yield price trajectory
Bond price
$1,032.4 Premium bond (9%)
Par bond (10%)

$1,000
$968.98 Discount bond (11%)
Maturity Time
date
The constant-yield price trajectory
[LOS 6.c] Describe matrix pricing
Matrix pricing is a method of estimating the required yield-to-maturity

(YTM) (or price) of bonds that are currently not traded or infrequently
traded.
Not traded or infrequently traded
YTM of subject bond
Linear interpolation
method to estimate (*)
YTM of comparable bonds
Similar in maturity, coupon

Actively traded
rates and credit quality
(*) Simple linear interpolation
YTM
y3
y=?
y2
y1
x1 x2 x3 Maturity
x
Given a table of data points (xi , yi ) for which yi is the YTM for a xi maturity
bond.
(y y )
→ y = y2 + (x - x2 ) × 3 2
(x
3 x2)
Example 5: Matrix pricing method for nontraded bond

Rob Phelps, CFA, is estimating the value of a nontraded 4% annual-pay,
A+ rated bond that has three years remaining until maturity. He has
obtained the following yields-to-maturity on similar corporate bonds:
• A+ rated, 2-year annual-pay, YTM = 4.3%
Estimate the value of the nontraded bond.
Answer:
YTM: 5 year – YTM = 5.1% (1) Take the average YTM of the 5-year bonds:
5 year – YTM = 5.3% 5.1 + 5.3
2 year – YTM = 4.3% = 5.2%.
2
Comparable bonds YTM
5.2 (2) 3-year YTM
Linear (3 −2)
4.6 = 4.3% +
(5 −2)
× (5.2% - 4.3%)
interpolation 4.3
= 4.6%
method Maturity
2 3 5
Subject bond
(3) Price the nontraded bond
YTM: 3 year – YTM = ? N = 3, PMT = 40, FV = 1,000, I/Y = 4.6, CPT
→ PV = -983.54
Matrix pricing also is used in underwriting new bonds to get an estimate

of the required yield spread (1) over the benchmark rate (2) (spread over
the benchmark)
(1) Required yield spread equal to the difference between the YTM on the
new bond and the benchmark bond.
(2) The benchmark rate is typically a government bond with a similar
term to maturity.
Example 6: Matrix pricing method for yield spread on new issue
Consider the following market yields:

• 5-year, U.S. Treasury bond, YTM 1.48%
• 5-year, A rated corporate bond, YTM 2.64%
• 7-year, U.S. Treasury bond, YTM 2.15%
• 7-year, A rated corporate bond, YTM 3.55%
• 6-year U.S. Treasury bond, YTM 1.74%
Estimate the required yield on a newly issued 6-year, A rated corporate
bond.
Example 6: Matrix pricing method for yield spread on new issue

Answer:
5-year spread = 1.16% (1) Calculate the spreads over the benchmark
7-year spread = 1.40% yields.
Given yield spreads • 5-year spread = 2.64 – 1.48 = 1.16%.
• 7-year spread = 3.55 – 2.15 = 1.40%.
Spread
1.40
Linear 1.28
interpolation 1.16
method Maturity
5 6 7
(2) 6-year spread
(6 − 5)
= 1.16% + × (1.4% - 1.16%) = 1.28%
(7 − 5)
(3) YTM on the newly issued 6-year, A rated

Required yield spread
bond
6-year spread = ? = 1.74% + 1.28% = 3.02%
Student’s notes
MODULE 7: YIELD AND YIELD

SPREAD MEASURES FOR FIXED-
RATE BONDS
MODULE 7: YIELD AND YIELD SPREAD
MEASURES FOR FIXED-RATE BONDS
LEARNING OUTCOMES
7.a. Calculate annual yield on a bond for varying compounding periods in

a year
7.b. Compare, calculate, and interpret yield and yield spread measures for
fixed-rate bonds
MEASURES FOR FIXED-RATE BONDS 194 Student’s notes
[LOS 7.a] Calculate annual yield on a bond for varying

compounding periods in a year
The effective annual rate (or effective annual yield) (EAR) on a fixed-rate
bond depends on the assumed number of periods in the year, which is
known as the periodicity of the stated annual rate or stated annual yield
(annual percentage rate – APR):
APR
EAR = (1 + n )n - 1
where n is the frequency of coupon payment
Example 1: Effective annual rate

What is the effective annual yield for a bond with a stated YTM of 10%:
1. When the periodicity of the bond is 2 (pays semiannually)?
2. When the periodicity of the bond is 4 (pays quarterly)?
Answer:
10%
1. Effective annual yield = (1 + 2 )2 - 1 = 10.25%
10% 4
2. Effective annual yield = (1 + ) - 1 = 10.38%
4
• Periodicity = 1 → annual compounding → EAR = APR

• As explained in Module – Quantitative Methods: Given the annual
percentage rate, as the number of compounding periods (periodicity)
increases, the effective annual rate increases.

To convert an annual percentage rate (APR) for m periods per year, APRm,
to an annual percentage rate for n periods per year, APRn, we can use the
following formula:
APRm APRn n APRm
(1 + m )m = (1 + n )n → APRn = [ (1+ m )m - 1] × n
• It may be necessary to adjust the quoted yield (APR) on a bond to make

it comparable with the yield on a bond with a different periodicity.
• Given the effective annual rate, as the number of compounding periods
(periodicity) increases, the annual percentage rate decreases.
(Illustrated in Example 9)
Example 2: Calculate the annual percentage rate for different

compounding frequencies
A 5-year, 6% semiannual-pay government bond is priced at 98 per 100 of
par value. Calculate the annual yield-to-maturity stated on a semiannual
bond basis (*) (or APR). Convert this annual percentage rate to:
1. An annual percentage rate based on annual compounding.
2. An annual percentage rate based on quarterly compounding.
(*) Semiannual bond basis yield is an annual rate (APR) or stated annual
yield having a periodicity of two

Example 2: Calculate the annual percentage rate for difference

compounding frequencies
Answer:
Step 1: Calculate the yield per semiannual period (*) on the semiannual-pay
bond.
N = 10; PMT = $3; FV = $100; PV = -$98; CPT I/Y; I/Y = 3.237%
→ Semiannual bond basis yield or APR = 3.237% x 2 = 6.47%
Step 2: Calculate the APR based on different compounding.
Annual compounding: Quarterly compounding:

6.47% APR1 6.47% APR4
(1 + 2 )2 = (1 + 1 )1 (1 + 2 )2 = (1 + 4 )4
→ APR1 = 6.58% = EAR → APR4 = 6.42%
With the similar EAR ( 6.58%), the annual percentage rate of 6.47% based on
semiannual compounding compares to an annual percentage rate of 6.58%
compounded annually and an annual percentage rate of 6.42%
compounded quarterly
(*) Yield per semiannual period = Semiannual bond basis yield /2

[LOS 7.b] Compare, calculate, and interpret yield and

yield spread measures for fixed-rate bonds
1. Yield measures for fixed-rate bond
a. Yield measures for option-free bond
Street convention yield > True yield

Uses the actual payment
Use scheduled payment dates dates to compute the IRR: if a
to calculate the IRR of the scheduled payment date falls
bond regardless of whether on the weekend or on a
any scheduled payment dates holiday, payment is actually
fall on weekends or holidays. made on the next business
day
Government equivalent yield
Corporate bond yield Restated using Government

(using 30/360 basis) actual/actual basis equivalent yield
To calculate the spread between a corporate bond yield and the

government bond yield (now based on the same actual/actual basis)

a. Yield measures for option-free bond
Current yield Simple yield
Annual cash coupon payment Annual cash coupon payment + gain/loss (∗)
Bond price Bond price
(*) A bond’s simple yield takes a discount or premium into account by

assuming that any discount or premium declines evenly over the remaining
years to maturity.
Gain/loss = the straight-line amortization of a discount/premium
Example 3: Calculate the current yield and simple yield
A 3-year, 8% coupon, semiannual-pay bond is priced at 90.165.
Calculate the current and simple yield at the end of the first year.
Answer:
Annual cash coupon payment 8
Current yield = Bond price = 90.165 = 8.87%
The discount from par value is 100 – 90.165 = 9.835.
Gain = annual straight-line amortization of the discount is 9.835/3 = 3.278.
Annual cash coupon payment + gain/loss 8 + 3.278
Simple yield = Bond price = 90.165 =
12.51%

b. Yield measures for option-embedded bond
Yield-to-call and yield-to-worst
• For callable bonds, the yield realized by the investor will depend on
whether and when (and at what call price) the bond is called. Investors
compute the yield-to-call for each call date (based on the call price and
the number of periods until the call date).
• The yield-to-worst is the worst or lowest yield among the yield-to-
maturity and the various yields to call for the bond.
Example 4: Calculate the Yield-to-call and Yield-to-worst
Consider a 10-year, semiannual-pay 6% bond trading at 102 on January 1, 2014 (Par =
$1,000).
The bond is callable according to the following schedule:
• Callable at 102 on or after January 1, 2019 (first call date).
• Callable at 100 on or after January 1, 2022 (second call date – first par call date).
1/1/2014 1/1/2019 1/1/2022 1/1/2024 (maturity)
PV = $1,020 $1,020 $1,000 $1,000 Call price

Calculate the bond’s YTM, yield-to-first call, yield-to-first par call, and yield-to-worst.

Answer:
1/1/2014 1/1/2019 1/1/2022 1/1/2024 (maturity)
PV = $1,020 $1,020 $1,000 $1,000 Call price
YTC = 5.882%
YTW = 5.686%
YTM = 5.734%
1. The yield-to-maturity on the bond is calculated as:

N = 20; PMT = 30; FV = 1,000; PV = -1,020; CPT→ I/Y = 2.867%
→ YTM = 2 × 2.867% = 5.734%
2. The yield-to-first call is calculated as the YTM using the number of
periods until the first call date (1/1/2019) for N and the call price (1,020)
for FV:
N = 10; PMT = 30; FV = 1,020; PV = -1,020; CPT→ I/Y = 2. 941%
→ yield-to-first call (YTC) = 2 × 2.941% = 5.882%

Answer:
3. The yield-to-first par call (second call date) is calculated as the YTM
using the number of periods until the first par call date (1/1/2022) for N
and the call price (1,000) for FV:
N = 16; PMT = 30; FV = 1,000; PV = -1,020; CPT→ I/Y = 2. 843%
→ yield-to-first par call = 2 × 2.843% = 5.686%
→ The lowest yield, 5.686%, is realized if the bond is called at par on
January 1, 2022, so the yield-to-worst is 5.686%.

Option-adjusted yield
To assess a callable bond yield, a more precise approach is to use an

option pricing model (*), in which the value of embedded call option
bond is added to the flat price of the callable bond is known as the
option-adjusted yield - the required market discount rate.
(*) Option pricing model
Option-adjusted price (Value of noncallable bond)

= Flat price of callable bond + Value of embedded call option
• Use option-adjusted price to calculate the option-adjusted

yield
• Option-adjusted yield will be lower than the YTM of the
callable bond

Affected by
microeconomic factors
Taxation
Spread Risk premium Liquidity
Credit risk
Affect
Expected real
rate
Risk-free rate
Benchmark
of return
Expected
inflation rate
Affected by
macroeconomic factors
Yield-to-Maturity Building Blocks


2. Yield spread over Benchmark rates
• Yield spread is the difference between the yields of two different

bonds. Yield spreads are typically quoted in basis points.
• Benchmark spread is a yield spread relative to a benchmark rate.
o G-spread is a yield spread over a government bond yield when using
government bond yields as benchmarks.

o I-spread is a yield spread over a swap rate when using rate for
interest rate swap as benchmarks.
Yield spreads are useful for analyzing the factors that affect a bond’s yield.
Both macroeconomic and microeconomic factors can cause the increase
in corporate bond yields:
• If a bond’s yield increases but its yield spread remains the same → the
yield on its benchmark must have also increased → macroeconomic
factors caused bond yields in general to increase.
• If the yield spread increases → the increase in the bond’s yield was
caused by microeconomic factors such as credit risk or the issue’s
liquidity.

3. Yield spread over the Benchmark yield curve
G-spread and I-spread each use the same discount rate for each cash flow
→ only correct if the spot yield curve is flat so that yields are
approximately the same across maturities.
Zero-Volatility Spread
• When the spot yield curve is upward-sloping → calculate a constant

yield spread over a government (or interest rate swap) spot curve
instead.
• An appropriate yield curve spread added to the benchmark spot rates
will produce a value that is equal to market price of the bond → zero-
volatility spread or Z-spread.
Option-adjusted spread (OAS)
An option-adjusted spread (OAS) which is used for bonds with embedded

call options is the spread to the government spot rate curve that the bond
would have if it were option-free.
OAS = Z-spread − Op on value

Example 5: Zero-volatility spread and Option-adjusted spread

The 1-, 2-, and 3-year spot rates on Treasuries are 4%, 8.167%, and
12.377%, respectively. Consider a 3-year, 9% annual coupon corporate
bond trading at 89.464. The YTM is 13.50%, and the YTM of a 3- year
Treasury is 12%.
1.Compute the G-spread and the Z-spread of the corporate bond
2. Compute the OAS if the option value = 60bps
Answer:
1. The G-spread is:
G-spread = YTMBond − YTMTreasury = 13.50 − 12.00 = 1.50%.
To compute the Z-spread, set the present value of the bond’s cash lows
equal to today’s market price. Discount each cash flow at the appropriate
zero-coupon spot rate plus a fixed spread ZS.
9 9 109
89.464 = 1.04 + ZS + (1.08167 + ZS)^2 + (1.12377 + ZS)^3
→ ZS = 1.67%
2. OAS = ZS – 0.6% = 1.07%
Student’s notes
MODULE 8: YIELD AND YIELD

SPREAD MEASURES FOR
FLOATING-RATE INSTRUMENTS
MODULE 8: YIELD AND YIELD SPREAD MEASURES
FOR FLOATING-RATE INSTRUMENTS 208 Student’s notes
LEARNING OUTCOMES
8.a. Calculate and interpret yield spread measures for floating-rate

instruments
8.b. Calculate and interpret yield measures for money market instruments
[LOS 8.a] Calculate and interpret yield spread measures

for floating rate instruments
Interest payments on a floating-rate note (FRN) are not fixed: the coupon
interest rates are reset periodically based on a reference rate
→ the values of FRN are more stable than the fixed-rate debt of similar
maturity → less market price risk when interest rates fluctuate
Required margin/Discount
Quoted margin
margin
Refer to the spread offered to Refers to the spread above the
investors on top of the reference reference rate such that the FRN
rate to calculate the effective is priced on a rate reset date:
coupon rate: Discount rate = reference rate +
Coupon rate = reference rate + discount margin (DM)
quote margin (QM)

Index + QM × Par Index + QM × Par Index + QM × Par

m m m + Par
PV = + +...+
(1 + Indexm+ DM)1 (1 + Indexm+ DM)2 (1 + Indexm+ DM)n
PV = present value, or the price of the floating-rate note

Index = reference rate, stated as an annual percentage rate
QM = quoted margin, stated as an annual percentage rate
Par = future value paid at maturity, or the par value of the bond
m = periodicity of the floating-rate note, the number of payment periods
per year
DM = discount margin, the required margin stated as an annual percentage
rate
n = number of evenly spaced periods to maturity
• If the credit quality decreases: the quoted margin < the required margin
→ the FRN will sell at a discount to its par value.
• If credit quality has improved: the quoted margin > the required margin
→ the FRN will sell at a premium to its par value.

Example 1: Valuation of a FRN

A $1,000 par quarterly-pay FRN has exactly one year to maturity. The
reference rate is 90-day LIBOR and the bond carries a quoted margin of
80 bps. LIBOR-90 today (which happens to be a coupon-reset date) is
2.50%, while the current required margin on the FRN is 94 bps. Assuming
a 30/360 day-count convention and evenly spaced periods, determine
the current value of the FRN?
Answer:
Coupon rate per quarter = (reference rate + quoted margin)/m
= (2.50% + 0.80%) x (90/360) = 0.825%
→ Coupon payment = 0.825% x $1,000 = $8.25
Discount rate per quarter = (reference rate + required margin)/m
= (2.50% + 0.94%) x (90/360) = 0.86%
The estimated value of the FRN as:
8.25 8.25 8.25 8.25 + 1,000
PV = + + + = $998.63
(1+ 0.86%)1 (1+ 0.86%)2 (1+0.86%)3 (1+0.86%)4
(FV = -$1,000; PMT = -$8.25; N = 4; I/Y = 0.86; CPT PV; PV = $998.63)

Notice that since the required margin is greater than the quoted margin,
this FRN will trade at a discount.
[LOS 8.b] Calculate and interpret yield measures

for money market instruments
Some important differences in yield measures between the money

market and the bond market
Yield in the money market Yield in the bond market
Interest basis Annualized but not Annualized and

compounded compounded
→ simple interest basis → compound interest basis
YTM Yields are quoted using non- Use standard time-value-of-

calculating standard interest rates money analysis or formulas
method → require different pricing programmed into a financial
equations to calculate YTM calculator to calculate YTM

Discount rate basis and Add-on rate basis for money market instruments
Discount rate (DR) basis Add-on rate (AOR) basis
DR AOR
PV FV (Par) PV (Par) FV
Principle
Days Days
Discount amount = FV × Year × DR Add-on amount = PV × Year × AOR
Pricing Days Days

PV = FV × ( 1 - × DR) FV = PV × (1 + × AOR)
model Year Year
Yield Year FV − PV Year FV − PV

DR = Days × FV AOR = Days × PV
measure
• PV = present value/the price of the money market instrument
• FV = future value (redemption amount) paid at maturity
• Days = number of days between settlement and maturity
• Year = number of days in the year
A bond equivalent yield is a money market rate stated on a 365-day AOR

basis.

Example 2: Money market yields

1. A $1,000 90-day T-bill is priced with an annualized discount of 1.2%
(360-day count basis). Calculate its market price and its annualized
add-on yield based on a 365-day year. (Quoted in US market)
2. A $1 million negotiable CD with 120 days to maturity is quoted with an
add-on yield of 1.4% based on a 365-day year. Calculate the payment
at maturity for this CD and its bond equivalent yield. (Quoted in Euro
market)
3. A bank deposit for 100 days is quoted with an add-on yield of 1.5%
based on a 360-day year. Calculate the bond equivalent yield.
Answer:
1. The current price is 1,000 × ( 1 – 1.2% × 90 / 360) = $997.

→ The equivalent add-on yield for 90 days is (1,000 – 997)/ 997 =
0.3009%.
→ The annualized add-on yield based on a 365-day year is 365/90 ×
0.3009 = 1.2203%. This add-on yield based on a 365-day year is referred
to as the bond equivalent yield for a money market security.

Example 2: Money market yields
Answer:
2. The add-on interest for the 120-day period is 120/365 × 1.4% = 0.4603%.
→ At maturity, the CD will pay $1 million × (1 + 0.004603) = $1,004,603.
The quoted yield on the CD is the bond equivalent yield because it is an add-
on yield annualized based on a 365-day year.
3. Because the yield of 1.5% is an annualized yield calculated based on a

360-day year, the bond equivalent yield, which is based on a 365-day year,
is: (365/360) × 1.5% = 1.5208%
Student’s notes
MODULE 9: THE TERM STRUCTURE

OF INTEREST RATES: SPOT, PAR AND
FORWARD CURVES
MODULE 9: THE TERM STRUCTURE OF INTEREST
RATES: SPOT, PAR AND FORWARD CURVES
LEARNING OUTCOMES
9.a. Define spot rates and the spot curve, and calculate the price of a
bond using spot rates
9.b. Define par and forward rates, and calculate par rates, forward rates
from spot rates, spot rates from forward rates, and the price of a
bond using forward rates
9.c. Compare the spot curve, par curve, and forward curve
RATES: SPOT, PAR AND FORWARD CURVES 218 Student’s notes
[LOS 9.a] Define spot rates and the spot curve, and calculate the
price of a bond using spot rates
• Spot rate are the market discount rates for a single payment to be
received in the future.
o The discount rates for zero-coupon bonds maturing at the date of
each cash flow are spot rates → “zero rates”
• Bond price (or value) determined using the spot rates is sometimes
referred to as the bond’s “no-arbitrage value ”
→ bond price = market price of the bond
PMT PMT PMT PMT + Par

PV = + + +...+
(1+S1)1 (1+S2)2 (1+S3)3 (1+Sn)n
Value/Price of bond
Discounted at spot rate S1

Pricing a bond using spot rate

Example 1: Calculate the price of bond using spot rates

Suppose a $1,000 par, annual-pay bond matures in 3 years and has a
coupon rate of 8%. The relevant spot rates are given below:
Maturity Yield on Zero-Coupon Bond (Spot
Rate)
1 year 7%
2 years 7.5%
3 years 8%
Verify that the value of the bond using spot rate?

Answer:
Coupon payment each period = 8% × $1,000 = $80
0 1 2 3
PV = ? $80 $80 $80 + $1,000 = $1,080

Discounted at 7%
Discounted at 7.5%
Discounted at 8%
80 80 80 + 1,000
PV = 1 + 2 + = $1,001.34
(1+ 7%) (1+ 7.5%) (1+8%)3
• A yield curve shows the relationship between yields-to-maturity and

terms-to-maturity.
• The term structure (or maturity structure) of interest rates refers to
the yields at different maturities (terms) for like securities or interest
rates.
In theory, maturity structure should be analyzed for bonds that have the
same properties (credit risk, liquidity risk, tax status, currency
denomination, similar periodicity of payment and reinvestment risk) other
than time-to-maturity – “all other things being equal” assumption
1. Spot rate curve
• The spot rate curve (spot curve), also called zero curve or strip curve,
refers to YTMs on a series of zero-coupon government bonds at various
maturities.
• Spot rate curve provides a more accurate relationship between yields
and terms to maturity relative to using yields to maturity on coupon-
bearing bonds because spot rates are free from reinvestment risk (no
coupon payment) → best meet the “all other things being equal”
assumption in analyzing maturity structure.
1. Spot rate curve
YTM (%)
6
5
4
3
2
1
0 5 10 15 20 25 30
A zero-coupon government bond spot curve
Under normal market conditions, longer-term government bond yields

usually > shorter-term government bond yields.
→ the spot curve is upward sloping and flattens for longer times-to-
maturity.
2. Yield curve for coupon bonds
A yield curve for coupon bonds shows the YTMs for coupon bonds at
various maturities.
YTM (%)
3
2.5
2
1.5
1
0.5
0 5 10 15 20 25 30
A yield curve for coupon bonds
Use linear interpolation method (refer to LOS 6.c) to estimate YTM for
maturities that are not available.
[LOS 9.b] Define par and forward rates, and calculate par rates,
forward rates from spot rate, spot rates from forward rates, and the
price of a bond using forward rates
3. Par curve
Par curve is a sequence of YTM such that each bond trades at par.
The par curve is derived from the spot rate curve, illustrated in Example 2
Example 2: Calculate Par rate from spot rate

The spot rates (expressed as effective annual rates) on government
bonds are 4.75% for 1 year, and 4.86% for 2 years. Compute the 1-year
and 2-year par rates
Answer:
When trying to calculate the par rate, the aim is to solve for “PMT” that
would result in the price of the bond equaling its par value.
→ coupon rate = YTM
PMT + 100
1. 1-year par rate : = 100 → PMT = 4.75
(1 + 4.75%)1
→ The 1-year par rate therefore equals 4.75%.
PMT PMT + 100
2. 2-year par rate: + = 100 → PMT = 4.8578
(1 + 4.75%)1 (1 + 4.86%)2
→ The 2-year par rate, therefore, equals 4.858%
forward rates from spot rate, spot rates from forward rates, and…
4. Forward curve
• Forward rates are yields for future periods. The rate of interest on a 1-
year loan that would be made two years from now is a forward rate.
• A forward curve shows the series of forward rates for bonds or money
market securities for the same tenor for annual periods in the future.
Eg: 2-year forward rate from 1 year, 2 years, 3 years… from now.
YTM (%)
Forward curve
6
5
Spot curve
4
3
2
1
0 5 10 15 20 25 30
Time (Years)
The forward curve above shows the yields of 1-year securities for each
future year.
• A forward rate is a borrowing/lending rate for a loan to be made at

some future date.
• A AyBy forward rate is the rate for a B-year loan (maturity of the loan)
to be made A years from now.
For example: 1y1y is the rate for a 1-year loan one year from now; 2y1y is
the rate for a 1-year loan to be made two years from now; 2y2y is the 2-
year forward rate two years from now; and so on.
2y2y
0 1 2 3 4 years
S1 1y1y 2y1y 3y1y
The idea here is that borrowing for three years at the 3-year spot rate, or
borrowing for one-year periods in three successive years, should have the
same cost. The Si is the current spot rates for i periods:
(1+Si )i = (1 + S1)(1 + 1y1y)(1 + 2y1y) … (1 + (i-1)y1y) (Equation 1)
For example: (1+S3 )3 = (1 + S1 )(1 + 1y1y)(1 + 2y1y)
Calculate spot rates from forward rates
We can restate the Equation 1 to calculate the spot rate from forward
rate:
Si = i (1 + S1 )(1 + 1y1y)(1 + 2y1y) … (1 + (i−1)y1y) - 1
Example: Calculate spot rates from forward rate

If the current 1-year spot rate is 2%, the 1-year forward rate one year from today
(1y1y) is 3%, and the 1-year forward rate two years from today (2y1y) is 4%, what is
the 3-year spot rate?
S3 = ?
Answer:
0 1 2 3
S1 = 2% 1y1y = 3% 2y1y = 4%
S3 = [(1.02)(1.03)(1.04)] ^1/3 − 1 = 2.997%
This can be interpreted to mean that a dollar compounded at 2.997% for three
years would produce the same ending value as a dollar that earns compound
interest of 2% the 1st year, 3% the next year and 4% the 3rd year.
Example: Calculate one-period forward rate from spot rates

The current 1-year spot rate is 5%, 2-year spot rate is 5.25%, and 3-year spot rate
is 5.55%. Calculate the 1-year forward rate 1 year from now and 2 years from now
Answer: S3 = 5.55%
S2 = 5.25%
0 1 2 3
S1 = 5% 1y1y = ? 2y1y = ?
1. Calculation of 1-year forward rate 1 year from today:
(1 + S2 )^2 = (1 + S1 )(1 + 1y1y)
→ 1y1y = [(1 + S2 )^2]/ (1 + S1 ) – 1 = (1.0525^2)/1.05 – 1 = 5.5%
2. Calculation of 1-year forward rate 2 years from today:
(1 + S3 )^3 = [(1 + S2 )^2](1 + 2y1y) = (1 + S1 )(1 + 1y1y)(1 + 2y1y)
→ 2y1y = [(1 + S3 )^3]/[(1 + S2 )^2] – 1 = [(1 + S3 )^3]/[(1 + S1 )(1 + 1y1y)]
= (1.0555^3)/(1.0525^2) = (1.0555^3)/(1.055 × 1.05) = 6.15%
Example: Calculate multiperiod forward rate from spot rates

Calculate the 4-year forward rate 12 years from today, given 12-year spot
rate is 4.5% and 16-year spot rate is 4.6%?
Answer:
S16 = 4.6%
0 1 12 16
… …
S12 = 4.5% 12y4y = ?
(1 + S16)^16 = (1 + S12)^12 × (1 + 12y4y)^4

→ (1 + 12y4y)^4 = [(1 + S16)^16]/[(1 + S12)^12] = (1.046^16)/(1.045^12)
→ 12y4y = 4.9%
Valuing bond using forward rates
Example: Valuing bond using forward rate

The current 1-year rate, S1, is 4%, the 1-year forward rate for lending
from time = 1 to time = 2 is 1y1y = 5%, and the 1-year forward rate for
lending from time = 2 to time = 3 is 2y1y = 6%. Value a 3-year annual-pay
bond with a 5% coupon and a par value of $1,000.
Answer:
50 50 1,050
PV = + +
1+ S1 (1+ S1)(1+1y1y) (1+ S1)(1+1y1y)(1+2y1y)
50 50 1,050
= + + = $1,000.98
1.04 (1.04)(1.05) (1.04)(1.05)(1.06)
[LOS 9.c] Compare the spot curve, par curve, and forward curve
General observations
• The spot rates are positive, and the spot curve is upward sloping.
• The spot and par curves are nearly identical; the par rates are slightly
lower than the spot rates, and the (slight) difference between the spot
and par curves is greater at longer maturities.
• Forward rates are greater than the spot and par rates.
Spot Curve Shape Par Curve Forward Curve
Upward Sloping Below spot curve Above spot curve
Flat Equal to spot curve Equal to spot curve
Downward Sloping
Above spot curve Below spot curve
(Inverted)
1. In case of upward-sloping
Forward curve
Spot curve
Par curve
If the spot curve is upward sloping:

• Par rates will be near—but below—spot rates, particularly at the long
end of the curve.
• Forward rates being above spot rates.
2. In case of flat
Forward curve
= Spot curve
= Par curve
If the spot rate is constant across all maturities

→ The par and forward rates will equate to the spot rate across all
maturities.
3. In case of downward sloping
Par curve
Spot curve
Forward curve
If the spot curve is upward sloping:

• Par rates will be near—but above—spot rates, particularly at the long
end of the curve.
• Forward rates being below spot rates.
Student’s notes
MODULE 10: INTEREST RATE

RISK AND RETURN
RISK AND RETURN 235 Student’s notes
LEARNING OUTCOMES
10a. Calculate and interpret the sources of return from investing in a

fixed-rate bond
10b. Describe the relationships among a bond's holding period return, its
Macaulay duration, and the investment horizon
10.c. Define, calculate, and interpret Macaulay duration

[LOS 10.a] Calculate and interpret the sources of return

from investing in a fixed-rate bond
1. Source of return
Coupon and principal Affected by Credit risk

payments. (*)
1.1. Three
sources of Reinvestment of
return on a coupon payments.
fixed-rate Affected by Interest rate
Potential capital gain risk (refer to
bond
or loss (**) if the bond LOS 10.a - 2)
is sold prior to
maturity.
(*) In this module, we assume that coupon and principal payments are
made as scheduled → not focus on credit risk
(**) Capital gain/loss arise if a bond is sold at a price different from its
carrying value.
• Carrying value refers to the present value of the remaining cash flow
(at any time between the purchase date and maturity date) that
discounted at the market discount rate (YTM) at issuance.
• Price of the bond is the present value of the remaining cash flow (at
any time between the purchase date and maturity date) that
discounted at current discount rate.

1. Source of return
1.2. Another dimension to the total rate of return of a bond when a bond
is purchased at a premium/discount
A discount bond A premium bond
Amortization of the discount Amortization of the premium

(the bond’s carrying value is (the bond’s carrying value is
pulled up to par (*) as it nears pulled down to par as it nears
maturity) serves to enhance the maturity) serves to lower the
return to bring it in line with the return to bring it in line with the
market discount rate market discount rate.
(*) Refer to Module 6: Fixed-Income Bond Valuation: Prices and Yields


2. Interest rate risks affect bondholder’s return
Interest rate risk (*)
Reinvestment risk Market price risk
The future value of any interim

The selling price of a bond (at
cash flows (**) received from a
any point during its term or
bond can be different from
before maturity) can be different
expected value if the interest
from the carrying value if the
rate changes.
interest rate changes.
(**) coupon and principal
→ capital gain/loss
payment, reinvestment income
(*) Risk broadly speaking, is exposure to uncertainty and causes

unpredictability of outcomes (Portfolio management – Module 4:
Introduction to risk management)
→ in this LOS, reinvestment risk and market price risk can be the increase
or decrease in the future value of any interim cash flows and selling price
of a bond.

Interest rate risk
No reinvestment risk Reinvestment

income Realized
Case 1:
unchanges rates of
Interest rates
return =
unchange No market price risk No capital YTM
gain/loss
Reinvestment
Reinvestment risk
income
Case 2: increases
Interest rates
increase Market price risk Realized
Capital loss
rates of
Reinvestment return
Reinvestment risk
income change
Case 3:
decreases
Interest rates
decrease Market price risk
Capital gain

Case 1: The interest rates are unchanged over investment horizons
Example 1: Investor A and B purchases a 10-year, 8% annual-pay bond at a

price of $85.50 (per 100 of par) and are able to reinvest all coupons
received at the YTM at issuance.
• Investors A holds the bond to maturity
• Investor B holds the bond for 4 years, after which she sells the bond
at a price that entails a YTM that is the same as the YTM at issuance.
1. Calculate the total amount of reinvestment income earned by 2
investors.
2. Determine their realized rates of return (*) on the investment.
(*) Realized rate of return (horizon yield) is the annual total return when
an investor sells a bond, calculated by combining interest earned, plus any
gains or losses realized during the period divided by the initial investment.

Case 1: The interest rates are unchanged over investment horizons
Answer:
We need to calculate the YTM at issuance:
N = 10; PMT = $8; PV = -$85.50; FV = $100; CPT I/Y; I/Y = 10.40%
→ YTM at issuance = 10.40%
Source of return for each investor:
Investor A Investor B
• Coupon payment • Coupon payment
• Reinvestment income • Reinvestment income
• Principal amount at maturity • Selling price (*)
0 1 2 3 4 10 0 1 2 3 4 … 10
…
-85.50 8 8 8 8 100 + 8 -85.50 8 8 8 8 + 89.67
(*) The selling price at the end of year 4 = PV of remaining future payments
= $89.67
(N = 6 ; I/Y = 10.40; PMT = $8; FV = $100; CPT PV; PV = $89.67)

Case 1: The interest rates are unchanged over investment horizon
Example 1: (Continue)
Investor A (10-year horizon) Investor B (4-year horizon)
1. Calculate the reinvestment 1. Calculate the reinvestment

income income
The FV of the coupons reinvested at The FV of the coupons reinvested at
the bond’s YTM (10.40%) over time the bond’s YTM (10.40%) over time
horizon horizon
= $8 × (1 + 1.104 + … + 1.1049) = $8 × (1 + 1.104 + … + 1.1043)
= $129.97 = $37.35
(I/Y = 10.40; PMT = $8; N = 10; PV = (I/Y = 10.40; PMT = $8; N =4; PV = 0;
0; CPT FV; FV = $129.97) CPT FV; FV = $37.35)
→ Reinvestment income → Reinvestment income
= $129.97 - $8 × 10 = $49.97 = $37.35 - $8 × 4 = $5.35

2. Calculate the realized rates of 2. Calculate the realized rates of

return return
FV10 = reinvestment income + FV4 = reinvestment income +
coupon payments + principal coupon payments + selling price
redemption = $49.97 + $80 + $100 = = $5.35 + $32 + $89.67 = $127.02
$229.97 → The realized rate of return
→ The realized rate of return 4 127.02
10 229.97 = 85.50 - 1 = 10.40% = YTM
= - 1 = 10.40% = YTM
85.50

Observation for case 1:

If the interest rate (YTM) for the bond and our assumed reinvestment
rate remain unchanged (no interest rate risk) over investment horizon:
• A buy-and-hold investor’s realized rate return will be equal to the YTM
of the bond when purchased.
• A short-term investor’s realized rate return will be equal to the YTM of
the bond when purchased.

Case 2: The interest rates increase before the first coupon date
Example 2: Similar to the Example 1, but after two investors purchase the
bond and before the first coupon payment, the interest rates rise to
11.40%.
Required:
1. Calculate the reinvestment income
2. Calculate the realized rate of return
Answer:

income income
11.40% over time horizon 11.40% over time horizon
= $8 × (1 + 1.114 + … + 1.1149) = $8 × (1 + 1.114 + … + 1.1143)
= $136.38 = $37.90
(I/Y = 11.40; PMT = $8; N = 10; PV = (I/Y = 11.40; PMT = $8; N =4; PV = 0;
0; CPT FV; FV = $136.38) CPT FV; FV = $37.90)
= $136.38 - $8 × 10 = $56.38 = $37.90 - $8 × 4 = $5.90

Example 2 (Continue)

return return
FV10 = reinvestment income + The selling price at the end of year 4
coupon payments + principal = PV of expected future payments
redemption = $56.38 + $80 + $100 = = $85.78
$236.38 (N = 6 ; I/Y = 11.40; PMT = $8; FV =
→ The realized rate of return $100; CPT PV; PV = $85.78)
10 236.38 → FV4 = reinvestment income +
= - 1 = 10.70% > YTM coupon payments + selling price
85.50
= $5.90 + $32 + $85.78 = $123.68
→ The realized rate of return
4 123.68
= - 1 = 9.67% < YTM
85.50

Discussion: Compare to the results in Example 1
Investor A – buy-and-hold investor:
Return Ex-2 Ex-1 Change Discussion Total realized

in rate of return
return
Re- Higher
investme reinvestment Rise by 30 bps
nt income $56.38 $49.97 $6.41 income → due to higher
Reinvestment reinvestment
risk income
Capital No capital (reinvestment
gain/loss gain/loss risk > market
0 0 0 price risk)
→ no market
price risk

Discussion: Compare to the results in Example 1
Investor B – short-term investor:
Return Ex-2 Ex-1 Change in Discussion Total realized

return rate of return
Re- $37.90 $37.35 $0.55 Higher

investment reinvestment Fall by 73 bps
income income because capital
→ Reinvestment loss offsets the
risk higher
reinvestment
Selling $85.78 $89.67 −$3.89 Capital loss income
price −$89.67 −$89.67 → market price (reinvestment
- Carrying = −$3.89 =0 risk risk < market
value price risk)
= Capital
gain/loss

Conclusion for case 2

If the interest rate (YTM) for the bond and our assumed reinvestment
rate increases:
• A buy-and-hold investor’s realized rate return will be higher than the
YTM of the bond when purchased due to reinvestment risk > market
price risk
• A short-term investor’s realized rate return will be lower than the YTM
of the bond when purchased due to reinvestment risk < market price
risk

Case 3: The interest rates decrease before the first coupon date
Example 3: Similar to the Example 1, but after two investors purchase the
bond and before the first coupon payment, the interest rates fall to
9.40%.
Required:
1. Calculate the reinvestment income
2. Calculate the realized rate of return
Answer:

income income
9.40% over time horizon 9.40% over time horizon
= $8 × (1 + 1.094 + … + 1.0949) = $8 × (1 + 1.094 + … + 1.0943)
= $123.89 = $36.80
(I/Y = 9.40; PMT = $8; N = 10; PV = 0; (I/Y = 9.40; PMT = $8; N =4; PV = 0;
CPT FV; FV = $123.89) CPT FV; FV = $36.80)
= $123.89 - $8 × 10 = $43.89 = $36.80 - $8 × 4 = $4.8

Answer:

return return
FV10 = reinvestment income + The selling price at the end of year 4
coupon payments + principal = PV of expected future payments
redemption = $43.89 + $80 + $100 = = $93.79
$223.89 (N = 6 ; I/Y = 9.40; PMT = $8; FV =
→ The realized rate of return $100; CPT PV; PV = $93.79)
10 223.89 → FV4 = reinvestment income +
= 85.50 - 1 = 10.10% < YTM coupon payments + selling price
= $4.8 + $32 + $93.79 = $130.59
→ The realized rate of return
4 130.59
= - 1 = 11.17% > YTM
85.50

Discussion: Compare to the results in the Example 1
Investor A – buy-and-hold investor:
Return Ex-3 Ex-1 Change in Discussion Total realized

return rate of return
Re- Lower
investment reinvestment Fall by 30 bps
income $43.89 $49.97 −$6.08 income due to lower
→ Reinvestment reinvestment
risk income
Capital No capital (reinvestment
gain/loss gain/loss risk > market
0 0 0 price risk)
→ no market
price risk

Discussion: Compare to the results in the Example 1
Investor B – short-term investor:
Return Ex-3 Ex-1 Change Discussion Total realized

in return rate of return
Re- Lower Rise by 77 bps

investment reinvestment because
income $36.80 $37.35 −$0.55 income capital gain
→ Reinvestment offsets the
risk lower
Capital Capital gain reinvestment
$93.79 income
gain/loss $89.67 → market price
- (reinvestment
(Selling - risk
$89.67 $4.12 risk < market
price $89.67
= price risk)
- Carrying =0
$4.12
value)

Conclusion for case 3:

If the interest rate (YTM) for the bond, our assumed reinvestment rate
decreases:
• A buy-and-hold investor’s realized rate return will be lower than the
YTM of the bond when purchased due to reinvestment risk > market
price risk.
• A short-term investor’s realized rate return will be higher than the
YTM of the bond when purchased due to reinvestment risk < market
price risk

Summary
From the results from Example 1-2-3, we can see that reinvestment risk
matters more for long-term investors, while market price risk matters
more for short-term investors:
• For long-term investors: reinvestment risk > market price risk
• For short-term investors: reinvestment risk < market price risk
Two investors holding the same bond (or bond portfolio) can have
different exposures to interest rate risk if they have different investment
horizons.
[LOS 10.b] Describe the relationships among a bond's holding period

return, its Macaulay duration, and the investment horizon
Illustration: Duration, market price risk and coupon reinvestment risk
Now let’s consider a third investor, Investor C, who has a 7-year

investment horizon. (≈ the bond’s duration)
Use the same approach as example 1 to 3 in Los 10.a, we calculate the
total return (Horizon yield) in 3 scenarios:
• Interest rate is 10.4%
• If the interest rate rises to 11.4% (as was the case in example 2)
• If the interest rate decreases to 9.4% (as was the case in example 3)
We spare you the calculations here.
The results are presented below:
Interest Rate Future Value Sale Price Total Return Horizon

of (FV7) Yield
Reinvested
Coupon
9.40% 74.512177 96.481299 170.993476 10.408%
10.40% 76.835787 94.073336 170.909123 10.400%
11.40% 79.235183 91.748833 256

170.984016 10.407%

Illustration: Duration, market price risk and coupon reinvestment risk
Discussion:
For Investor C (the 7-year investor), the horizon yields are almost the
same regardless of the change in interest rates.
Or, we can say that:
• When interest rises: The benefit gained by coupon reinvestment
offsets the risk of market price decrease.
• When interest decreases: The risk of coupon reinvestment offsets the
benefit of market price increase.
Important property regarding Macaulay duration:

Given a particular assumption about yield volatility, Macaulay duration
indicates the investment horizon for which coupon reinvestment risk
and market price risk offset each other.

1. Analysing the case of interest rates rising
The gain in future value of reinvested coupon

starts out small, but increases at an increasing
rate over time (LOS 5.a)
Gains
Macaulay Duration
t=0
Macaulay Duration Maturity
Losses Money Duration date
Capital loss during the bond‘s life.
• Money duration measures the immediate decline in the value of the

bond.
• Over time, the value of the bond is pulled up to par.
• The gain in future value of reinvested coupon starts out small, but
increases at an increasing rate over time.
• At a certain point during the life of the bond, the gain on reinvested
coupon and the loss on the sale of the bond offset each other → That
point is the Macaulay duration of the bond.

2. Analysing the case of interest rates falling
Capital gain during the bond’s life

Gains
Money Duration
Macaulay Duration
t=0
Maturity
Losses date
The loss in future value of reinvested coupon
starts out small, but increases at an increasing
rate over time
• Money duration measures the immediate increase in the value of the

bond.
• Over time, the value of the bond is pulled down to par.
• The loss in future value of reinvested coupon starts out small, but
increases at an increasing rate over time.
• At a certain point during the life of the bond, the gain on sale of the bond
and the loss on the future value of reinvested coupon offset each other
→ That point is the Macaulay duration of the bond

3. Duration, investment horizon and interest risk
• The conclusion that we can draw from all the analysis mentioned above is
that market price risk and coupon reinvestment risk changes as the
investment horizon varies.
• Here in this part we further discuss the interest risk that investors face, by
(1) comparing the length of their investment horizon to the investments’
duration, or (2) by considering the duration gap (mentioned below).
Duration gap is the difference between the Macaulay duration of a bond

and the investment horizon.
Duration gap = Macaulay duration - Investment horizon
In the case that:

• Investment horizon is less than the Macaulay duration (Positive
duration gap)
Investment horizon Macaulay duration Maturity

o Market price risk > coupon reinvestment risk
o Investors face the risks that the market price will fall, which means they
fear that interest rate rises

3. Duration, investment horizon and interest risk
In the case that:
• Investment horizon is equal to the Macaulay duration (Zero duration

gap)
Investment horizon
Macaulay duration Maturity

o Market price risk = coupon reinvestment risk
• Investment horizon is greater than the Macaulay duration (Negative

duration gap) Investment
horizon
Macaulay Maturity
duration
o Market price risk < coupon reinvestment risk
o Investors face the risks that the return of reinvesting coupons will fall,
which means they fear that interest rate falls.
[LOS 10.c] Define, calculate, and interpret Macaulay duration
Duration is used to measure the interest rate risk of the bond:

Duration measures the sensitivity or responsiveness of a bond’s full price
(including accrued interest) to changes in its yield-to-maturity (or market
discount rate).
Yield duration Curve duration
Measures the responsiveness of a Measures the responsiveness of a

bond’s price with respect to its bond’s price with respect to a
own yield-to-maturity. benchmark yield curve.
1. Macaulay duration. 3. Effective duration (Los 13.a)
2. Modified duration (Los 11.a)
LOS 11.a. Money duration, and

the price value of a basis point
Macaulay duration represents the weighted (*) average of the time it

would take to receive all the bond’s promised cash flows.
(*) the weights are calculated as the present value of each cash flow
divided by the bond’s full price.
MacDur
PMT PMT PMT + FV
(1+r)1 −t/T (1+r)2 −t/T (1+r)N −t/T
= (1 – t/T) × + (2 – t/T) × + … + (N – t/T) ×
PVFull PVFull PVFull
where:
PMT PMT PMT + FV
PVFull = + +…+
(1+r)1 −t/T (1+r)2 −t/T (1+r)N −t/T
• t = the number of days from the last coupon payment to the settlement date
• T = the number of days in the coupon period
• t/T = the fraction of the coupon period that has gone by since the last
payment
• PMT = the coupon payment per period
• FV = the future value paid at maturity, or the par value of the bond r = the
yield-to-maturity, or the market discount rate, per period
• N = the number of evenly spaced periods to maturity as of the beginning of
the current period
Example 4: Calculate Macaulay duration

Consider a 7-year, 5% semiannual-pay bond that matures on September
15, 2020, which is purchased on January 3, 2014. The coupon payments
are made on March 15 and September 15 each year. The yield-to-maturity
is 5% quoted on a street-convention semiannual bond basis. Compute the
bond’s Macaulay duration at time of purchase.
Answer:
1. Calculate the full price of the bond:
• t = 108 days (from the last coupon payment date to the settlement
date (January 3, 2014))
• T = 180 days → t/T = 108/180 = 0.6
• Number of periods (including the current period) = 14 periods
• Coupon payment each period = $100 × 5%/2 = $2.5
• Discount rate each period = 5%/2 = 2.5%
PMT PMT PMT FV

→ PVFull = + +…+
(1+r)1 −t/T (1+r)2 −t/T (1+r)N −t/T
2.5 2.5 102.5
= + +...+
(1+2.5%)1 − 0.6 (1+2.5%)2 − 0.6 (1+2.5%)14 − 0.6
= $101.49
2. Calculate the Macaulay duration:

Period Time to Cash PVn Weight n×
(N) receipt flow = CF/(1.025n) = PVn /PVFull weight
(n = N – t/T)
1 0.4 2.5 2.48 0.024 0.010
2 1.4 2.5 2.42 0.024 0.033
3 2.4 2.5 2.36 0.023 0.055
4 3.4 2.5 2.30 0.023 0.078
5 4.4 2.5 2.24 0.022 0.097
6 5.4 2.5 2.19 0.022 0.119
7 6.4 2.5 2.13 0.021 0.134
8 7.4 2.5 2.08 0.021 0.155
9 8.4 2.5 2.03 0.020 0.168
10 9.4 2.5 1.98 0.020 0.188
11 10.4 2.5 1.93 0.019 0.198
12 11.4 2.5 1.89 0.019 0.217
13 12.4 2.5 1.84 0.018 0.223
14 13.4 102.5 73.62 0.725 9.715
PVFull = 101.49 MacDur = 11.390
Note that duration = 11.39 in this Example is in term of semiannual periods

 Annualized Macaulay duration = 11.39/2 = 5.695 years
Student’s notes
MODULE 11: YIELD-BASED BOND

DURATION MEASURES AND
PROPERTIES
MODULE 11: YIELD-BASED BOND DURATION
MEASURES AND PROPERTIES 267 Student’s notes
LEARNING OUTCOMES
11a. Define, calculate, and interpret modified duration, money duration,

and the price value of a basis point (PVBP)
11b. Explain how a bond's maturity, coupon, and yield level affect its
interest rate risk
[LOS 11.a] Define, calculate, and interpret modified duration, money

duration, and the price value of a basis point (PVBP)
1. Modified duration
Modified duration is calculated by dividing Macaulay duration by one

plus the yield per period.
MacDur
ModDur = 1 + r
MacDur
• For annual – pay bond: ModDur = 1 + r
MacDursemi
• For semiannual – pay bond: ModDursemi =
1 + r/2
Example 1: Calculate Modified duration
1. Calculate Modified duration for the annual – pay bond with
MacDur = 2.88
2. Calculate Modified duration for the semiannual – pay bond in the
Example 4
Answer:
1. Modified duration for the annual – pay bond
MacDur
ModDur = = 2.88/(1.05) = 2.747 years
1+r
2. Modified duration for the semiannual – pay bond in the Example 5
MacDursemi
ModDursemi = = 11.39/(1 + 5%/2) = 11.11 (semiannual
1 + r/2
periods)
→ Annualized Modified duration = 11.11/2 = 5.56 years

a. Implications of Modified duration
Modified duration has a very important application in risk management. It

can be used to estimate the percentage price change for a bond in
response to a change in its annual yield-to-maturity:
%∆PVFull ≈ – ModDur × ΔYield (*)
(*) The formula above estimates the percentage price change in the full price
of a bond and uses the annual modified duration and the annual yield-to-
maturity.
Minus sign (–) explains the inverse relationship between the bond price and
the YTM
Modified duration only provides a linear estimate (refer to the Line

tangent to the Price-Yield curve) of the change in the price of a bond in
response to a change in yields.
→ Good estimates for bond prices in response to relatively small changes
in yields, but not for larger changes in yields due to the curvature
(convexity) of the price-yield profile.

a. Implications of Modified duration
Example 2: Using Modified duration to estimate the change in a bond

price
Given an annualized modified duration of 5.56 for the bond in Example 4 -
Module 10, estimate the change in value of the bond in response to (1) a
10 bp increase in yields and (2) a 10 bp decrease in yields.
Answer:
(1) If the yield-to-maturity increases by 10 bps (to 5.1%), the estimated
loss in the value will be: %∆PVFull = - 5.56 x 0.001 = - 0.00556 or - 0.556%
(2) If the yield-to-maturity decreases by 100 bp (to 4.9%), the estimated
loss in the value will be: %∆PVFull = - 5.56 x (- 0.001) = 0.00556 or 0.556%

b. Approximate Modified duration
If Macaulay duration is not already known, Modified duration can be

approximated directly using bond values for an increase in YTM and for a
decrease in YTM of the same size:
PV − PV+
Approximate ModDur = 2 × PV− × ∆Yield
0
where:
• PV− is the price of the bond if YTM is decreased by ΔYTM and PV+ is the
price of the bond if the YTM is increased by ΔYTM (PV− > PV+ )
• PV0 is the current price of the bond
The objective of the approximation is to estimate the slope of the line

tangent to the price–yield curve (illustrated in the next slide)

Price Price-Yield curve
PV−
Approximate slope of
PV0 tangent line
PV+
Line tangent to the

Price-Yield curve
∆Yield ∆Yield YTM

Example 3: Calculate the approximate the Modified duration

A bond is trading at a full price of 980. If its yield-to-maturity increases by
50 basis points, its price will decrease to 960. If its yield to maturity
decreases by 50 basis points, its price will increase to 1,002. Calculate the
approximate modified duration?
Answer:
PV− − PV+
The approximate modified duration =
2 × PV0 × ∆YTM
1,002 −960
= 2 ×980 ×0.5% = 4.29
→ the approximate change in price for a 1% change in YTM is 4.29%


2. Money duration
• Money duration (dollar duration) is a measure of the price change in

units of the currency in which the bond is denominated.
MoneyDur = annual ModDur × PVFull
• Money duration is sometimes expressed as money duration per 100 of
bond par value.
Recall that: %∆PVFull ≈ – ModDur × ΔYield

→ ∆PVFull /PVFull ≈ – ModDur × ΔYield
→ ∆PVFull ≈ – (ModDur × PVFull ) × ΔYield
→ The estimated (dollar) change in the price of the bond is calculated as:
∆PVFull = – MoneyDur × ∆Yield

2. Money duration
Example 4: Calculate the money duration

1. Calculate the money duration on a coupon date of a $2 million par
value bond that has a modified duration of 7.42 and a full price of
101.32, expressed for the whole bond and per $100 of Par value.
2. What will be the impact on the value of the bond of a 25 basis points
increase in its YTM?
Answer:
1. The money duration for the whole bond = annual ModDur × PVFull
= 7.42 × $2,000,000 × 101.32% = $15,035,888
The money duration per $100 of par value is: 7.42 × $101.32 = $751.79
2. ∆PVFull = - MoneyDur × ∆Yield
∆PVFull = - $15,035,888 × 0.0025 = - $37,589.72
The bond value decreases by $37,589.72.

3. Price value of a basis point (PVBP)
The price value of a basis point (PVBP) is another version of money

duration. It estimates the change in the full price of a bond in response to
a 1 bps change in its yield-to-maturity:
PV − PV+
PVBP = ∆PVFull at +0.01% change = 2xPV − x0.01% x 0.01% x PVFull
Full
PV − PV+
→ PVBP = −
2
Price
PV− − PV+
PVBP = 2
PV−
PV0
PV+ Price-Yield curve in
case of very small
change in YTM
Y0 YTM
-1bps +1bps

3. Price value of a basis point (PVBP)
Example 5: Price value of a basis point

A newly issued, 20-year, 6% annual-pay straight bond is priced at 101.39.
Calculate the price value of a basis point for this bond assuming it has a
par value of $1 million.
Answer:
First, calculate the YTM of the bond: YTM = 5.88%

(N = 20; PV = –101.39; PMT = 6; FV = 100; CPT → I/Y = 5.88)
Now we need the values for the bond with YTMs of 5.89 and 5.87.
• YTM = 5.89; CPT → PV = –101.273 (PV+)
• YTM = 5.87; CPT → PV = –101.507 (PV− )
→ PVBP (per $100 of par value) = (101.507 – 101.273) / 2 = 0.117
[LOS 11.b] Explain how a bond's maturity, coupon,

and yield level affect its interest rate risk
Properties of Bond durations
The Macaulay and Modified yield duration statistics for a traditional fixed-
rate bond are functions of the input variables:
1. The fraction of the coupon period that has elapsed (t/T)
2. Other properties of bond duration (in case that t/T = 0):
2.1. the coupon rate or payment per period (C)
2.2. the time to maturity (N)
2.3. the yield-to-maturity per period (r)

1. Effect of the fraction of the coupon period (t/T)
For a constant yield-to-maturity (r), the Macaulay duration decreases

smoothly as t goes from t = 0 to t = T, which creates a “saw-tooth” pattern
(illustrated below)
MacDur
Coupon payment date Time to maturity
As times passes during the coupon period (moving from right to left in the
diagram), the Macaulay duration declines smoothly and then jumps
upward after the coupon is paid.

2. Effect of other properties of bond duration (t/T = 0)
2.1. Effect of coupon rate on interest rate risk
0 1 2 3 … Maturity
PMT PMT PMT PMT PMT PMT + Par
Recall that: Macaulay duration represents the weighted average of the time
it would take to receive all the bond’s promised cash flows.
• For zero-coupon bond: PMT = 0 → MacDur = time – to – maturity = N

• For any bond that pays a coupon: the MacDur will be less than its time-
to-maturity (N), because some amount of coupon payments will be
received before the maturity date.
o The lower a bond’s coupon (trading at discount), the longer its
MacDur, because proportionately less payment is received before
final maturity.
o The higher a bond’s coupon (trading at premium), the shorter its
MacDur, because proportionately more payment is received before
final maturity.
All else being equal, a lower-coupon bond has a higher duration and more
interest rate risk than a higher-coupon bond.

2.2. Effect of time-to-maturity on interest rate risk
General rule: All else being equal:

• The longer a bond’s maturity, the longer its MacDur and the higher
interest rate risk, because it takes more time to receive full payment.
• The shorter a bond’s maturity, the shorter its MacDur and the lower
interest rate risk, because it takes less time to receive full payment.
Exception:
The longer-term discount bond (interest rate risk may be less than a short-
term bond) and perpetuity bond (interest rate risk is constant over time to
maturity).
(More detail in the next slide)

a. Zero-coupon bond
MacDur of a zero-coupon bond = N
→ The relationship between the Macaulay duration and the time-to-
maturity for a zero-coupon bond is the 45-degree line.
b. Perpetuity
A perpetuity (perpetual bond) is a bond that does not mature
PMT
→ there is no principal to redeem → PV of perpetuity =
r
% ∆PV ∆PV 1 − PMT r 1
ModDur = - =- × =- × =
∆r ∆r PV r2 PMT r
1+r
→ MacDur = ModDur × (1 + r) = r
→ The relationship between the Macaulay duration and the time-to-
maturity for a perpetuity is the horizontal line.
c. Floating-Rate Notes and Loans
The coupon rate of an FRN has two components:
Coupon rate = reference rate (MRR) + quote margin
→ At predetermined dates, payment amounts are reset to reflect changes
in the MRR.
T−t
→ MacDurFloating =
r
→ Macaulay duration for a floating-rate bond is simply the fraction of a
period remaining until the next reset date.

d. Discount bond
As N increases, the Macaulay duration increases. At some point when the
time-to-maturity is high enough, the Macaulay duration exceeds (1+r)/r,
reaching a maximum and then approaches the threshold from above.
→ On long term discount bonds, the interest rate risk can actually be less
than on a shorter-term bond, which explains why the word “generally” is
needed in describing the maturity effect for the relationship between
bond prices and yields-to-maturity in Module 6 – LOS 6.b
e. Premium bond
The Macaulay duration is always less than (1 + r)/r, and it approaches
that threshold from below as the time-to-maturity increases.
→ The relationship between the MacDur and the time-to-maturity for a
premium bond is an upward curve with the threshold of (1 + r)/r.
Note: The detailed explanation for the relationship between MacDur and
time-to-maturity of discount and premium bonds is shown in CFA
Curriculum Level I Volumn 4, page 284-288.

Summary for 2.1 and 2.2

The characteristics of bond duration related to changes in the the time-
to-maturity and coupon rate are illustrated in the graph below:
MacDur Zero-coupon bond
Discount bond
1+r
Perpetuity
r
Premium/Par bond
Time to maturity
Note: This graph considers the coupon payment dates that is the same as
the settlement dates (t/T = 0) → not display the saw-tooth pattern
between coupon payments.

2.3. Effect of yield-to-maturity on interest rate risk
Recall about the Price-yield curve and its slope in Module 6:

At lower yields (YTM), the price-yield curve has a steeper slope indicating
that price is more sensitive to a given change in yield → higher interest
rate risk.
All other things remaining the same, a lower yield-to-maturity bond has
higher duration and more interest rate risk than a higher yield-to-
maturity bond.
Student’s notes
MODULE 12: YIELD-BASED BOND

CONVEXITY AND PORTFOLIO
PROPERTIES
MODULE 12: YIELD-BASED BOND CONVEXITY
AND PORTFOLIO PROPERTIES 287 Student’s notes
LEARNING OUTCOMES
12a. Calculate and interpret convexity and describe the convexity

adjustment
12b. Calculate the percentage price change of a bond for a specified

change in yield, given the bond's duration and convexity
12c. Calculate portfolio duration and convexity and explain the limitations
of these measures
[LOS 12.a&b] Calculate and interpret convexity and describe the

convexity adjustment;
Calculate the percentage price change of a bond for a specified
change in yield, given the bond's duration and convexity
1. Bond convexity as a measure of the change in bond prices
The true relationship between the bond price and the yield-to-maturity is
the curved (convex) line shown below.
Price
Convex Price–Yield Curve
(1)
P0
(2) Line Tangent to
the Price–Yield
YTMo Curve
estimated change due to duration Yield-to-maturity
estimated change due to convexity
estimated total change
The convexity of a bond is always positive.

convexity adjustment; Calculate the percentage price change…

Observing the graph in the previous slide, we see that:
The true relationship between the bond price and the yield-to-maturity
is the curved (convex).
Duration only shows a linear relationship between change in yield-to-

maturity and bond price.
Modified duration only measures the primary effect on a bond’s percentage

price change given a change in the yield-to-maturity, not the total effect.
For large changes in yields, duration:
• Underestimates the increase in price when yields fall. (1)
• Overestimates the decrease in prices when yields rise. (2)
The convexity statistic for the bond should be used to improve the estimate
of the percentage price change provided by modified duration alone.289

Annual convexity (AnnConvexity) is a measure of convexity, and it can be

approximated using the following equation:
PV− + PV+ − [2 x PV0 ]
ApproxCon =
(∆Yield)2 x PV0
The convexity adjusted (convexity statistic added) estimate of the

percentage change in the bond’s full price is shown below:
1
%∆PVfull ≈ −AnnModDur x ∆Yield + x AnnConvexity x (∆Yield)2
2
“First-order” (duration) effect. If “Second-order” effect or convexity

there in an increase (decrease) in adjustment. Notice that the
yields, the duration effect on a convexity adjustment has a
bond’s price will be negative positive impact on the bond price
(positive). estimate for either an increase or
a decrease in yields.

Example 1: Calculate the change in bond price as the YTM changes using
bond convexity
We continue with the bond we worked in the Example 4.
Relevant information is provided below:
• Maturity = 7 years; coupon payment = $2.50 and pays semiannually;
par value = $100 and the bond is purchased 108 days since the last coupon
payment.
• Initial YTM = 5%
• PV0 = $101.492586
• PV+ = $101.2110
• PV− = $101.7750
• ∆Yield = 0.0005
• ApproxModDur = 5.55278
1. Calculate approximate convexity.
2. Calculate the estimated convexity-adjusted percentage price change
resulting from a 100 bp increase (5% to 6%) in the yield-to-maturity.
3. Compare the estimated percentage price change with the actual change,
assuming the yield-to-maturity jumps to 6% on the settlement date. 291

bond convexity
Answer:
1. Calculate approximate convexity
PV− + PV+ − [2x PV0 ] 101.775+101.211− 2x101.492586
ApproxCon = = =
(∆Yield)2x PV0 (0.0005)2x101.492586
32.6329
2. Calculate estimated percentage price change
1
%∆PVfull ≈ −AnnModDur x∆Yield + 2 x AnnConvexity x (∆Yield)2
1
= (-5.55278 x 0.01) + 2 x 32.6329 x (1%)2 = -0.0555278 + 0.00163165
= -0.053896 or - 5.3896%
3. Compare estimated percentage price change with the actual change
If the yield-to-maturity increase by 1% to 6%, the new full price can be
calculated as:
N = 14; PMT = $2.50; FV = $100; I/Y = 3%; CPT PV→ PV = -$94.35196
→ PVfull = $94.35196 x (1.03)108/180 = $96.040249

bond convexity
Answer:
(cont)
96.040249− 101.492586
→ %∆PVfull = 101.492586 = - 0.0537215 or -5.37215%
Observation:
-5.55278%. -5.3896% -5.37215% Change in
Convexity- Actual price
Estimate
based on adjusted change
duration estimate
→ The convexity adjustment brings the change in price estimate that is
based on duration alone closer to the actual change in the price of the
bond.
See how we illustrate this relationship in the next slide.

bond convexity
Answer:
(cont)
Price
Convexity-adjusted price at
5%
Duration-estimated price at
5% 5% 5.05% YTM
Estimated change based on duration = - 0.0555278
Convexity adjustment = 0.00163165
Convexity-adjusted estimated change = - 0.0555278 + 0.00163165
Remember that the convexity adjustment brings the change in price
estimate closer to the actual change

2. Money convexity
Money convexity measures the second-order effect on the full price of a

bond (in dollar terms) given a change in the yield-to-maturity.
MoneyCon = AnnConvexity x PVfull
The convexity adjusted (convexity statistic added) estimate of the change in

the bond’s full price (in dollar terms) is shown below:
Recall that we have this formula of calculating percentage of price change, using
both duration and convexity:
1
%∆PVFull ≈ (−AnnModDur × ∆Yield) + [ × AnnConvexity × (∆Yield)2]
2
Multiplying PVfull on both sides to find the absolute price change, we have:
%∆PVfull ×PVfull ≈ (−AnnModDur×PVfull ×∆Yield) +
1
[ ×AnnConvexity×PVfull ×(∆Yield)2
2
The estimated (dollar) change in the price of the bond, after adding the
effect of convexity is calculated as:
1
∆PVfull ≈ (−MoneyDur × ∆Yield) + [ × MoneyCon × (∆Yield)2]
2

3. Factors that affect convexity
c. The factors that lead to greater duration also lead to greater convexity
Factors Change in factor Change in convexity
Term-to-maturity ↑ ↑
Coupon rate ↓ ↑
Yield-to-maturity ↓ ↑
Dispersion of cash ↑ ↑
flow (*)
(*) Dispersion of cash flow measures the degree to which payments are
spread out over the bond’s term.
For example: a bond that pays interest only twice in its life has a lower level
of dispersion than a bond which pays interest 10 times in its life, given that
the 2 bonds have the same par value and are valued at the same price.

3. Factors that affect convexity
d. Positive attributes of greater bond convexity
The more convex

Price bond appreciates Note: In comparision with P0
more in price
The more convex bond
depreciates less in
price
P0
YTM
Decrease YTMo Increase
More convex bond ()
Less convex bond
Conclusion: The more convex bond outperforms the less convex bond in
both bull (rising price) and bear (falling price) markets.

4. Effective convexity
Recall that in 1 - LOS 12a&b, we learn that the “first-order” effect of a shift in
the benchmark yield curve to bond price is measured by effective duration.
→ The secondary, or second-order, effect is measured by effective convexity.
The effective convexity of a bond is calculated by this formula
PV− + PV+ − [2 x PV0 ]

EffCon =
(∆Curve)2 x PV0
This formula may look like the Aproximate yield convexity. But note that, here,
the denominator includes the change in the benchmark yield curve squared,
(∆Curve)2
Implication: The reasons why effective duration should be used in measuring

interest rate risk for bonds with embedded options:
→ Using the same explanation, it is important to remember that effective
convexity should be used to measure the “second-order” effect of interest rate
risk for embedded option bonds.
Further details on effective convexity for embedded options bonds are
mentioned in the next slides.

a. Effective convexity of a callable bond
• When the benchmark yield is low, value of convexity for a callable bond
is negative (also known as concavity) – and this an important feature of
callable bond.
• When the benchmark yield is high, callable and straight bonds
experience the same positive value of convexity.
• There is a point of inflection which indicates the yield at which convexity
for the callable bond goes from positive to negative.
Price Straight bond
Callable bond
Positive
Negative convexity
convexity
point of inflection
Benchmark
Low benchmark yield YTMo High benchmark yield Yield

Illustration: Look at the graph below, we can see that when the yield is low
and there is an decrease in benchmark yield:
Increase in callable bond price < Increase in straight bond price
The driven-down increase in callable bond price is estimated via 2 following
factors:
1. Effective duration: lower than that of straight bond
2. Effective convexity: negative, while that of straight bond is positive
Price Straight bond

Increase in callable bond price
Increase in straight bond price
Callable bond
Benchmark Yield
YTM1 YTMo

b. Effective convexity of a putable bond
Putable bonds always have positive convexity.

• When the benchmark yield is low, value of convexity for a putable bond
is equal to that of a straight bond
• When the benchmark yield is high, value of convexity for a putable bond
is greater than that of a straight bond
Price
Putable bond
Straight bond Greater

convexity
Benchmark
Low benchmark yield High benchmark yield Yield

Illustration: Look at the graph below, we can see that when the yield is high
and there is an increase in benchmark yield:
Decrease in putable bond price < Decrease in straight bond price
The driven-down decrease in putable bond price is estimated via 2 following
factors:
2. Effective convexity: positive and higher than that of straight bond
Price
Putable bond Decrease in putable bond price
Decrease in straight bond price
Straight bond
Benchmark Yield
[LOS 12.c] Calculate portfolio duration and convexity and

explain the limitations of these measures
1. Calculate the duration of a portfolio
Approach 1 Approach 2 (additional reading)
• Calculate the durations of Project all cash flows on all

individual bonds (contain traditional bonds and embedded
embedded option bonds). option bonds contained in the
• Calculate the weights of each portfolio
bond simply by the proportion of → Calculate the cash flow yield (IRR
the full price of each bond in the of the bond portfolio)
total portfolio value. → Calculate the weighted average
→ Calculate the weighted average of time to receipt of the aggregate
of the individual bond durations cash flows
that comprise the portfolio
The first method is commonly

The second method is the
used by fixed-income portfolio
theoretically correct approach,
managers, but it has its own
but it is difficult to use in practice
limitations.

Formula: Formula:
MacDur of portfolio MacDur of portfolio
= w1 D1 + w2 D2 +…+ wN DN CFi
∑N (i – t/T) ×
i=1 (1+r)i −t/T
= CFi
where:
∑N
• N = Number of bonds in portfolio. i=1 (1+r)i −t/T
• Di = Duration of Bond i. where:
• wi = Market value of Bond i • PVPortfolio = the market value of
divided by the market value of portfolio
portfolio. • r is the cash flow yield of the
portfolio

2. Limitations of portfolio duration
This measure of duration assumes a • The cash flow yield is not usually
parallel change in the yield curve calculated for bond portfolios.
(i.e., yields across all maturities • The amount and timing of
change by the same amount and in payments on bonds with
the same direction) → this is not embedded options and floating-
accurate in practice because rate bonds is uncertain.
portfolios of bonds are composed of • Interest rate risk should be
a variety of bonds that may have measured based on a change in
different maturities, credit risks, and benchmark interest rates, not on
embedded options. a change in the cash flow yield.
• For an individual bond, the
amount of change in its cash flow
yield is not necessarily the same
as the change in its yield-to-
maturity.

Example 2: Calculate the duration of a portfolio

Suppose an investor holds the following portfolio of two zero-coupon bonds:
Bond Maturity Price Yield MacDur ModDur Market value Weight
X 1y 98.00 2.04% 1 0.98 9,800,000 50%
Y 30y 9.80 8.05% 30 27.77 9,800,000 50%
The price are per 100 of par. The Par value of bond X is 10,000,000 and of
bond Y is 100,000,000. The total market value of the portfolio is
$19,600,000. Calculate the portfolio duration by both approaches?
Answer:
1. Approach 1
Portfolio MacDur = w1 D1 + w2 D2 +…+ wN DN = 0.5 (1) + 0.5 (30)
= 15.50 years
Portfolio ModDur = 0.5 (0.98) + 0.5 (27.77) = 14.37 years

Example 2: Calculate the duration of a portfolio

2. Approach 2
Calculate the cash flow yield of the portfolio:

10,000,000 0 0 100,000,000
19,600 000 = 1 + 2 +…+ 29 +
(1+r) (1+r) (1+r) (1+r)30
→ r = 7.86% = cash flow yield

CFn
∑N (n – t/T) ×
n=1 (1+r)n −t/T
MacDur = CFn
∑N
n=1 (1+r)n −t/T
1 × 10,000,000 0 +…+ 0 + 30 × 100,000,000
(1 + 7.86%)1 (1+7.86%) 2 (1+7.86%)29 (1 + 7.86%)30
= 10,000,000 + 100,000,000
(1 + 7.86%)1 (1 + 7.86%)30
= 16.28 years
ModDur of portfolio = 16.28/(1 + 7.68%) = 15.10 years

Student’s notes
MODULE 13: CURVE-BASED AND

EMPIRICAL FIXED-INCOME RISK
MEASURES
MODULE 13: CURVE-BASED AND EMPIRICAL
FIXED-INCOME RISK MEASURES
LEARNING OUTCOMES
13.a. Explain why effective duration and effective convexity are the most
appropriate measures of interest rate risk for bonds with embedded
options
13.b. Calculate the percentage price change of a bond for a specified

change in the benchmark yield, given the bond’s duration and
convexity
13.c. Define key rate duration and describe its use to measure price
sensitivity of fixed-income instruments to benchmark yield curve
changes
13.d. Describe the difference between empirical duration and analytical

duration
[LOS 13.a] Explain why effective duration and effective convexity are
the most appropriate measures of interest rate risk for bonds with
embedded options
1. Effective duration
a. Reason for using effective duration in measuring interest rate risk for
bonds with embedded options.
For bonds with embedded options, the future cash flows are uncertain
since option exercise depends on the level of market interest rates
relative to coupon interest being paid (or received).
→ Bonds with embedded option do not have well-defined yields-to-
maturity.
→ Macaulay and modified duration are not appropriate interest rate risk
measures for such bonds.
→ We must use effective duration to estimate the interest rate risk of
these bonds, a curve duration rather than a yield duration statistic.
the most appropriate measures of interest rate risk for bonds…
1. Effective duration
b. Details about effective duration
Effective duration measures the sensitivity of a bond’s price to a change

in the benchmark yield curve.
PV − PV+
EffDur = 2 × PV− × ∆Curve Equivalent to Yield
0 in MacDur formula
where:
• ∆Curve is the change in the benchmark yield curve used with bond
pricing model to calculate PV− and PV+.
Example: Effective duration calculation

A callable bond is currently trading at 101.05 per 100 of par. When the
government par curve is raised by 25 bps, the value of the bond falls to
99.04, and when it is lowered by 25 bps, the value of the bond rises to
102.87. Calculate the effective duration of this bond.
Answer:
PV − PV+ 102.87 − 99.04
Effective duration = 2 × PV− × ∆Curve = 2 × 101.05 × 0.25% = 7.58
0
We learn that the “first-order” effect of a shift in the benchmark yield

curve to bond price is measured by effective duration.
→ The secondary, or second-order, effect is measured by effective
convexity.
The effective convexity of a bond is calculated by this formula
PV + PV+ − 2 × PV0
EffCon =
∆Curve 2 × PV0
This formula may look like the Aproximate yield convexity. But note that,
here, the denominator includes the change in the benchmark yield curve
squared, (∆Curve)2
Implication: We mentioned the reasons why effective duration should be

used in measuring interest rate risk for bonds with embedded options.
→ Using the same explanation, it is important to remember that effective
convexity should be used to measure the “second-order” effect of
interest rate risk for embedded option bonds.
Further details on effective convexity for embedded options bonds are
mentioned in the next slides.
• When the benchmark yield is low, value of convexity for a callable

bond is negative (also known as concavity) – and this an important
feature of callable bond.
• When the benchmark yield is high, callable and straight bonds
experience the same positive value of convexity.
• There is a point of inflection which indicates the yield at which
convexity for the callable bond goes from positive to negative.
Price Straight bond
Callable bond
Positive
Negative
convexity
convexity
point of inflection Benchmark

Low benchmark yield YTMo High benchmark yield Yield
Illustration: Look at the graph below, we can see that when the yield is
low and there is an decrease in benchmark yield:
Increase in callable bond price < Increase in straight bond price
The driven-down increase in callable bond price is estimated via 2
following factors:
2. Effective convexity: negative, while that of straight bond is positive
Price Straight bond

Increase in callable bond price
Increase in straight bond price
Callable bond
Benchmark Yield
YTM1 YTMo
Putable bonds always have positive convexity.

• When the benchmark yield is low, value of convexity for a putable
bond is similar to that of a straight bond
• When the benchmark yield is high, value of convexity for a putable
bond is greater than that of a straight bond
Price
Putable bond
Straight bond Greater convexity
Benchmark Yield
Low benchmark yield High benchmark yield
Example: Effective duration and convexity calculation

Consider BRWA’s five-year, 3.2% (semiannual) coupon bond priced at par
for settlement on 15 October 2025 and maturity on 15 October 2030.
Using PV0 = 100.00, ∆Curve = 0.0005, PV− = 99.76, PV+ = 100.241.
Calculate effective duration and covexity for BRWA’s bond.
Answer:
Effective duration:
PV − PV+ 100.241 99.76
= 2 × PV− × ∆Curve = 2 × 100 × 0.0005 = 4.816
0
Effective convexity:
PV− + PV+ − [2 × PV0 ] 100.241 + 99.76 − [2 × 100 ]
= = = 40.000
(∆Curve)2 × PV0 (0.0005)2 × 100
3. Interest rate risk of embedded option bonds
Callable bond
The embedded call option favors the issuer → An investor would pay less
for a callable bond than for an otherwise identical noncallable bond
→ Value of a noncallable bond = Value of a callable bond + Value of the
embedded call option
Putable bond
The embedded put option favors the investors → An investor would pay
more for a putable bond than for an otherwise identical nonputable bond
→ Value of a nonputable bond = Value of a putable bond – Value of the
embedded put option
a. Callable bond
Price Value of the Embedded call option
Call price
Non-callable bond
Callable bond
Y∗ Benchmark Yield
Low benchmark yields (<Y∗ ) High benchmark yields (>Y∗ )
Low yield → High market price The issuer will not call the bond
→ The issuer will call the bond at a given → The the value of the embedded call
call price (the highest price of the bond option is relatively low
to be called) → The price appreciation → The sensitivity of the callable and
would be limited by the call option noncallable bond prices are very similar
→ The sensitivity of the bond price to → The effective durations (slopes of the
change in yield is lower than that of price-yield profiles) of the callable and
noncallable bond noncallable bonds are very similar.
→ The effective duration is lower.
b. Putable bond
Price
Putable bond Value of the Embedded

Put price
put option
Non-putable bond
Y∗ Benchmark Yield
Low benchmark yields (<Y∗ ) High benchmark yields (>Y∗ )
The investor will not put the bond High yield → Lower market price
→ The the value of the embedded put The investor will put the bond at a given
option is much greater for the issuer put price (the lowest price of the bond to
→ The sensitivity of the putable and be put) → The price depreciation would
nonputable bond prices are very similar be limited by the put option
→ The effective duration of the putable → The sensitivity of the bond price is
bond and nonputable bond are very lower than that of nonputable bond
similar. → The effective duration is lower.
[LOS 13.b] Calculate the percentage price change of a bond for a

specified change in the benchmark yield, given the bond’s duration
and convexity
We can estimate the expected price change for a bond with respect to an
expected change in yield curve using EffDur and EffCon in the same way
we use modified duration and convexity with respect to ∆YTM.
1
%∆PVfull ≈ −EffDur × ∆Curve + 2 × EffCon × (∆Curve)2
Note:
Unlike modified duration and convexity, effective duration and convexity
do not necessarily provide better estimates of bond prices for smaller
changes in yield.
This is because for bonds with embedded options, considerations other
than the level of government rates determine whether the option is likely
to be exercised (e.g., the level of credit spreads on a corporate bond or
the amount of principal outstanding on a mortgage).
[LOS 13.b] Calculate the percentage price change of a bond for a

change in the benchmark yield...
Example: Percentage price change of a bond

BRWA’s five year, 3.2% (semiannual) coupon bond priced at par for
settlement on 15 October 2025 and maturity on 15 October 2030.
Effective duration = 4.816 and Effective convexity = 26.723. Find the
percentage changes in the bond’s full price for ± 100 bp shifts in the
benchmark government par curve.
Answer:
1
%∆PVfull ≈ −EffDur × ∆Curve + × EffCon × (∆Curve)2
2
Bond price changes given 100 bp increase in the benchmark government
par curve:
1
%∆PVfull ≈ −4.816 × 0.01 + × 40 × (0.01)2 = − 4.68%
2
Bond price changes given 100 bp decrease in the benchmark government
par curve:
1
%∆PVfull ≈ −4.816 × −0.01 + × 40 × (−0.01)2 = 4.95%
2
[LOS 13.c] Define key rate duration and describe its use to measure
price sensitivity of fixed-income instruments to benchmark yield
curve changes
Maculay and Modified duration is an adequate measure of bond price risk

only for parallel shifts in the yield curve (the change in YTM for any
maturity is the same).
For nonparallel shifts in the yield curve, we must use key rate duration to
measure the interest rate risk of the bond.
Key rate duration (or partial duration) is a measure of a bond’s (or bond
portfolio’s) sensitivity to a change in the benchmark yield for a specific
maturity, holding other yields constant (nonparallel shifts in the yield
curve).
price sensitivity of fixed-income instruments...
The key duration of a bond is calculated in the following formula
−1 ∆PV
KeyRateDu rk = × (1)
PV ∆rk
n
KeyRateDu rk = EffDur (2)
k=1
Where:
• rk represents the kth key rate.
• kth key rate could be 1-, 2-, 20-, or 30-year rate (shifted up and down by
1 bp)
Why might key rate duration be useful for a portfolio manager even
though key duration values of the bonds in a portfolio sum to the
portfolio duration?
Answer: Knowing the portfolio duration and overall movement of the
benchmark yield curve can provide a quick estimate of gains or losses;
however, by using key durations, a portfolio manager can over- or
underweight specific tenors to maximize risk-adjusted return.
price sensitivity of fixed-income instruments...
Example: Key rate duration and changes in specific yields

A portfolio has equally weighted investments in a 5-year zero-coupon
bond yielding 5% and a 10-year bond yielding 6%. Yields are quoted on an
annual coupon basis. What would be the performance of the portfolio if
5-year yields increase by 50 basis points and 10-year yields decrease by
25 basis points?
Answer:
Recall: Modified duration = Macaulay duration / (1 + periodic yield),
where Macaulay duration of a single cash flow is equal to its maturity.
For the 5-year cash flow: ModDur = 5 / (1.05) = 4.762
The 5-year key rate duration = 4.762 × 0.5 = 2.381.
The impact of a 50 bp increase in the 5-year yield
= −2.381 × 0.0050 = -1.19%.
For the 10-year cash flow: ModDur = 10 / (1.06) = 9.434
The 10-year key rate duration = 9.434 × 0.5 = 4.717.
The impact of a 25 bp decrease in the 10-year yield
= −4.717 × −0.0025 = 1.18%.
Overall, the portfolio value will change by
= −1.19% + 1.18% = -0.01%.
[LOS 13.d] Describe the difference between empirical duration and

analytical duration
Analytical duration Empirical duration
• Estimate duration and convexity

statistics by using mathematical
• Estimate duration and convexity
formulas.
statistics by using historical data
• Implicitly assume that
in statistical models that
government bond yields and
incorporate various factors
spreads are independent
affecting bond prices.
variables that are uncorrelated
with one another.
Analytical duration and empirical duration may show us different results

under many circumstances.
Example: In the case of market stress:

→ The same macroeconomic factors driving government bond yields lower
will cause high-yield bond credit spreads to widen because of an increase
in expected default risk.
→ Credit spreads and benchmark yields are negatively correlated.
→ Wider credit spreads will partially or fully offset the decline in
government benchmark yields.
→ Lower empirical duration estimates than analytical duration estimates.
Student’s notes
MODULE 14: CREDIT RISK

MODULE 14: CREDIT RISK 327 Student’s notes
LEARNING OUTCOMES
14.a. Describe credit risk and its components, probability of default and
loss given default
14.b. Describe the uses of ratings from credit rating agencies and their
limitations
14.c. Describe macroeconomic, market, and issuer-specific factors that

influence the level and volatility of yield spreads
[LOS 14.a] Describe credit risk and its components, probability of

default and loss given default
Credit risk is the risk associated with losses to fixed income investors
stemming from the failure of a borrower to make payment of interest or
principal (referred to as to servicing their debt).
When a borrower fails to service their debt, they are said to be in default.
Key drivers of credit risk
Bottom-up factors Top-down factors
Capacity Capital Collateral Conditions Country
Convenants Characters Currency


1. Cs of credit analysis (Bottom-up)
The borrower’s ability to make their debt

Capacity
payments on time
Other resources available to the borrower that

Capital
reduce reliance on debt.
The quality and value of assets pledged to

Collateral provide the lender with security in the event of
default
The legal terms and conditions the borrowers

Convenants
and lenders agree to as part of a bond issue
The borrower’s integrity (e.g., management for a

Characters corporate bond) and their commitment to make
payments under their debt obligation

1. Cs of credit analysis (Top-down)
The general economic environment that affects

Conditions all borrower’s ability to make payments on their
debt
The geopolitical environment, legal system, and

Country
political system that apply to the debt
Foreign exchange fluctuations and their impact

Currency on a borrower’s ability to service foreign-
denominated debt

2. Sources of credit risk and repayment
At its core, credit risk stems from the possibility that the borrower’s sources of
repayment will not provide enough cash to service their debt.
Different
Source of repayment Source of credit risk
type of debt
Secured • Operating cash flows • Poor economic and market

corporate • Collateral cash flows or conditions
bond sale • Increased compettion
• Shrinking profitability
• Operating cash flows • Excessive debt levels
Unsecured • Investments of the issuer
corporate • Asset sales, divestures of
bond subsidiaries, or additional
debt/equity issuance
• Tax revenues • Poor economic conditions

• Tariffs • Political uncertainty
Sovereign • Other fees charged by the • Fiscal deficits
bond government issuer • High debt levels relative to
• Additional debt issuance the size of the economy
and sale of public assets

3. Measuring credit risk
Credit risk is measured by assessing the expected loss from a debt investment
in the event of default.
Components of credit risk:
Expected Total projected exposure

Exposure (EE) under event of default
Recovery Rate Percentage of loss

(RR) recovered in default
Loss Given Amount of loss if a

EE x (1 – RR) = LGD
Default (LGD) default occurs
Probability of Conditional probability of

Default (POD) borrower default
Expected loss Probability-weighted

LGD x POD = EL amount of loss
(EL)

Expected loss POD LGD
The probability that a borrower fails to pay

Probability
interest or repay principal when due. The
of default
probability is typically expressed on
(POD)
annualized basis.
The loss an investor will suffer if the issuer

defaults. This can be stated as monetary
amount or as a percentage.
There are
LGD% = Expected exposure × (1 – Recovery
two
rate)
components
Where:
of expected
Loss given Recovery rate is the percentage of the
loss:
default principal amount recovered in the event of
(LGD) default.
Expected exposure is the difference
between the amount the investor is owed
and the value of the collateral available to
repay the investor.
Loss severity (= 1 – Recovery rate) is the
uncovered portion of the claim.

3.1. Expected loss vs. Credit spread
Note: We can use the annualized expected loss (as a percentage) as an

estimate of the annualized credit spread over a risk-free benchmark that
an investor should demand for facing the credit risk of the investment.
Credit spread ≈ POD LGD%
• If the actual credit spread is higher than this estimated credit spread.
→ More than fairly compensated for the credit risk of the investment.
• If the actual credit spread is lower than estimated credit spread.
→ Not adequately compensated for credit risk and should avoid investing.

3.1. Expected loss vs. Credit spread
Example:
A bond issuer has a 3% probability of default, and one of its bond issues
has a recovery rate of 75%. The bond has a 4% coupon and is currently
trading at par. A government security of similar maturity yields 2.5%.
Assess whether the credit spread of the bond issue is adequately
compensating investors for credit risk.
Answer:
The bond is trading at par, so its coupon of 4% is also its yield. The actual
credit spread of the bond is:
4% - 2.5% = 1.5%.
The estimated credit spread for the bond is its probability of default times
(1 − recovery rate):
0.03 × (1 − 0.75) = 0.0075, or 0.75%
→ The bond is providing an actual spread that is double that which is fair,
meaning that bond investors are more than adequately compensated for
the credit risk of the bond.

3.2. Probability of default (POD)
POD is driven by an issuer’s ability to service debt based on both

qualitative and quanitative factors, including:
Profitability Coverage Leverage
Stable, predictable Sufficient cash Relative reliance on

cash flows and profits. flows/profits to make debt financing.
debt payments.
e.g: High EBIT margin e.g: High EBIT/Interest e.g: Low Debt/EBITDA
Low probability of default

High credit quality

3.3. Loss given default (LGD)
Estimated LGD depend on whether the bond is secured or unsecured, and

the level of seniority of the bond issue in the capital structure of the
issuer:
First Lien Loan More senior,

Secured debt secured debt
LOD increases
Second Lien Loan will have lower
losses given
Senior Unsecured default than
… junior,
Unsecured debt unsecured
Junior debt.
Subordinated
• For investors in unsecured investment-grade bonds or loans with a

high LGD, the greatest risk of expected loss arises due to a rise in POD.
• High-yield investors expecting a greater likelihood of default seek to
minimize EL by seeking covenant restrictions and/or security to lower
LGD.

Credit rating from credit rating agencies
Rating agencies issue credit ratings, which reflect an opinion on the

potential risk of default of a particular bond issue or bond issuer.
Moody’s Fitch and S&P

Aaa AAA
High-quality grade
Aa1 → Aa3 AA+ → AA-
Investment
grade Upper-medium grade A1 → A3 A+ → A-
Low-medium grade Baa1 → Baa3 BBB+ → BBB-
Ba1 → Ba3 BB+ → BB-

Non- B1 → B3 B+ → B-
investment Low Grade or
Caa1 → Caa3 CCC+ → CCC-
Grade (High Speculative Grade
Ca CC
yield or C C
Junk)
Default C D
[LOS 14.b] Describe the uses of ratings from credit rating agencies
and their limitations
Risks of relying on agency ratings
Investors should not assume that a bond’s credit

Credit ratings can
rating will remain the same from the time of
change over time
purchase through the entire holding period.
Bond prices and credit spreads tend to change more

Credit ratings tend
quickly (to reflect changes in perceived
to lag the market’s
creditworthiness) than credit ratings assigned to
pricing of credit risk
bonds.
Ratings agencies are not perfect, resulting in mistakes

occur from time to time.
Example:
Rating agencies
Rating agencies assigned inappropriately high credit
may make
ratings to subprime-backed mortgage securities
mistakes
(before 2008 financial crisis), and failed to detect
accounting fraud at large companies like Enron and
WorldCom.
Some risks such as litigation risk, which can affect

Some risks are
tobacco companies or environmental and business
difficult to capture
risks faced by chemical companies and utility power
in credit ratings
plants.
[LOS 14.c] Describe macroeconomic, market, and issuer-specific

factors that influence the level and volatility of yield spreads
Factors affecting the level and volatility of yield spreads
1. Macroeconomic 2. Market 3. Issuer-specific

factors factors factors
1. Macroeconomic factors
Credit risk changes largely in line with the economic cycle.

• Growth period: The probability of default decreases, causing spreads to
contract.
• Recession period: The probability of default increases, causing spreads
to widen.

Credit spread curves over the economic cycle
Credit spreads for high-yield issuers (HY) may behave differently than credit spreads for
investment grade issuers (IG) over a business cycle.
Early expansion Late expansion

Spread Spread
HY
HY
IG
IG
Tenor Tenor
Contraction Peak
Spread Spread
HY
HY IG
IG
Tenor Tenor

Reasons for investing in high-yield bonds
Beyond the higher coupons typically offered by high-yield bonds to

compensate for their greater risk, other incentives for exposure to this HY
bonds include the following:
High-yield bond prices have low or even negative

Diversification correlation with investment grade bonds, so they
can diversify a fixed-income portfolio.
The larger spread changes for high-yield issues

Capital appreciation produce larger price gains during economic
recoveries compared to investment grade issues.
According to some empirical data, high-yield debt

Equity-like return
offers equity-like returns with lower volatility than
with lower volatility
equity markets.

Other systematic factors affecting yield spreads
Increasing regulations of broker-dealers and

market makers in corporate bonds
→ Increase the cost of funding bond positions.
Funding stresses in markets

Wider spreads
→ Increase risk aversion.
Heavy new issuance of debt into bond markets

with insufficient demand.
→ Increase illiquidity.

2. Market factors
Market liquidity risk
Definition Measurement
The risk that the actual transaction Liquidity risk is reflected in the size
price (buying or selling price) may of bid-ask spread
differ from market price due to Higher bid-ask spread → Lower
insufficient volumes (liquidity) in market liquidity and higher
the market. liquidity risk.
Factors affecting
Change in factor Change in liquidity risk
liquidity risk
Size of issuer * ↓
↑
Credit quality of issuer ↓
(*) Size of issuer refers to the aggregate value of publicly traded debt an issuer has outstanding.

3. Issuer-specific factors
The expected financial performance of individual issuers has a significant

effect on both the level and volatility of yields and yield spreads. Two main
issuer-specific factors impacting on yield and yield-spread of issuers are
debt coverage and debt leverage along with other factors.
Debt coverage Debt leverage

Refers to the sufficiency of a Measures a borrower’s relative
borrower’s resources or cash reliance on debt verses other
flows to make necessary interest sources of financing.
and principal payments
Other factors
• Source of repayment
• Use of proceeds
• Issuer’s yield spread vs.
Average yield spread *
(*) For an issuer with problems servicing its debt, yield spreads will be wider than
the average for the issuer’s credit rating.

4. The price impact of spread changes
The price impact from spread changes is driven by two main factors:
(1) The modified duration (price sensitivity with respect to changes in
interest rates).
(2) The magnitude of the spread change.
For small, instantaneous yield spread change, the price impact can be
approximated by:
%∆PVFull ≈ −AnnModDur × ∆Spread
For large yield spread change, the price impact can be approximated by:
1
%∆PVFull ≈ − AnnModDur × ∆Spread + ( 2 × AnnConvexity × ∆Spread2)
Note: AnnConvexity should be rescaled so that it has the same order of

magnitude as the duration squared.

4. The price impact of spread changes
Example:
For a bond with duration of 5.0 and reported convexity of 0.235, one
would re-scale convexity to 23.5 before applying the formula. For a 1%
(i.e., 100 bps) increase in spread, the result would be:
1
%∆PVFull ≈ − 5.0 × 0.01 + 2 × 23.5 × 0.01 2 ≈ −0.048825 or −4.8825%
→ If spreads tighten by 100 basis points, the bond’s price will decrease by
4.88%.
Note:
• For a given change in the yield spread, the change in price is generally
more sensitive for a longer-duration bond.
• Compared to shorter-maturity bonds, longer-maturity bonds of a given
issuer typically trade at wider yield spreads to comparable-maturity
government bonds. This is why spread curves (also referred to as credit
curves) are generally upward sloping.
Student’s notes
MODULE 15: CREDIT ANALYSIS

LEARNING OUTCOMES
15.a. Explain special considerations when evaluating the credit of

sovereign and non-sovereign government debt issuers and issues
[LOS 15.a] Explain special considerations when evaluating the credit

of sovereign and non-sovereign government debt issuers and issues
1. Sovereign government debt
1.1. Qualitative factors
Government Successful policymaking, minimal corruption, checks

institution & and balances among institutions, and a culture of
policy honoring debts.
Government’s willingness and ability to increase

Fiscal
revenue or cut expenditures to ensure debt service,
Flexibility
trends in debt as a percentage of GDP.
Ability to use monetary policy for domestic economic

Monetary objectives (this might be lacking with exchange rate
effectiveness targeting or membership in a monetary union),
credibility and effectiveness of monetary policy.
Economic Growth trends, income per capita, and diversity of

assessment sources for economic growth
External Foreign reserves, external debt, and the status of its

status currency in international markets.

1.2. Quantitative factors
Fiscal strength Economic growth and stability

(1.2.1.) (1.2.2.)
Debt Economic growth Size and income

Debt burden
affordability and volatility level
External stability
(1.2.3.)
Currency
External debt
reserves

1.2.1. Fiscal strength
Key financial ratios to measure fiscal strength are presented below:
Measurement Ratio Interpretation
Debt to GDP
General government debt
GDP
Similar to
Debt burden
leverage
Debt to Revenue
General government debt Higher ratio
Revenue
Interest to GDP Lower credit

General interest payments rating
Similar to GDP
Debt
coverage
affordability
Interest to Revenue
General interest payments
Revenue

1.2.2. Economic growth and stability
Key financial ratios to measure economic growth and stability are presented
below:
Growth and stability Size and Scale
Average Real GDP Growth Size of Economy

Real GDPt−1 − Real GDPt
GDP in PPP terms
Real GDPt
Real GDP Growth Volatility Per Capita GDP

Standard deviation of Real GDP
GDP Population
Lower real GDP growth, lower real economy size, lower per-capita GDP,
and higher volatility of real GDP growth
→ Lower credit rating.

1.2.3. External stability
• A country’s external stability depends critically upon whether foreign

investors are able and willing to hold assets in a country’s currency.
• Quantitative meausres of external stability focus on the relative size of
external debt as compared to available sources of repayment.
Key financial ratios to measure external stability are presented below:
Currency Reserves External Debt
FX Reserves to GDP External Debt Burden

FX Reserves LT External Debt
GDP GDP
Reserve Ratio External Debt Due

FX Reserves External Debt Due in 12m
External debt GDP
Lower currency reserves ratio, higher external debt ratio

→ Lower credit rating

2. Non-sovereign government debt
Different issuers of non-sovereign government debt
Agencies Government banks
Supranational Regional government


Issuers Characteristics Credit rating
Established to carry out a Similar to the

Agencies particular government- relevant sovereign
sponsored role debt rating.
Set up with a specific Similar to the

Government government-sponsored sovereign entity.
banks and mission (e.g: issuing green
financing bonds to raise finance for
institutions projects designed to mitigate
climate change)
Depends on the
Set up by groups of implicit support of
Supranational sovereign governments to the sponsored
issuers carry out projects with governments and
varied missions global development
institutions.

Regional government bond
The majority of local government bonds, including municipal bonds, are

either general obligation bonds or revenue bonds.
• GO bonds are unsecured bonds issued with the full
faith and credit of the issuing entity and are
General supported by the taxing authority of the issuer.
obligation
• Serviced with taxes and fees collection
(GO) bonds
• Credit analysis of GO bonds is quite similar to that of
sovereign bonds.
• Revenue bonds are issued for financing a specific

project (e.g., a toll road, bridge, hospital, etc.)
• Serviced with revenues generated from projects →
Revenue bonds
Higher credit risk than GO bonds.
• Credit analysis of revenue bonds is similar to analysis
of corporate bonds.
Student’s notes

FOR CORPORATE ISSUERS
LEARNING OUTCOMES
16.a. Describe the qualitative and quantitative factors used to evaluate a

corporate borrower’s creditworthiness
16.b. Calculate and interpret financial ratios used in credit analysis
16.c. Describe the seniority rankings of debt, secured versus unsecured

debt and the priority of claims in bankruptcy, and their impacts on
credit ratings
[LOS 16.a] Describe the qualitative and quantitative factors used to

evaluate a corporate borrower’s creditworthiness
1. Qualitative factors
Key qualitative factors include a company’s business model and the industry
within which it operates, as well as the competitive forces and business risks
it faces.
Corporate Governance
Industry and
Business Model
Competition
Business Risk
Issuer-specific Industry-specific External


• Business model with stable and predictable cash

flows  Higher credit quality. Changes in the
business model Increase business risk.
Business model • For longer-term debt issues, a credit analyst should
consider both the existing business model and any
long-term changes to it that the issuer will need to
make to remain competitive.
• Less intensive competition  More favorable

Industry credit quality.
competition • Analysts need to consider any change in the
competitive landscape over the long term.
• Lower risk of unexpected deviations from expected

revenues and margins  Higher credit quality.
Business risk
• Business risk can originate from issuer-specific,
industry-specific, or external sources.
Corporate • Debt convenants and accounting policies

governance (further details in the next slide)

Corporate governance
Unsecured investment-grade issuers:

• Primarily have affirmative convenants (compliance
with rules and laws, maintenance of company
assets, and paying taxes)  Assess the potential to
issue additional debt that would dilute the claims
Debt convenants of existing debtholders.
High-yield issuers:
• Have negative covenants (restricting the issuer’s
ability to pay dividends or issue further debt) +
affirmative covenants  Assess the past actions of
management whether any actions led to credit
rating downgrades.
Aggressive accounting policies mask the

performance and the risk of the underlying business
Accounting
and are potential warning flags to the true character
policies
of the business and its leaders.
→ Adversely impact an issuer’s creditworthiness

2. Quantitative factors
Top-down approach
Macroeconomy Industry Event risk

GDP growth Addressable market Scenario analysis
Cyclicality Market share External shocks
Hybrid approach
Liquidity Revenue growth Debt service coverage

Profitability Operating profit Interest coverage
Cash flow
Balance sheet Income statement
statement
Bottom-up approach

2. Quantitative factors
The goal of quantitative analysis is to identify key factors that drive a

corporate issuer’s POD and how they change over the credit cycle, including
the following factors:
• Strong operating profits and recurring revenues.
• Low levels of leverage and less reliance on debt in the capital structure.
• High coverage of debt service payments with periodic income.
• High levels of liquidity to meet short-term debt payments.
[LOS 16.b] Calculate and interpret financial ratios used in credit

analysis
Key financial ratios for corporate creditworthiness
Indication of
Ratio type Ratio Name Calculation higher credit
quality
EBIT Margin Operating Income

Profitability Higher ratio
Revenue
EBIT to Interest Operating Income

Coverage Higher ratio
Expense Interest Expense
Debt to EBITDA Debt Lower ratio

EBITDA
Leverage
RCF to New Retained Cash Flow
Higher ratio
Debt Debt − Cash and Marketable Securities
[LOS 16.c] Describe the seniority rankings of debt, secured versus

unsecured debt and the priority of claims in bankruptcy, and their
impacts on credit ratings
1. Seniority ranking
Debt with different ranking:
First Lien/Motgage
Secured debt
Debtholders have a
Senior Secured
Priority of claims in the event of default

direct claim (pledge) on
certain assets and their
associated cash flows.
Junior Secured
Category of debt
Cost of debt
Restriction
Senior Unsecured
Unsecured debt
Senior Subordinated
Debtholders have only a
general claim on the
issuer’s assets and cash
Subordinated
flow.
Junior Subordinated

unsecured debt and the priority of claims in bankruptcy...
2. Recovery rate
Recall: The provision in which all creditors at the same debt seniority level
are treated as one class without taking coupon and maturity into account, is
referred to as bonds ranking pari passu (“on an equal footing”) in right of
payment.
Example: In the event of bankruptcy, a senior unsecured bondholder whose

bond matures in 10 years will have the same pro rata claim on the issuer’s
assets as another senior unsecured bondholder whose bond matures in just
another 3 months.
Relationship between recovery rates and seniority ranking
First Lien Loan

Recovery rate
Secured debt Senior Secured Investors

Credit risk
demand a higher
Junior Secured yield to invest in
… lower-ranked
debt
Subordinated instruments.
Unsecured debt
Junior Subordinated

2. Recovery rate
Key characteristics of recovery rates are as follows:
Recovery rates are usually lower for industries

a. Recovery rates can that are in secular decline* compared to
vary widely by industry industries that are only experiencing a cyclical
economic downturn.
b. Recovery rates can Recovery rates are usually lower at or near the
also vary depending on bottom of a credit cycle (which is usually very
when they occur in a closely linked with the economic cycle) than at
credit cycle other times in the cycle.
c. Recovery rates can Recovery rates are tend to be lower for lower-
vary greatly across ranked debt if a company has a relatively
companies within the higher proportion of secured debt in its capital
same industry structure.
(*) Secular decline/increase refers to long-lasting and essential shift in an

industry leading to substaintial decline/growth and has low correlation to the
business cycle.

3. Issuer vs. Issue ratings
Rating agencies usually provide credit ratings for the issuer (referred to as a
corporate family rating) and for different issues (referred to as corporate
credit rating) as well.
Corporate family rating (CFR) Corporate credit rating (CCR)
• Based on overall creditworthiness • Based on factors such as the

of the issuer. issue’s relative seniority ranking
in capital structure.
• Typically apply to the issuer’s • Apply to specific financial
senior unsecured debt. obligation of the issuer.
Cross-default provisions
Under the terms of a cross-default provision, when there is a default event

(such as nonpayment of interest) on any one bond issued by a company,
provisions in bond indentures may trigger default on the remaining issues
as well → Same default probability for all issues.

Notching
Definition: While the probability of default (POD) for an issuer and its issues
may be the same due to cross-default provisions, issuer ratings may differ
due to loss given default (LGD) differences because of seniority,
subordination, and sources of repayment → Such rating adjustment
methodology is known as notching.
Mechanism: Rating agencies move credit ratings for specific issues up or
down relative to the issuer rating (which applies to senior unsecured debt).
General rule: The higher the senior unsecured rating, the smaller the
notching adjustment.
For more risky issuers The probability of default is higher, so the

(lower credit ratings) potential difference in loss from a lower or
A larger notching higher seniority ranking is a bigger consideration
adjustment in assessing the issue’s credit risk.
For less risky issuers

(higher credit ratings) The probability of default is lower, so there is
less of a need to notch ratings to capture any
A smaller notching potential difference in loss severity.
adjustment

Factors affecting notching
Primary factor Secondary factors
Probability of Seniority Potential loss Structural

default ranking severity subordination
Arises in a holding company structure when the debt of operating

subsidiaries is serviced by the cash flow and assets of the subsidiaries
before funds can be passed to the holding company to service debt at the
parent level.
Student’s notes

SECURITIZATION
SECURITIZATION
LEARNING OUTCOMES
17.a. Explain benefits of securitization for issuers, investors, economies,

and financial markets
17.b. Describe securitization, including the parties and the roles they play
SECURITIZATION
OVERVIEW
Securitization: Process, Collateralized debt

Covered bonds
Benefits, and Risks obligations (CDO) LOS 18.a
LOS 17.a-b LOS 18.d
Creating
Residential mortgage
loans
LOS 19.b Assets-backed
securities
Creating
Residential mortgage- Commercial mortgage- Non-mortgage asset-

backed securities (RMBS) backed securities (CMBS) backed securities
LOS 19.b-c LOS 19.d LOS 18.c
Agency RMBS Credit tranching Auto Loan ABS
Mortgage pass- Credit Card Receivable

Creating through ABS
securities
Collateralized mortgage
Time tranching
obligations (CMO)
LOS 19.a
LOS 19.c
Non-agency RMBS
SECURITIZATION
[LOS 17.a] Explain benefits of securitization for issuers, investors,

economies, and financial markets
Before the advent of securitization
Financing for most mortgages and other financial assets was provided by
financial institutions (e.g., commercial banks).
Investors only participate in financings was by holding deposits, debt, or

equity issued by those financial institutions.
There are some problems
1. The financial institution represented an additional layer between

originating borrowers and ultimate investors.
2. Investors were only able to gain exposure to the bank’s entire portfolio
of assets → they were unable to pick and choose the types of assets
they desired exposure to.
Securitization solves these problems, and provides the additional benefits

SECURITIZATION

1 Benefits of securitization
1.1. For economies and financial markets
Lower cost of funds
1. It removes the layer between borrowers and investors

→ reduce the role of the financial intermediary
→ reduce the borrowers’ cost of fund (Solve problem 1)
Improve liquidity of the underlying financial assets
2. Securitized bonds are sold in the public market

→ they have better liquidity (lower liquidity risk) than the original loans
(mortgages) on bank balance sheets.
→ financial markets are made more efficient.
3. It allows investors to have a stronger legal claim on the collateral pool of
assets.
SECURITIZATION

1 Benefits of securitization
1.1. For economies and financial markets
Diversification
4. Asset-backed securities (ABS) offer companies an alternative means of

raising finance that can be considered alongside bond and equity issuance.
5. Investors can pick and choose the types of securities (ABS) that match
their risk, return, and maturity profiles to invest in. (Solve problem 2)
Example: A pension fund with a long-term horizon can gain access to long-
term real estate loans by investing in residential MBS without having to
invest in bank bonds or stocks
More funds for selling
6. Financial intermediaries are able to originate more loans (by using

financing provided by outside investors to originate loans) than they would
be able to if they were only able to issue loans that they could finance
themselves → an improvement in their profitability.
7. The increase in the total supply of loanable funds benefits organizations

(governments and companies) that need to borrow.
SECURITIZATION

1. Benefits of securitization
1.2. For issuers
Banks act as the intermediary between borrowers and investors. If they can
separate loan origination from loan financing, they can improve their
profitability, earning origination fees and reducing capital requirements for
loans that are sold to investors.
Banks and Securitization
loans ABS
cash cash
Bank SPE Investor

Assets Liabilities Assets Liabilities
Cash Deposits Loans ABS issued

Loans Debt
Other assets Equity
SECURITIZATION

1.2. For issuers
Increased Banks securitize loans → Receiving proceeds →

business activity Using proceeds to make more loans.
The originating bank or corporation can charge fees

Improved
for originating the initial transaction that creates the
profitability
collateral and for selling the collateral to the SPE.
Banks removes credit risk from its balance sheet by

Lower capital selling loans to the SPE → Reducing the capital
reserves for reserves that regulators require the bank to hold →
banks Allowing the bank to allocate more funds to
profitable activities.
Banks can use securitization to sell illiquid loan

Improved
portfolios → Operating more efficiently from a
liquidity
risk/return perspective.
SECURITIZATION

1.3. For investors
Allowing investors to tailor interest rate and credit

Tailored risk and
risk exposures to suit their specific risk, return, and
return
maturity needs.
Allowing investors to gain exposure to private debts

without having specialized resources and expertise
Access necessary to provide loan origination such as credit
evaluation, origination, underwriting, and servicing
→ More efficient and diversified portfolios.
ABSs can be sold to other investors more easily than

the underlying collateral → Allowing investors to
Liquidity response more quickly to changes in market
conditions than they could if they held the loans
directly.
SECURITIZATION

2. Risks of securitization
Although securitization brings many benefits to economies, it is not

without risks. Broadly, these risks fall into two categories below.
Risk related to
Timing of the ABS’s Inherent credit risk of the

cash flows collaterals backing the ABS
e.g: e.g: Borrowers default on

• Contraction risk their loans → SPE may not be
able to make cash payments
• Extension risk to the security holders.
(further discussed in later modules)

SECURITIZATION
[LOS 17.b] Describe securitization, including the parties and the

roles they play
1. The Securitization Process
To understand how securitization works, we consider the following example

An Example of a Securitized Transaction – ABC Co
Characteristics of ABC’s business - Originator

• ABC Company is in the business of manufacturing and selling motor
vehicles.
• While some of its sales are made for cash, most sales are made on
installment sales contracts where ABC advances loans to customers to
finance their purchases.
• ABC wants to raise $1 billion for its expansion program and decides to
securitize these loans to raise the funds instead of issuing corporate
bonds
SECURITIZATION

roles they play
1. The Securitization Process
An Example of a Securitized Transaction – ABC Co
A fully graph for securitization process as follows:
Customers
Creating
Buy motor Make a
customer loan
vehicles customer loan
Originator
ABC Co
Selling
Sell customer Pay cash for
customer
loan loan purchase
loans for SPE
SPE
Payments received
Issue securitized from the collateral
Cash (loans) are used to fulfil
Issuing ABS bond (ABS)
principal and interest
Investors payments to ABS
holders
SECURITIZATION

roles they play
2. Parties to a Securitization and Their Roles
The three main parties to a securitization are

Parties Description Parties in example
Originator/Seller Originates the loans and sells loans ABC Co
to the SPE
Issuer/Trust the SPE that purchases the loans or SPE
receivables and uses them as
collateral to issue the ABS
Servicer Services the loans ABC Co
There are several other parties involved in a securitization:
Servicer (when it is different from the originator)

Are referred
1. Independent accountant 4. Underwriters to as third
parties to the
2. Lawyers/attorneys 5. Rating agencies
securitization
3. Trustees 6. Fnancial guarantors
SECURITIZATION

roles they play
3. Key Role of the Special Purpose Entity
The SPV is a bankruptcy-remote entity, its obligations remain secure even if the parent
company goes bankrupt.
Bankruptcy remoteness
Originator no longer has
ownership rights on loans
Bankruptcy remoteness
Sell customer Special purpose Issuing bond
Originator Investors
loans entity (SPE)
The assets of SPE are legally

separate from those of the originator
In the event of the originator’s bankruptcy
Creditors of Originator have no claim on SPE’s pool

The SPE is able to continue to
of assets
make interest and principal
payments to investors using funds
The cash flows backing the ABS issued by SPE are
generated from the assets.
secure within the SPE
The credit rating of the ABS securities may be higher than credit ratings of bonds
issued by Originator
→ Lower cost of funds when issuing ABS than traditional bonds.
Student’s notes
MODULE 18: ASSET-BACKED

SECURITY (ABS) INSTRUMENT
AND MARKET FEATURES
MODULE 18: ASSET-BACKED SECURITY (ABS)
INSTRUMENT AND MARKET FEATURES
LEARNING OUTCOMES
18.a. Describe characteristics and risks of covered bonds and how they
differ from other asset-backed securities
18.b. Describe typical credit enhancement structures used in

securitization
18.c. Describe types and characteristics of non-mortage asset-backed

securities, including the cash flows and risks of each type
18.d. Describe collateralized debt obligations, including their cash flows

and risks
OVERVIEW: TYPES OF ABS
Assets-backed securities
Residential mortgage- Residential mortgage

backed securities (RMBS) loans
LOS 19.c LOS 19.b
Secure for
Commercial mortgage-
Commercial mortgage
backed securities (CMBS)
loans
LOS 19.d
Similar to ABS
Non-mortgage asset-backed
Non-mortgage assets
securities
(Auto loan, credit card,…)
LOS 18.c
Secure for
Diversified pool of Collateralized debt

securities obligations (CDO)
(ABS, bond, loan,…) LOS 18.d
Secure for
Institution’s assets
Covered bonds
(remaining on balance
LOS 18.a
sheet)
[LOS 18.a] Describe characteristics and risks of covered bonds and

how they differ from other asset-backed securities
Covered bonds are similar to asset-backed securities (ABS), but the underlying
assets (the cover pool), although segregated, remain on the balance sheet of the
issuing corporation (no SPE is created).
Covered bonds are issued primarily by European and Asian.
Characteristics
• Covered bonds usually consist of one bond class per cover pool
• Covered bonds offer bondholders dual recourse from both the issuing
financial institution and the underlying asset pool.
• Covered bonds do not expose investors to prepayment risk.

Cover pool sponsors must replace any prepaid or non-performing assets (assets
that do not generate the promised cash flows) in the cover pool to ensure
sufficient cash flows until the maturity of the covered bond.
• Covered bonds usually carry lower credit risks and offer lower yields than
otherwise similar ABS.
[LOS 18.a] Describe characteristics and risks of covered bonds and

how they differ from other asset-backed securities
Characteristics
Covered bonds may have different provisions in case their issuer defaults
• Hard-bullet covered bonds

If payments do not occur according to the original schedule, a bond default is
triggered and bond payments are accelerated
• Soft-bullet covered bonds

Soft-bullet covered bonds delay the bond default and payment acceleration of
bond cash flows until a new final maturity date, which is usually up to a year
after the original maturity date
• Conditional pass-through covered bonds

Conditional pass-through covered bonds convert to pass-through securities after
the original maturity date if all bond payments have not yet been made.
[LOS 18.b] Describe typical credit enhancement structures used in

securitization
Credit enhancement
1. Subordination (credit tranching)
Creating more than one bond class or tranche
Ordering the claim priorities for interest in an asset between the tranches
The most senior tranche is unaffected
unless losses exceed the amount of In the event of default
the subordinated tranches
Senior tranches The proceeds from
The tranches of highest seniority liquidating assets will
first be used to repay
Provide Subordinated tranches the most senior
credit (junior tranches) creditors
protection
to the senior Subordinated tranches Losses are allocated
classes (junior tranches) from the bottom up

securitization
Credit enhancement
1. Subordination (credit tranching)
Example: To understand how the senior-subordinate structure works, consider

the following senior/subordinated structure:
Par Value Initial Pass Through

Bond Class ($ million) Rate (%)
A (Senior) 250 3
B (Subordinate) 60 3.5
C (Subordinate) 15 4.2
Company fails to make a payment of $75 millions:

• The first $15m of losses are absorbed by Class C.
• The remaining loss ($60m) are absorbed by Class B.
→ Class C provides credit enhancement not only to Class A (senior bond class),
but also to Class B (higher subordinate bond class).
Company fails to make an payment that exceeds $75 millions: Class A only
suffers from credit losses.

securitization
Credit enhancement
2. Overcollateralization
Overcollateralization: The value of the pledged collateral is greater than the

par value of the debt issued.
The excess collateral can be used to absorb future losses
Example: A bond issue of $100 million with collateral value of $110 million
has excess collateral of $10 million.
One limitation of this method of credit enhancement is that the additional

collateral is also the underlying assets, so when asset defaults are high, the
value of the excess collateral declines in value.

securitization
Credit enhancement
3. Reserve accounts (reserve funds)
A cash reserve fund An excess spread account
an allocation of any asset cash

a cash deposit used to absorb
flows remaining after paying
losses.
interest to bondholders.
The excess spread (or excess interest cash flow) can be retained and
deposited into a reserve account as a first line of protection against losses.
The excess spread can be used to retire the principal, with the most senior
tranche having the first claim on these funds – “turboing” process.
[LOS 18.c] Describe types and characteristcs of non-mortage asset-

backed securities, including the cash flows and risks of each type
Securitization process
Non-mortgage assets 1 Investor 1
Non-mortgage assets 2 Non- Investor 2

mortgage
… Pool …
ABS
Non-mortgage assets n Investor m
Numerous types of non-mortgage assets have been used as collateral in

securitization. The largest non-mortgage assets in most countries are:
• Auto loan
• Lease receivables
• Personal loans
• Commercial loans

The collateral includes Amortizing The collateral includes non-
Loans amortizing Loans
The periodic cash flows include These only require a monthly

interest payments, principal minimum payment with no
repayments (in accordance with an scheduled principal payment.
amortization schedule), and (if Example: Credit card receivables (2)
allowed) prepayments.
An ABS backed by non-amortizing
Example: Residential mortgage loans
loans are not affected by
Automobile loans (1)
prepayment risk.
When the lockout period is over
The cash flows from collateral assets are
no longer reinvested but instead is
distributed to investors.
Total par value of
collateral loans Total par value of
collateral loans
Time Time
During the lockout (revolving) period
Any principal repayments from the pool of
Over time, some of the loans will receivables are used to purchase additional
be paid off receivables to maintain the size of the pool

1. Auto loan ABS
• Auto loan ABS are backed by auto loans and lease receivables
• Backed by Amortizing Loans
Cash flows for auto loan-backed securities consist of regularly scheduled monthly
interest and principal payments and prepayments*.
* Prepayments result from the following:

• Sales and trade-ins requiring full payoff of the loan
• Repossession and subsequent resale of the automobile
• Proceeds from insurance claims arising from loss or destruction of the
vehicle
• Cash payments to save interest costs
• Refinancing of the loan at lower interest rates
Automobile loan ABS all have some sort of credit enhancements to make them
attractive to institutional investors

2. Credit Card ABS
• Credit Card ABS are backed by credit card receivables

• Backed by non-amortizing loans → have lockout period
Extend a loan to
Issuer of
Cardholder
credit card
Repay the amount borrowed
Credit cards may be These receivables for the credit card company are
issued by banks, used as collateral for credit card receivable-
retailers, and travel backed securities
and entertainment
companies. A pool of credit card receivables
The cash flow from a pool of credit card receivables includes :

• Finance charges collected (interest charges),
• Fees (for late payments and membership),
• Principal repayment.
Interest payments are made to security holders periodically. The interest rate
may be fixed or floating (typically with no cap).

3. Solar ABS
• Solar ABS are backed by loans to homeowners wishing to finance the

installation of solar energy systems to reduce their energy bills.
• The loans can be collarteralized by a lien pledged on the installed systems,
on the property itself, or both.
• When the solar energy system loans are structured as residential home
improvement loans, the solar ABS effectively securitizes a subordinated
(junior) mortgage on the property.
Benefits of Solar ABS

• Solar loans are usually made to homeowners with good credit scores,
who are saving on energy bills through installing the solar energy system.
• Solar ABS investors are typically protected through overcollateraliZation,
subordination, and excess spreads → Default risk is likely to be low.
• Solar ABS contain a pre-funding period, allowing the trust to acquire
during a certain period of time after the close of the transaction
additional qualifying transactions that meet certain eligibility criteria.
[LOS 18.d] Describe collarteralized debt obligations, including their

cash flows and risks
A collateralized debt obligation (CDO) is a security that is backed by a diversified
pool of securities that may include:
• Corporate bonds and emerging market bonds (collateralized bond obligations
- CBOs).
• ABS, RMBS, and CMBS and other CDOs (structured finance CDOs).
• Leveraged bank loans (collateralized loan obligations - CLOs).
• Credit default swaps and other structured securities (synthetic CDOs).
Collateral assets are traded include:

Collateral manager’s responsibilities
• Corporate bonds
Buy and sell debt obligations for and from
• ABS, RMBS, and CMBS
the CDO’s collateral to generate sufficient
• Leveraged bank loans
cash flows to meet the obligations to the
• Credit default swaps and other
CDO bondholders.
structured securities
CDO manager CDO senior

Sale tranche
Originator SPE CDO mezzanine
Cash payment tranche
CDO equity
Cash flows from the underlying assets include tranche
• Coupon interest payments Make interest and
• Proceeds from maturing assets principal payments
• Proceeds from sale of assets.

1. From the investors perspective
Each class of bonds entails a different level of risk
CDO senior Earning a potentially higher yield than

tranche that on a comparably rated corporate
bond by gaining exposure to debt
CDO mezzanine products that they may not otherwise be
SPE tranche able to purchase.
Having the potential to earn an equity-

CDO Equity type return, thereby offsetting the
tranche increased risk from investing in the
subordinated class
The key to whether a CDO is viable depends upon whether a structure can be
created that offers a competitive return for the equity tranche

2. From the asset manager/issuer’s perspective
The aim is to earn a rate of return on the collateral pool of assets that is higher
than the interest costs of bonds issued
The return in excess of what is paid out to the bond classes accrues to the
holders of the equity tranche and to the CDO manager.
Interest payment like a other traditional bonds
CDO mezzanine CDO senior

CDO Residual tranche tranche
SPE
manager returns
CDO Equity
tranche
Residual returns
(return from collateral > interest cost of bonds)
CDO is a leveraged transaction

Investors who invest in the equity tranche use borrowed funds (the bond classes
issued) to generate a return above the funding cost.

2. From the asset manager/issuer’s perspective
The aim is to earn a rate of return on the collateral pool of assets that is higher
than the interest costs of bonds issued
Restrictive covenants are placed on the manager to ensure that the credit
ratings assigned to the various tranches at issuance are maintained during the
term of the CDO.
Certain restrictions are placed on the manager (via various tests and limits) to
ensure that the senior bond classes are adequately protected and the ratings
issued to the bond classes are maintained.
Failure to meet these tests may trigger an immediate payoff to the senior bond
classes until the tests are satisfied.
3. The major difference between an ABS and a CDO
The major difference between an ABS and a CDO is that in an ABS the cash flows
from the collateral pool are used to pay off bondholders without the active
management of collateral
In a CDO, the manager buys and sells debt obligations (assets) to

• generate the cash flow required to repay bondholders
• earn a competitive return for the equity tranche.

4. Generic CLO structure
Three major types of CLOs
Payments to CLO investors are generated through

Cash flow CLOs
cash flows on the underlying collateral.
Market value Payments to CLO investors are generated through

CLOs trading the market value of the underlying collateral.
The collateral pool exposure is generated through

Synthetic CLOs credit derivative contracts. In this type of CLO, the
CLO trust does not take ownership of the collateral

4. Generic CLO structure
The Capital Structure of a Generic CLO Transaction
CLO Collateral
Senior Selected for • Diversifed portfolio of
Secured Loans CLO Collateral Pool senior secured loans
Unsecured/ • Value of collateral
Suborrdinated Debt exceeds value of CLO debt
• Generally 100-225 Issuers
Equity • Actively managed by
collateral manager
Highest claim on cash flows
AAA Tranche
CLO Capital
Structure
AA Tranche
A Tranche CLO debt
BBB Tranche
BB Tranche
Equity Tranche First loss
Lowest claim on cash flows

Student’s notes
MODULE 19: MORTGAGE-BACKED

SECURITY (MBS) INSTRUMENT AND
MARKET FEATURES
MODULE 19: MORTGAGE-BACKED SECURITY (MBS)
LEARNING OUTCOMES
19.a. Define prepayment risk and describe time tranching structures in

securitisations and their purpose
19.b. Describe fundamental features or residential mortgage loans that

are securitised
19.c. Describe types and characteristics of residential mortgage-backed

securities, including mortgage-pass through securities and
collateralised mortgage obligations, and explain the cash flows and
risks for each type
19.d. Describe characteristics and risks of commercial mortgage-backed

securities
[LOS 19.a] Define prepayment risk and describe time tranching

structures in securitisations and their purpose
1. Structure of a securitization
Structure of the securitization can also be structured with multiple classes of securities
(tranches), each with a different claim to the cash flows of the underlying assets.
Distribute Tranche 1
With this structure, a
to particular risk of the ABS
Secutities Tranche 2
… securities is redistributed
across the tranches.
Tranche n
Credit risk Prepayment risk

The risk of loss resulting from the issuer The uncertainty that the cash flows will
failing to make full and timely payments be different from the scheduled cash
of interest and/or repayments of flows in the loan agreement because of
principal. the borrowers’ ability to alter payments.
1.1. Subordination - Credit tranching 1.2. Time tranching
With each risk above, the structure of a securitization may allow the redistribution of
them to into tranches, some bear more of the risk and others bear less of the risk
→ The total risk is unchanged, simply reapportioned.

1.1. Subodination – Credit tranching

The bond classes differ as to how they will share any losses resulting from defaults of
the borrowers whose loans are in the collateral
→ Ordering the claim priorities for interest in an asset between the tranches
→ “Waterfall” structure
The most senior tranche is unaffected unless losses
exceed the amount of the subordinated tranches
In the event of default
Senior tranche
The tranches of highest seniority The proceeds from
liquidating assets will first
Provide credit be used to repay the
protection to Subordinated tranche most senior creditors
the senior (junior tranches)
classes
Subordinated tranche Losses are allocated from
(junior tranches) the bottom up
This structure redistribute the credit risk associated with the collateral
Allow investors to choose the level of credit risk that they prefer to bear.

1.1. Subodination – Credit tranching
Example 1: To understand how the senior-subordinate structure works,

consider the following senior/subordinated structure:
Bond Class Par Value ($ million)

A (Senior) 180
B (Subordinate) 14
C (Subordinate) 6
In this structure, Bond Class A is the senior bond class whereas both Bond
Class B and Bond Class C are subordinated bond classes from the perspective
of Bond Class A.
The rules for the distribution of losses are as follows.
Bond Class C → Bond Class B → Bond Class A
• If the losses on the collateral do not exceed US $6 million. no losses will
be realized by Bond Class A or Bond Class B.
• If the losses exceed US $6 million, Bond Class B must absorb the losses
up to an additional US $14 million
For example, if the total loss on the collateral is US $16 million, Bond Class C
loses its entire par value of US $6 million and Bond Class B realizes a loss of
US $10 million of its par value of US $14 million.

1.2. Time tranching
The borrowers have ability to alter payments, usually to take advantage of

interest rate movements
The creation of tranches that possess different expected maturities is referred to

as time tranching
Time tranching is the process in which a set of bond classes or tranches is created
that allow investors a choice in the type of prepayment risk that they prefer to
bear.
The first tranche receives all principal

Tranche 1 repayments from the underlying assets up to the
principal value of the tranche
Secutities The second tranche would then receive all

Tranche 2
principal repayments from the underlying assets
There may be other tranches with sequential

… claims to remaining principal repayments

2. Prepayment risk
Contraction risk Extension risk
Contraction risk is the risk that Extension risk is the risk that
prepayments will be more rapid than prepayments will be slower than
expected expected
Homeowners will Homeowners give

When interest refinance at now- When interest up the benefits of
rates decline available lower rates rise a contractual low
interest rates interest rate
A security backed Actual A security backed Actual

by mortgages will prepayments will by mortgages will prepayments will
have a shorter be higher than have a longer be lower than
maturity forecasted maturity forecasted
[LOS 19.b] Define fundamental features or residential mortgage

loans that are securitized
A residential mortgage loan is a loan secured by the collateral of some specified
real estate property that obliges the borrower to make a predetermined series of
payments to the lender.
To understanding how residential mortgage created, we consider an example:
You have only $100, but you want to buy a house for $1,000. Therefore, you
decide to lend the bank a residential mortgage loan of $900, where it’s secured
by this house.
Make a loan to buy house
Foreclose on the loan
The mortgage gives the lender the right to foreclose on the loan
Borrower fails to make her mortgage payments, the lender has the right to seize
the property and recover the amount due by selling it.

1. Characteristics of residential mortgage loan
1.1. Amount of loan and collateralized asset’s price
The amount of the mortgage

loan < The property’s purchase price
The purchase price − The amount borrowed = The down payment
At initiation
Borrower’s equity = the down payment
Mortgage loan’s term
Over time
Borrower’s equity also changes
• Changes in market value of the property

• Borrower makes mortgage payment that include principal repayment.

1.2. Loan-to-value ratio
Loan-to- value (LTV) ratio is the ratio of the amount of the mortgage loan to
the purchase price.
Mortgage loan value
LTV =
Assets′ s purchase price
Implication:
Lower The LTV ratio Higher
Higher Borrower’s equity Lower
Less Likely the borrower is to default More
Protection the lender has for recovering the

More Less
amount loaned in case the borrower defaults

1.3. Two types of mortgages based on the credit quality
In the United States, market participants typically identify two types of

mortgages based on the credit quality of the borrower
Prime loans Subprime loans
Prime loans generally have Subprime loans have borrowers

borrowers of high credit quality with lower credit quality and/or
with strong employment and credit are loans without a first lien on the
histories, income sufficient to pay property
the loan obligation, and substantial
equity.

2. Five primary specifications of mortgage design
2.5.
Rights of the 2.1.
Lender in a Maturity
Foreclosure
2.4. Mortgage
Prepayment design 2.2.
Options and Interest Rate
Prepayment Determination
Penalties
2.3.
Amortization
Schedule

2.1. Maturity
The term of a mortgage loan refers to the number of years to maturity

• In the United States, the typical term or number of years to maturity of
a mortgage ranges from 15 to 30 years.
• For most European countries, a residential mortgage typically has a
maturity between 20 and 40 years, whereas in France and Spain, it can
be as long as 50 years.
• Japan is an extreme case, with mortgage maturities of 100 years.
2.2. Interest Rate Determination
The interest rate on a mortgage is called the mortgage rate or contract rate
a. Fixed rate c. Initial period fixed rate
b. Adjustable-rate mortgage
d. Convertible
(ARM) or variable-rate mortgage

a. Fixed rate
The mortgage rate remains the same during the life of the mortgage.
b. Adjustable-rate mortgage (ARM) or variable-rate mortgage
The mortgage rate is reset periodically (daily, weekly, monthly, or annually).
The determination of the new mortgage rate for an adjustable-rate

mortgage (ARM) at the reset date may be based on:
• Indexed-referenced ARM: some reference rate or index
• Reviewable ARM: a rate determined at the lender’s discretion
An ARM usually have a maximum interest rate by which the mortgage rate
can change at a reset date and a maximum interest rate that the mortgage
rate can reach during the mortgage’s life.

c. Initial period fixed rate
The mortgage rate is fixed initially for a specified period and is then
adjusted to a new fixed rate or ARM
Mortgage rate is Hybrid

Mortgage adjusted to ARM mortgage
rate
Mortgage rate is adjusted to Rollover

Fixed term
a new fixed rate mortgage
Time

d. Convertible
The mortgage rate is initially either fixed or adjustable. At some point, the
borrower having an option to convert the mortgage into a fixed rate or
adjustable rate for the remaining term of the mortgage.
Mortgage
rate
Fixed term
ARM
Fixed term
Time
Convert Convert
point point

2.3. Amortization Schedule
In most countries, residential mortgages are amortizing loans
An amortizing bond is one that makes periodic interest and principal

repayments over the term of the bond.
A bond may be fully or partially amortized until maturity:
a. Fully amortized bond
b. Partially amortized bond Discussed in detail in

Module 1
c. Interest-only mortgage (bullet mortgages)


2.4. Prepayment Options and Prepayment Penalties
a. Prepayment Options
A mortgage loan may allow the borrower to prepay a portion (or the entire
amount) of the outstanding mortgage principal at any point during the term
of the mortgage.
This option is known as a prepayment option or early retirement option
The effect of a prepayment option is that the cash flow amounts and timing
from a mortgage cannot be known with certainty
Prepayment penalty mortgages was born

Detail in the next slide

2.4. Prepayment Options and Prepayment Penalties
b. Prepayment Penalties
Prepayment penalty mortgages may stipulate that the borrower pay some
sort of penalty if she prepays within a certain time period following
inception or the mortgage
They compensate the lender for the difference between the contract rate
and the prevailing mortgage rate if the borrower prepays when interest rates
decline.
Prepayment penalty is effectively a mechanism that provides for yield

maintenance for the lender.

2.5. Rights of the Lender in a Foreclosure
When the borrower fails to make

the contractual loan payments
However, the proceeds received

The lender can repossess the
from the sale of the property may be
property and sell it
insufficient to recoup the losses.
A mortgage can be a recourse loan or a non-recourse loan
Recourse loan Non-recourse loan

The lender has a claim against the The lender does not have such a
borrower for the shortfall claim for shortfall

2.5. Rights of the Lender in a Foreclosure
The recourse/non-recourse feature of a mortgage has implications for

projecting the likelihood of defaults by borrowers
Particularly in the case of “underwater mortgages” when:

the value of the property < the amount owed by the borrower.
With a nonrecourse loan With a recourse loan

The borrower has an incentive not to
repay the loan even if she has the The borrower will be less likely to
funds available strategically default because the
lender can come after her other
income/assets to recover the shortfall
This is known as a strategic default

3. Residential mortgage-backed securities (RMBS)
Residential mortgage-backed securities (RMBS) are the bonds created from

the securitization of mortgages related to the purchase of residential
properties.
Residential mortgage loans
Securitization process
RMBS
Depending on the issuer of the securities
Agency RMBS Nonagency RMBS
Agency RMBS are issued by Nonagency MBS are issued by private

• Federal agencies entities.
• Quasi-government entities (GSEs -
government-sponsored enterprises)

Agency RMBS
Issued by Federal agencies Issued by GSE
Federal agencies refer to GSEs such as Fannie Mae and
Government National Mortgage Freddie Mac.
Association (GNMA or Ginnie Mae),
a part of the US Department of
Housing and Urban Development.
The RMBS are guaranteed by the RMBS issued by GSEs do not carry
full faith and credit of the US the full faith and credit of the US
government government.
There is no credit risk for agency There is minimal credit risk for
RMBS issued by Ginnie Mae agency RMBS issued by GSEs
[LOS 19.c] Describe types and characteristics of residential

mortgage-backed securities, including mortgage-pass through
securities and collateralized mortgage obligations, and explain the
cash flows and risks for each type
Securitized loans included in agency RMBS must meet specific underwriting

standards established by various government agencies
• Maximum size of the loan
• Loan documentation required
• Maximum loan-to-value ratio
• Insurance is requirement
This section starts with a discussion:

2. Mortgage pass-through securities
3. Collateralized mortgage obligations


mortgage-backed securities…
2. Agency RMBS – Mortgage pass-through securities
A mortgage pass-through security is created when shares or participation certificates

in a pool of mortgage loans are sold to investors.
The cash flows of a mortgage pass-through security depend on the cash flows of
the underlying pool of mortgages.
The cash flows consist of
• Monthly mortgage payments (interest) Cash payments are made to security
• The scheduled repayment of principal holders each month.
• Prepayments
Mortgage 1 Investor 1
Mortgage 2 Investor 2
Cash Cash
… flows Pool flows …
Mortgage n Investor n
The amount and timing of
Cash flows collected Cash flows paid to
from the collateral investors in the pass-
pool of mortgages through securities
The differences due to servicing and guaranteeing fees


2.1. Characteristics
2.1.1. Mortgage pass-through security’s coupon rate
A mortgage pass-through security’s coupon rate is called the pass-through rate
Mortgage rate on
Servicing and
The pass- the underlying
guaranteeing
through rate pool of mortgages
fees
(2.1.2)
The pass-through rate that the investor receives is said to be “net interest” or
“net coupon”.
Servicing and guaranteeing fees is the charge related to administrative tasks:

• Collect monthly payments from borrowers
• Forward proceeds to owners of the loan
• Send payment notices to borrowers
• Remind borrowers when payments are overdue
• Maintain records of the outstanding mortgage balance
• Initiate foreclosure proceedings if necessary
• Provide tax information to borrowers when applicable

2.1.2. Mortgage rate on the underlying pool of mortgages

The mortgages in the pool typically have different mortgage rates and different
maturities.
a. The WAC is calculated by weighting the mortgage rate of each mortgage in

the pool by the percentage of the outstanding mortgage balance relative to the
outstanding amount of all the mortgages in the pool
WAC WAM = %P1 ×X1 +%P2 × X2 +…+%Pn × Xn
Where:
• %Pi is the weights of each mortgage.
• Xi represents for:
o Coupon rate for mortgage i when calculating WAC.
o Remaining number of months for mortgage i when calculating WAM.
b. The WAM is calculated by weighting the remaining number of months to

maturity of each mortgage in the pool by the outstanding mortgage balance
relative to the outstanding amount of all the mortgages in the pool

2.1.2. Mortgage rate on the underlying pool of mortgages
Example 2:
Assume that a pool includes three mortgages with the following characteristics:
Mortgage Outstanding mortgage Coupon Rate Number of Months
balance (%) to Maturity
($) (Months)
A 1,000 (10%) 5.1 34
B 3,000 (30%) 5.7 76
C 6,000 (60%) 5.3 88
The outstanding amount of three mortgages is US$10,000. Thus, the weights of

Mortgages A, B, and C are 10%, 30%, and 60 %, respectively.
WAC = 10% × 5.1% + 30% × 5.7% + 60% × 5.3% = 5.4%.
WAM = 10% × 34 + 30% × 76 + 60% × 88 = 79 months.

2.2. Prepayment Rate Measures
The two key prepayment rate measures are

• Monthly measure: the single monthly mortality rate (SMM)
• Corresponding annualized rate: the conditional prepayment rate (CPR)
The SMM reflects the dollar amount of prepayment for the month as a fraction of
the balance on the mortgage after accounting for the scheduled principal
repayment for the month.
Prepayment in month t
SMMt =
Beginning mortgage balance for month t − Scheduled principal payment in month t
CPR is a corresponding annualized SMM.
Example:
A CPR of 6%, for example, means that approximately 6% of the outstanding
mortgage balance at the beginning of the year is expected to be prepaid by the
end of the year.

2.2. Prepayment Rate Measures
In the United States

Market participants describe prepayment rates in terms of the Public Securities
Association (PSA) prepayment benchmark over the life of a mortgage pool.
• The PSA prepayment benchmark assumes that the monthly prepayment rate for a
mortgage pool increases as it ages (becomes seasoned).
• The PSA prepayment benchmark is defined in terms of a monthly series of CPRs
• The standard for the PSA model is 100 PSA
Example: The 100 PSA benchmark assumes the following:
• A CPR of 0.2% in Month 1.
• The CPR increases by 0.2% per year every month for the next 30 months until it
reaches 6 % per year.
• A CPR of 6% for the remaining term.
Slower or faster prepayment speeds are described in terms of percentages of 100 PSA.
Example: 75 PSA implies three quarters of the CPR of the 100 PSA benchmark, while
250 PSA implies 2.5 times the CPR of the 100 PSA benchmark.

2.3. Weighted Average Life
A standard practice in the bond market is to refer to the maturity of a bond. This
practice is not followed for MBS because principal repayments are made over the
life of the security.
Although an MBS has a legal maturity*, the legal maturity does not reveal much
about the actual principal repayments and the interest rate risk.
Market participants use weighted average life, or simply the average life as a
measure of the interest rate risk of a MBS.
We can calculate MBS’s average life based on the prepayment rate
The average life of an MBS depends on the assumed prepayment rate:

Higher prepayment rate assumed → Shorter the average life of MBS
Lower prepayment rate assumed → Longer the average life of MBS
(*) the date when the last scheduled principal repayment is due

• Collateralized mortgage obligations (CMOs) are securities that are

collateralized by RMBS
• CMOs redistribute the cash flows from mortgage-related products (RMBS)
into tranches with different risk exposures to prepayment risk (similar to
time tranching)
Mortgage-related
CMO
products
Each CMO has CMO Mortgage pass-

Securities 1
multiple bond tranche 1 through securities
classes (CMO
Secure
tranches) that CMO Mortgage pass-
Securities 2
have different tranche 2 through securities
exposures to
prepayment CMO Mortgage pass-
risk. Securities 3
tranche 3 through securities
The total prepayment risk of the underlying RMBS is not changed; the
prepayment risk is simply reapportioned among the various CMO tranches.

The major CMOs are reviewed in the following subsections.
3.1. Sequential-Pay CMO structures
3.2. CMO structures including planned amortization class and support

tranches
3.3. Floating-Rate CMO


3.1. Sequential-Pay CMO structures
Sequential-Pay CMO Structures where each tranche would be retired sequentially
Disbursement of principal repayments:
Distribute all principal

tranche 1 tranche 1 is paid off
payments to tranche 1
Contraction risks
Extension risks


Total prepayment risk is not changed.


3.2. Planned Amortization Class (PAC) CMO
Another CMO structure has one or more planned amortization class (PAC)
tranches and support tranches.
Reducing the prepayment risk of

PAC tranche
Contraction and
the PAC tranche

extension risks
Support tranches absorb all

Support tranche prepayment risks (both contraction
and extension risks) first
Total prepayment risk is not changed.


Illustration for disbursement of principal payments
When the cash flow from mortgage loans is sufficient to fulfil all required
principal repayment
Cash flow from mortgage loans in one year
$15 millions
Required principal
10
repayments this year
2
PAC tranche Support tranche
Any excess principal Contraction risk

payments in a month
over the amount 3
necessary to satisfy 10
the schedule for PAC 2
tranche are paid to PAC tranche Support tranche
support tranche Actual principal repayments this year

Illustration for disbursement of principal payments

When the cash flow from mortgage loans is not sufficient to fulfil all required
principal repayment
Cash flow from mortgage loans in one year
$11 millions
Required principal
10
repayments this year 2
PAC tranche Support tranche
Extension risk
Principal repayments
to the support
tranche are curtailed 10 1
so the scheduled PAC
1
payments can be PAC tranche Support tranche
made
Actual principal repayments this year

The creation of PAC tranches requires the specification of two PSA

prepayment rates: a lower PSA prepayment assumption and an upper PSA
prepayment assumption → PAC band/collar.
For example: 100 – 300 PSA
When the prepayment rate is within the PAC band, all prepayment risk is
absorbed by the support tranche.
When the prepayment rate is outside the PAC band → broken PAC
→ PAC tranche will absorb the prepayment risk.
The key to the prepayment protection that PAC tranches offer investors is
the amount of support tranches outstanding
If the support tranches are paid off quickly because of faster-than-expected

prepayments, they no longer provide any protection for the PAC tranches.

3.3. Floating-Rate CMO
Although the collateral pays a fixed rate, it is possible to create a tranche with a
floating rate
Constructing a floater and an inverse floater combination from any of the fixed-
rate tranches in the CMO structure.
• The floater varies positively with interest rates They offset
• the inverse floater varies negatively with interest rates each other

4. Non-Agency RMBS
Entities that issue non-agency RMBS are typically

• Thrift institutions
• Commercial banks
• Private conduits
Securitization process for non-agency RMBS
Private conduits
Purchase Pool Issue
Non-conforming Non-agency
mortgages* Pool RMBS
Backed by underlying pool of non-conforming mortgages

(*) refer to LOS 19 c-1)

4. Non-Agency RMBS
Non-agency RMBS are not guaranteed by the government or a GSE, so credit risk
is an important consideration
Credit enhancement is necessary to make these securities attractive to investors
These credit enhancements allow investors to reduce credit risk or transfer credit
risk between bond classes → enabling investors to choose the risk–return profile
that best suits their needs.
There are two primary types of credit enhancements
Internal credit enhancement - relies on structural features regarding the

bond issue
External credit enhancement - refers to financial guarantees received from a

third party, often called a financial guarantor
[LOS 19.d] Describe characteristics and risks of commercial

mortgage-backed securities
1. Commercial mortgage-backed securities
Commercial mortgage-backed securities (CMBS) are backed by a pool of

commercial mortgages on income-producing property
Income-producing property may:
• Multifamily properties (e.g., Apartment buildings)
• Office buildings, industrial properties (including warehouses)
• Shopping centers, hotels, and health care facilities (e.g., Senior housing care
facilities).
Commercial loans 1 Investor 1

Commercial loans 2 Investor 2
Pool CMBS
… …
Commercial loans n Investor m
Difference between RMBS loan and CMBS loans

RMBS loans CMBS loans
Repayment Repaid by Repaid by real estate investors who, in turn, rely
source homeowners on tenants and customers to provide the cash
Type of debt Recourse loans Nonrecourse loans

1.1. Credit Risk
Commercial mortgage-backed securities (CMBS) are backed by a pool of

commercial mortgages* on income-producing property
(*) Commercial mortgages are non-recourse loans
Evaluation of credit risk for commercial mortgage loans requires examining

• The income-generating capacity
• Value of each property on a stand-alone basis
1.1.1. Loan-to-value ratio (LTV) (Refer to M19.b – 1)
1.1.2 Debt-service-coverage ratio (DSC)


1.1. Credit Risk
1.1.2 Debt-service-coverage ratio (DSC)
The debt-service coverage ratio (DSC) is used to evaluate the adequacy of

income generated from the property to service the loan
The property’s annual net operating income (NOI)

DSC =
The debt service
Where:
• The debt service = annual amount of interest payments and principal
repayments
• NOI = the rental income - cash operating expenses - a non-cash replacement
reserve (reflecting the depreciation of the property over time).
Evaluation:
• A ratio greater than 1 means that cash flow from the property covers debt
servicing costs adequately.
• The higher the ratio, the lower the credit risk.

1.2. Basic CMBS Structure
The basic CMBS structure is created to meet the risk and return needs of the
CMBS investor
A credit-rating agency determines the level of credit enhancement necessary to

achieve a desired credit rating
The highest-rated
tranche 1
tranche
Priority order
Subordination is
Each CMBS is Tranches are
used to achieve tranche 2
segregated into ordered by the
the desired credit rating
tranches …
credit rating
The lowest-rated
tranche n
tranche
Losses arising from loan defaults are

charged against the outstanding
principal balance of the CMBS
tranche with the lowest priority *

Two characteristics that are usually specific to CMBS structures are the presence
of call protection and a balloon maturity provision.
1.2.1. Call Protection
Call protection is the protection against early prepayments available to investors,

it is a critical investment feature that distinguishes CMBS from RMBS
a. The loan level
• A prepayment lockout: is a contractual agreement that prohibits any

prepayments during a specified period.
• Prepayment penalty points: are predetermined penalties that a borrower
who wants to refinance must pay to do so; a point is equal to 1% of the
outstanding loan balance.
• A yield maintenance charge (make-whole Charge): are intended to
compensate the lender for interest lost due to prepayments. These charges
make lenders indifferent to the timing of prepayments

1.2.1. Call Protection
b. The structural level
Call protection at the structural level comes by structuring CMBS into

sequential-pay tranches, by credit rating.
• A lower-rated tranche cannot be paid off until the higher-rated tranche are
retired
• Principal losses resulting from defaults, however, are affected from the
bottom of the structure upward.

1.2.2. Balloon Maturity Provision
Balloon maturity provisions require a significant amount of principal to be repaid

at maturity
This exposes investors to balloon risk - the borrower fails to make the balloon payment
The borrower fails to make The lender may extend the loan over a
the balloon payment period known as the “workout period”
Original loan’s term Workout period
The lender may modify the

original terms of the loan and
charge a higher interest rate
“default interest rate”
Student’s notes
05/01/2024

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Student’s notes

1.a. Describe the features of a fixed-income security

1.b. Describe the contents of a bond indenture and contrast affirmative

[LOS 1.a] Describe the features of a fixed-income security

1. Introduction for fixed-income securities

Fixed-income securities allow governments, companies, and other issuers to

The most common type of fixed-income security is a bond that promises to

In comparision with equity, fixed-income security has some characteristics:

Fixed-income security Equity

[LOS 1.a] Describe the features of a fixed-income security

2. Overview of a Fixed-Income Security

A bond is a contractual agreement between the issuer and the bondholders

Three important elements that an investor needs to know about when

3. The bond’s features

Assign bond … Time

The contingency provisions that may affect

The legal, regulatory, and tax considerations (LOS 2.b)

Note: In this section, we focus on “traditional” or “non-securitized” bonds.

[LOS 1.a] Describe the features of a fixed-income security

3. The bond’s features

[LOS 1.a] Describe the features of a fixed-income security

3. The bond’s features

Issued by organizations that operate globally

[LOS 1.a] Describe the features of a fixed-income security

3. The bond’s features

Time remaining – Tenor

[LOS 1.a] Describe the features of a fixed-income security

3. The bond’s features

Fixed-income securities, which, at the time of

Fixed-income securities, which, at the time of

Fixed-income securities, which have no stated

[LOS 1.a] Describe the features of a fixed-income security

3. The bond’s features

3.3. Par value

Bond prices are quoted as a percentage of their par value

The bond is trading at a

Bond’s price < par value The bond is trading at a discount

[LOS 1.a] Describe the features of a fixed-income security

3. The bond’s features

3.4. Coupon Rate and Frequency

The annual amount of interest payments made is called the coupon:

[LOS 1.a] Describe the features of a fixed-income security

3. The bond’s features

3.4. Coupon Rate and Frequency

3.4.2. Coupon rate

Pay a floating rate of interest Pay a fixed rate of interest

Zero-coupon, or pure discount bonds

Pay no interest prior to maturity

[LOS 1.a] Describe the features of a fixed-income security

3. The bond’s features

A debt issue’s seniority or priority of repayment among all issuer obligations

Senior secured debts

Subordinated secured debt Senior debt has a

[LOS 1.a] Describe the features of a fixed-income security

3. The bond’s features

3.6. Contingency Provisions

(*) Embedded options

Some common types of bonds with embedded options include:

[LOS 1.a] Describe the features of a fixed-income security

3. The bond’s features

3.7. Yield Measures

Current yield Simple yield

(*) A bond’s simple yield takes a discount or premium into account by