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Debt Markets and Investments
FINANCIAL MARKETS AND INVESTMENTS SERIES
1
1
Oxford University Press is a department of the University of Oxford. It furthers
the University’s objective of excellence in research, scholarship, and education
by publishing worldwide. Oxford is a registered trade mark of Oxford University
Press in the UK and certain other countries.
1 3 5 7 9 8 6 4 2
Printed by Sheridan Books, Inc., United States of America
CONTENTS
List of Figures ix
List of Tables xiii
Acknowledgments xvii
About the Editors xix
About the Contributors xxi
PART I BACKGROUND
5. Government Debt 81
K e i t h Pa r e t i a n d R o b K e n n e d y
6. Municipal Bonds 95
X i a o h u D e n g , C h r i s t o p h e r G o e b e r t, G e r s h o n M o r g u l i s , a n d
I s a a c Yat e s
v
vi Contents
12. Yield Curves, Swap Curves, and Term Structure of Interest Rates 203
T o m P. D av i s a n d D m i t r i M o s s e s s i a n
18. Other Bond Products: Social Impact Bonds, Death Bonds, Catastrophe
Bonds, Green Bonds, and Covered Bonds 325
E r i k D e vo s , R o b e r t K a r p o w i c z , a n d A n d r e w C . S p i e l e r
ix
x Figures
16.5 Convertible Bond Price Performance versus S&P 500 Index 295
16.6 Convertible Arbitrage Fund Assets under Management between 2000 and
2017 296
16.7 Relation Between Convertible Bond and Underlying Equity 297
16.8 Extendible Bond Issuance by Sector, between 2005 and 2017 300
17.1 Net Issuance of Mutual Fund Shares by Investment Classification 308
17.2 Net Issuance of CEF Shares by Investment Classification 315
17.3 Net Issuance of ETF Shares by Investment Classification 317
18.1 Social Impact Bond 328
18.2 Death Bond Structure 335
18.3 Catastrophe Bond Structure 339
20.1 End-of-Period Data from the Federal Reserve on Mortgage Pools and
Trusts 371
20.2 Data on ABS Issuance by Asset Class 372
20.3 Graphic Representation of Different Risk and Return for Investors in a
Mortgage-Backed CDO 374
21.1 Annual Mortgage-Related Securities Outstanding 385
21.2 Annual Mortgage-Related Securities Issuance 385
21.3 PSA Prepayment Model 397
21.4 Cash Flow Patterns of Three PSA Models 398
22.1 ABS Issuances in the United States between 1985 and 2016 404
22.2 Key Differences between Auto Loans and Auto Leases 412
22.3 Auto Lease Securitization Process 413
24.1 New Bond and Equity Issuance 438
24.2 Yield Curve Shapes 440
24.3 CDS Notional Amount 447
25.1 Callable Convertible Bond Issued by ALZA Corp. 455
25.2 Annual Issuance of Callable and Convertible Bonds between 1996 and
2016 456
25.3 Price Compression in a Callable Bond 456
25.4 Hypothetical Z-Spread Illustration 460
25.5 One-Step Binomial Tree 461
25.6 Binomial Tree Setup 462
25.7 Binomial Tree Calibration at Six Months: Setup 464
25.8 Binomial Tree Calibration at Six Months: Results 465
25.9 Binomial Tree Calibration at One Year: Setup 466
25.10 Binomial Tree Calibration at One Year: Results 467
25.11 Binomial Tree Application: Callable Bond Valuation 468
25.12 Binomial Tree Application: Puttable Bond Valuation 469
25.13 Convertible Bonds of A-R ating Issuers 472
26.1 Varying CPR Ramps Associated with Different PSA “Speeds” 483
26.2 Hypothetical S-Curve Function Illustrating a Fixed-R ate MBS’s Refinancing
Incentive over Various Levels of Interest Rates 486
26.3 Graphical Depiction of a 100 Percent Standard Default Assumption 491
27.1 Evolution of the TED Spread between 2004 and 2018 502
28.1 Cash Conversion Cycle 530
Figures xi
xiii
xiv Table s
21.1 Average Daily Trading Volume of MBSs versus Other Fixed Income
Securities 386
25.1 Summary of Bond Provisions 454
25.2 Illustration of the Yields in the Example 463
27.1 Example for Bootstrapping the LIBOR Forward Curve with OIS
Discounting 504
27.2 Example for Valuation of an FRA 506
27.3 Example for Valuation of an Off-Market Interest Rate Swap 507
27.4 Convexity Adjustment between Futures and Forward Rates 509
28.1 Five Cs in Practice: Balance Sheet 526
28.2 Five Cs in Practice: Income Statement 526
28.3 Five Cs in Practice: Cash Flow Statement 527
28.4 Financial Analysis in Practice: Income Statement 540
28.5 Financial Analysis in Practice: Balance Sheet 541
28.6 Financial Analysis in Practice: Statement of Cash Flow 542
28.7 Financial Analysis in Practice: Ratios 543
29.1 Auction Schedule 550
29.2 List of Current Primary Dealers 551
29.3 Example of Auction Announcement and Auction Results 553
29.4 Treasury Auction Format 556
29.5 Summary of Average Underpricing in Empirical Studies 562
30.1 Examples of Fixed Rate Bonds Issued at Par, Premium, and Discount 569
30.2 Examples of Floating Rate Notes Issued at Par, Premium, and Discount 570
30.3 Sample Presentation of a Bond Liability at Book Value 571
30.4 Duration Hedging of the Balance Sheet 574
30.5 Analysis of Fixed Rate Bond 577
30.6 Accounting Entries to Record Issuance of a $5 Billion Bond at 99.457
Percent 577
30.7 Amortization Calculations Using the Effective Interest Method 578
30.8 Accounting Entries to Record Interest Expense on July 26, 2017 579
30.9 Presentation of Bond Liability at Book Value as of July 26, 2017 579
30.10 Fair Market Value Calculations as of January 28, 2018 580
30.11 Accounting Entries to Record Bond Retirement on January 26, 2018 581
30.12 Analysis of Zero-Coupon Bond with Issuance Cost 581
30.13 Accounting Entries to Record Zero Coupon Issuance on July 1, 2014 582
30.14 Zero-Coupon Bond Amortization Using the Effective Interest Method 583
30.15 Zero-Coupon Bond Issuance Cost Amortization Using the Effective Interest
Method 584
30.16 Accounting Entries to Record Interest Expense and Issuance Cost
Amortization on July 1, 2015 586
30.17 Presentation of Zero-Coupon Bond Liability at Book Value as of July 26,
2017 586
30.18 Analysis of a Floating Rate Note Issued at a Premium 588
30.19 Accounting Entries to Record Issuance of €900,000,000 FRN at 100.5671
Percent on December 21, 2016 588
30.20 FRN Amortization Using the Effective Interest Rate Method 589
Table s xv
30.21 Accounting Entries to Record Interest Income on March 21, 2017 591
30.22 FRN Amortization Using the Effective Interest Rate Method After Interest
Rate Reset 592
30.23 Analysis of an Interest Rate Swap Entered to Hedge Bond Investments 594
30.24 Accounting Entries to Record Bond Investment on January 1, 2000 595
30.25 Accounting Entries to Interest Income and Expenses on March 31,
2000 596
30.26 Accounting Entries to Record Fair Value Changes on March 31, 2000 596
31.1 Credit Rating Agency Scale—Long Term Rating 601
31.2 T-Mobile Bonds Outstanding 616
32.1 Example of Possible Payouts under Financial Distress 625
32.2 Example of Possible Payouts with Risky Asset Substitution 625
32.3 Another Example of Payouts under Financial Distress 626
32.4 Payouts of Potential Investment Opportunities 627
32.5. Payout to Stakeholders If the Firm Invests in Both Opportunities 627
32.6 Payout to Stakeholders If the Firm Only Invests in Opportunity A 627
32.7 Payout to Stakeholders If the Firm Invests in Both Opportunities and
Receives a Principal Write-Down on Its Debt 628
33.1 List of Primary Dealers 644
34.1 Average Growth Rate above Inflation Required for Drawdown Rate to Last
Desired Time Frame 668
34.2 Holders of Municipal Securities (in Billions of USD) 670
35.1 Inter-Year Average Yield of Major Bond Indices and the S&P 500 Composite
Index, 2007–2016 680
35.2 Pure Discount Bond Price Sensitivity and Macaulay Duration 684
35.3 Duration of Bonds with Different Coupon Rates under Different Discount
Rates 684
35.4 Duration and Convexity 686
35.5 Bond Value at Year 5 690
ACKNOWLEDGMENTS
xvii
A B O U T T H E E D I TO R S
H. Kent Baker, CFA, CMA, is University Professor of Finance in the Kogod School of
Business at American University. Professor Baker is an award-w inning author/editor
of 33 books including Navigating the Investment Minefield; Financial Behavior: Players,
Services, Products, and Markets; Investment Traps Exposed: Navigating Investor
Mistakes and Behavioral Biases; Investor Behavior: The Psychology of Financial Planning
and Investing; Survey Research in Corporate Finance; and Understanding Financial
Management: A Practical Guide. As one of the most prolific finance academics, he
has published more than 180 peer-reviewed articles in such outlets as the Journal
of Finance, Journal of Financial and Quantitative Analysis, Financial Management,
Financial Analysts Journal, Journal of Portfolio Management, and Harvard Business
Review. He has consulting and training experience with more than 100 organiza-
tions. Professor Baker holds a BSBA from Georgetown University; MEd, MBA, and
DBA degrees from the University of Maryland; and an MA, MS, and two PhDs from
American University.
Greg Filbeck, CFA, FRM, CAIA, CIPM, PRM, is the Samuel P. Black III Professor of
Finance and Risk Management at Penn State–Erie, the Behrend College, and serves as the
Director for the Black School of Business. He formerly served as Senior Vice President
of Kaplan Schweser and held academic appointments at Miami University and the
University of Toledo, where he served as the Associate Director of the Center for Family
Business. Professor Filbeck is an author/editor of eight books and has published more
than 100 refereed academic journal articles in the Financial Analysts Journal, Financial
Review, and Journal of Business, Finance, and Accounting, among others. Professor Filbeck
holds and conducts training worldwide for candidates for the CFA, FRM, and CAIA
designations. Professor Filbeck holds a BS from Murray State University, an MS from
Penn State University, and a DBA from the University of Kentucky.
Andrew C. Spieler, CFA, FRM, CAIA, is a Professor of Finance in the Frank G. Zarb
School of Business at Hofstra University and founder of Advanced Quantitative
ConsultingTM, LLC, which provides quantitative analysis, professional education, and
advisory services to multivariant clients. He has published in Real Estate Economics,
Journal of Real Estate Finance and Economics, Journal of Real Estate Portfolio Management,
Global Finance Journal, and other journals. He served as Chair of the Derivatives
xix
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them, and concluded with “ye know these women are guilty of
treason!” One of the jury remarked, “they are not guilty of matters of
fact.” “Treason is fact,” replied the accuser, and added, “’tis true it is
but treason in their judgment; but go on according to our law, and if
you will not do it, I know how to proceed.” He then addressed the
prisoners, “’Tis not for religion we are pursuing you, but for treason.”
“It is for religion,” replied Harvey; “for I am of the same religion that
ye all are sworn to be of! I am a true Presbyterian; and,” turning to
the jury, “I charge you before the tribunal of God, as ye shall answer
there! ye have nothing to say to me but for my owning the
persecuted gospel.” They were both brought in guilty upon their own
confession, and condemned to be hanged at the Grassmarket on the
26th. They were executed according to their sentence, and died, not
with composure only, but with rapture.
When being brought from the tolbooth to the council-chamber to
be carried to the place of execution, the youngest, who had several
friends attending her, exclaimed, with an air of unearthly ecstacy,
“Behold, I hear my beloved saying unto me, ‘Arise, my dove, my fair
one, and come away!’” When in the room waiting the last
preparations, Bishop Paterson, with a kind of fiendish exultation,
said, “Marion, you said you would never hear a curate pray, now you
shall be forced to hear one,” and ordered a suffragan of his who was
in attendance to proceed; on which she turned to her companion,
and saying, “Come, Isobel, let us sing the 23d Psalm;” they
commenced immediately, and drowned the voice of the poor curate,
who, with his employers, stood amazed at the clear unbroken tones
of the youthful confessors.
On the scaffold, the most of her discourse was of God’s love to her
and the commendation of free grace. Ascending the ladder a few
steps, she sat down and said, “I am not come here for murder; for
they have no matter of fact to charge me with, but only my judgment.
I am about twenty years of age. At fourteen or fifteen, I was a hearer
of the curates and indulged; and while I was a hearer of these, I was
a blasphemer and Sabbath breaker, and a chapter of the Bible was a
burden to me; but since I heard this persecuted gospel, I durst not
blaspheme nor break the Sabbath, and the Bible became my
delight;” on which the town major called to the hangman—“Cast her
over,” which he immediately did.
Isobel, looking to the crowd from the scaffold, cried out—“Rejoice
in the Lord, ye righteous; and again I say rejoice.” When she went up
the ladder, “O! be zealous, sirs; be zealous! Love the Lord all ye his
servants; for in his favour there is life. O! ye his enemies, what will ye
do—whither will ye fly? for now there is a dreadful day coming on all
the enemies of Jesus Christ. Come out from among them all ye that
are the Lord’s own people;” then added, “Farewell, all created
comforts! farewell, sweet Bible! in which I delighted most, and which
has been sweet to me since I came into prison. Now, into thy hands I
commit my spirit, Father, Son, and Holy Ghost!” And while these
words yet trembled on her lips, she was launched into eternity. In
order to imbitter their punishment, they were hanged along with five
other women for child murder. The latter were attended by a curate,
who gave them every consolation, but upbraided their virtuous
companions in suffering in the most opprobrious terms as traitors.
Within a few days, John Murray, in Borrowstounness, Christopher
Miller, weaver, Gargunnock, and, on March 8th, William Gowgar,
Borrowstounness, with Robert Sangster, a Stirlingshire man, were
found guilty by a like speedy process, and hanged together in the
Grassmarket on the 11th, except Murray, who was reprieved.[133]
Their testimonies embraced the same topics, and were in every
respect similar to those of their worthy predecessors who had
vindicated the religious and civil liberties of their afflicted country at
the expense of their lives. Gowgar was rather more harshly used
than the rest. Some heads of an intended speech, written on a small
slip of paper, having fallen out of his Bible in the council chamber,
whither he had been taken just before being led to the gallows. After
some of the councillors had read it, they ordered the executioner to
tie his arms harder than usual, so that he could scarcely climb the
ladder; and when he began to speak, the drums were immediately
commanded to roll; nor would they even allow him to pray.
133. Murray had presented a petition to the Duke of York disowning king-killing
principles, which concluded rather strangely, considering the person to whom
it was addressed:—“For I declare I am no papist, and hate and abhor all
these jesuitical, bloody, and murdering principles.” When this was read in
council, Murray was asked who drew it, and with much difficulty was induced
to name Mr Spreul. Spreul was thereupon immediately called, and being
interrogated, asked to see the paper. This reasonable request was not
complied with; but York rose and imperiously demanded—“Sir, would you kill
the king?” Spreul, turning to the Chancellor, said—“My lord, I bless God I am
no papist. I lothe and abhor all these jesuitical, bloody, and murdering
principles; neither my parents nor the ministers I heard ever taught me such
principles.” York frowned; and Spreul afterwards suffered for his freedom of
speech, but Murray appears to have benefited by the business, for he was
afterwards pardoned as being “misled rather than malicious.”
136. Crookshanks says, “Robert Godwin and John Hodge, two Glasgow men who
were witnesses to this, went to visit him. Godwin desired him to write what
kept him from speaking. He wrote that it was a just judgment from the Lord,
and the sayings of the minister verified upon him for his mocking at him; and
if he had the whole world, he would give it for the use of his tongue again.
But he died in great torment and seeming terror.” Vol. ii. p. 86.