FIN4002

Fixed Income Securities

PART ONE: BOND MARKET

Topic 1: Introduction – Fixed Income

Market Overview
Bond Market

In the spectrum of financial capital market, a major part of fund

raising was originated through issuance in the fixed income
market.
Borrowers (or issuers) issued different forms of fixed income
instruments to borrow money from investors.
• The short maturity issue of the fixed income market is
called the “money market” while the medium to long term
issue is called the bond capital market.

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What are bonds?

A bond is a certificate of debt (usually interest-bearing or

discounted) that is issued by the borrower in order to raise
money (funds).
A bond will pay a fixed or floating amount of interest
(known as coupon) at regular interval over a fixed period
of time. The nominal amount (or PAR) is intended to be
reimbursed totally (or partially) at the end of the period.
(Partially or earlier redemption is possible depending on
whether derivatives (callable/puttable) features have been
added.)

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Features of a Bond

• Principal (or face amount): the amount on which the issuer pays
interest, and which has to be repaid at the end. It is also known as
the par value. Bonds are not always sold at par value.
• Issue price: the price at which investors buy the bonds when they
are first issued, which will typically be approximately equal to the
nominal amount. Normally it is represented by a “%” of face
amount.
• Credit rating: quality of the issue, which influences the probability
that the bondholders will receive the amounts promised, at the due
dates.
• Issuer: When you purchase a bond, you are lending money to a
government, municipality, corporation, federal agency or other
entity known as the issuer.

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Features of a Bond

• Maturity date: the date on which the issuer has to repay the
nominal amount. As long as all payments have been made,
the issuer has no more obligations to the bond holders after
the maturity date. Maturities range significantly, from 1 year
to 40+ years for some corporate bonds.
• Early Termination: a bond may sometimes contain an
embedded condition; that is, it grants option-like features to
the holder or the issuer:
- Call Feature: Some bonds give the issuer the right to
repay the bond before the maturity date on the call dates
- Put Feature: Some bonds give the holder the right to
force the issuer to repay the bond before the maturity
date on the put dates.

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Features of a Bond

• Coupon: the interest rate that the issuer pays to the bond
holders. The coupon is set when the bond is issued and is
usually expressed as an annual percentage of the par value
of the bond. Payments usually occur every six months, but
this can vary.
Coupon Types:
1. Fixed – The same amount is paid every period.
2. Floating – The payments are related to a bench-mark interest rate (e.g. LIBOR)
or an equation.
3. Deferred Coupon – Coupon payments do not begin immediately.
4. Step Up – Fixed coupon will increase on a future date.
5. Zero Coupon – No coupons are paid. The return take the form of a capital gain.

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Example of a Bond Termsheet - BOC

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Bond Example - Tencent
Bond Example - Cheung Kong
Credit Ratings

• The credit quality informs investors on the credit worthiness

(or risk of default) of the issuer. Usually, credit quality is
determined by private independent rating agencies such as
Standard & Poors or Moody’s. The quotes given vary from
high (AAA to AA), to medium (A to BBB) to low (BB to C).

• How many credit rating agencies do you know? (Check

“RATD” on Bloomberg).

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Credit Ratings
Agencies Agencies
A.M. Best (AMBC) Korea Ratings (KR)
Bloomberg Composite (COMP) Kroll Bond Rating Agency (KBRA)

BRC Investor Services SA (BRC) Malaysian Rating Corporation Berhad (MARC)

Capital Intelligence (CI) Midroog Ltd. (MIDROOG)

China Cheng Xin Int'l (CHENGXIN) Moody's Investors Service (MOODY'S)
China Lianhe (LIANHE) Morningstar Credit Ratings LLC (MORNINGSTAR)

Credit Analysis & Research Ltd. (CARE) National Rating Agency (NRA)

Credit Rating Information Services of India Ltd. (CRISIL) Natt'l Information & Credit Evaluation (NICE)

Dagong Global Credit Rating Co., Ltd. (DAGONG

Pefindo Credit Rating Indonesia Ltd. (PEFINDO)
GLOBAL)

Dominion Bond Rating Service Ltd. (DBRS) Philippine Rating Services Corporation (PhilRatings)

Egan-Jones Ratings Company (EJR) Lanka Rating Agency Limited (LRA)

Expert RA Rating Agency (EXPERT RA) RAM Holdings Berhad (RAM)

Fitch Ratings (FITCH) Rating & Investment Information, Inc. (R&I)

Global Credit Ratings (GCR) RusRating (RR)

ICRA Limited (ICRA) Shanghai Brilliance (SB)
Japan Credit Rating Agency (JCR) Standard & Poors (S&P)
Korea Investors Service Inc. (KIS) Taiwan Ratings Corporation (TRC)
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Credit Ratings (Investment and Speculative Grades)
Each of the rating agencies assigns its ratings based on an in-depth
analysis of the issuer's financial condition and management, economic and
debt characteristics, and the specific revenue sources securing the bond.
(Check “RATD” on Bloomberg).

• When the rating is high, the bond is classified as “Investment grade”

in opposition with or “Speculative “( or “High Yield” / “Junk”) which is
used for lower rating bonds.

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Credit Ratings
• What rating do you think of Sovereign Bonds (i.e. bonds issued by
government? (Check “CSDR” on Bloomberg”)

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Credit Ratings

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Credit Ratings

• Note the rating on Greece, Ireland…… What happened?

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Types of Bonds
I. By Coupon Features
Zero Coupon Bonds
• Zero Coupon Bonds are issued at a discount to their face value and at the time of
maturity, the principal/face value is repaid to the holders.
• No interest (coupon) is paid to the holders and hence, there are no cash inflows in
zero coupon bonds.
• The difference between issue price (discounted price) and redeemable price (face
value) itself acts as interest to holders.
• The issue price of Zero Coupon Bonds is inversely related to their maturity period, i.e.
longer the maturity period bigger the discount and vice-versa.
Fixed Rate Bonds
• Stays same until maturity; ie: buy a US$1000 bond with 8% fixed interest rate and you
will receive US$80 every year until maturity and at maturity you will receive the
US$1000 back.

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Types of Bonds

Floating Rate Coupon Bonds (or Floaters)

• Bonds with coupon rate fluctuating from period to period,
with reference to a benchmark interest rate (e.g. Libor,
inflation rate). Such types of bonds are referred to as
Floating Rate Bonds.
• Example
- An investor buying a floating-rate bond whose coupon rate is equal to
3-month Libor + 20bp is entitled to receiving, every period
determined in the contract (usually every 3 months), a coupon
payment
- The coupon rate will be reset every 3 months in order to reflect the
new level of the 3-month Libor
- Usually, the reset frequency is equal to the coupon payment
frequency
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Types of Bonds
Floating Rate Coupon Bonds (or Floaters)
Example - Inflation-indexed bonds
•Bonds (coupons and principal) that are indexed on the future inflation
rates so as to protect investor against inflation.
•They are mainly issued by governments to make it clear they are
willing to maintain a low inflation level.
•An inflation-indexed bond can be used to
- hedge a portfolio against a rise in the inflation rate
- diversify a portfolio based on low correlation with stocks, fixed-
coupon bonds and cash

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Types of Bonds

II. By Maturity variability (some bonds can terminate

earlier than maturity date)
Callable Bonds
• Issuer of a callable bond has the right (but not the
obligation) to change the maturity of a bond (call option).
The issuer may redeem a bond fully or partly before the
actual maturity date. These options are present in the bond
from the time of original bond issue and are known as
embedded options.
• This embedded option helps issuer to reduce the costs
when interest rates are falling, and when the interest rates
are rising it is helpful for the holders.

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Types of Bonds

Callable Bond Example

• UBS AG/Jersey Branch has issued in 2016 a 300Million G
BP bond with coupon 5.25%, maturity 21/06/2031 callable
on and anytime after the dates shown at the following price
s:
- on 6/21/26 at 100
- on 6/21/27 at 100
- on 6/21/28 at 100
- on 6/21/29 at 100
- on 6/21/30 at 100

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Types of Bonds

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Types of Bonds

Puttable Bonds
• The holder of a puttable bond has the right (but not an
obligation) to seek redemption (sell) from the issuer at any
time before the maturity date.
• An increase in the interest rates poses additional risk to
the issuer of bonds with put option (which are redeemed
at par) as he will have to lower the re-issue price of the
bond to attract investors.

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Types of Bonds

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Types of Bonds

Convertible Bonds (CB)

• Holder of a CB has the option to convert the bond into
equity (in the same value as of the bond) of the issuing
firm (borrowing firm) on pre-specified terms.
• This results in an automatic redemption of the bond before
the maturity date. The conversion ratio (number of shares
in lieu of a convertible bond) and the conversion price
(determined at the time of conversion) are pre-specified at
the time of bonds issue.
• For the part of the convertible bond which is redeemed,
the investor receives shares and the non-converted part
remains as a bond.

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Types of Bonds

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Types of Bonds

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Bond Ranking
Capital Structure Hierarchy
Senior (secured) debt
Senior Unsecured Debt Repayment Priority
when bankrupt
Second lien debt
Subordinated debt
Mezzanine debt
Convertible /Exchangeable debt
Preferred equity
Warrant
Shareholder loan
Common equity
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Day Count Basis – Computing the # of Days

• Convention 1
- Actual /360 basis: exact # of days divided by 360
- Used on the money market
- Example 764 days between 08/01/1999 and
09/03/2001
• Convention 2
- Actual/Actual basis: exact # of days divided by 365 or
366
- Used for computing accrued interest
- Example: from 08/01/1999 to 09/03/2001, 152/365 + 1
+ 246/365 = 2.0904

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Day Count Basis – Computing the # of Days

• Convention 3
- 30/360 basis : year divided into 12 “30-days” month
- Used on swap market
- Example: from 01/01/2001 to 03/25/2001 : 2 x 30 + 24
= 84 days
• Convention on starting/end dates
- Most deals start spot (t+2)
- For week-ends and holidays: following day, preceding
day, following day if same month, preceding day if
same month

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Day Count Basis – Computing the Return or
Yield Rate
• Conversion formulas
 360 
r360  r365   
 365 
 365 
r365  r360   
 360 

• Examples
- r365 = 10% corresponds to r360 = 9.86%
- r365 = 5% corresponds to r360 = 4.93%
- r365 = 20% corresponds to r360 = 19.73%
- Difference increases with rate

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Bond Settlement

• The settlement date is the date on which payment is

due in exchange for the bond (used for interest
computations)
• It is generally equal to the trade date plus a number of
working days
• Examples:

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Bond Settlement - Examples
- In the US, the settlement date for Treasury bonds and T-bills is
equal to the trade date + 1 working day
- In the Euro zone, the settlement date for Treasury bonds is equal to
the trade date + 3 working days as it can be 1, 2 or 3 workings days
for T-bills depending on the country under consideration
- In the UK, the settlement date for Treasury bonds and T-bills is
equal to the trade date + 1 and 2 working days respectively
- In Japan, the settlement date for Treasury bonds and T-bills is equal
to the trade date + 3 working days.

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Fixed Income Overview
Who borrows debt finance? Who invests in debt finance?
• Governments • Pension funds
• Supranational • Insurance companies
• Agencies • Money managers
• Corporates • Mutual funds
• Financial Institution • Hedge funds
• SPVs (Special Purpose
Vehicle)

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Fixed Income Overview

Financial Market &

Intermediaries

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Who are Issuers (or Borrowers)
• Sovereignty (Government) - US, UK, Japan
• Municipalities - Semi government such as HKMC,
California State in US…
• Financial Institutions – Banks, Investment Banks,
Insurance Companies
• International Corporations - Cheung Kong, IBM, MTR, etc

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Sovereign Issuers (Example - US)

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Municipal (Provincial) Issuers

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Municipal Issuers

An example on US Municipal Bonds

•Who purchases municipal bonds? TAX DRIVEN
- To Buy a T-bond pays 5% or a Municipal bond pays 3.8%
- What if an investor pays US Marginal Tax Rate (MTR) at 20%? 35%?

•After-tax return
- MTR = 20%: (5%)x(0.8) = .04 > .038
- MTR = 35%: (5%)x(0.65) = .0325 < .038
•When will the investor be indifferent?
- When the MTR - (5%) x (1 - t) = 3.8% => t = .24 = 24%

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Corporate Issuers
• THREE Sources of Risk
- Interest Rate Risk
- Default or Credit Risk
- Liquidity Risk
• Different “seniority” classes
- Secured Bonds
- Subordinated debentures
- Debentures

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Impact of Credit Ratings on Bond Yields

• Standard & Poor, Moody’s and other firms score ‘the

probability of continued & uninterrupted streams of interest
& principal payments to investors’

• Classes of grades
- Moody’s Investment Grades: Aaa,Aa,A,Baa
- Moody’s Speculative Grades: Ba, B, Caa, Ca, C
- Moody’s Default Class: D

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Impact of Credit Ratings on Bond Yields

Bond Yield = Benchmark Yield (usually US Treasury Yield)

+
Default Risk Premium
(Default risk premium sometimes called credit spread or yield spread
or the spread over Treasuries.)

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Risks Associated with Investing in Bonds
1. Interest-rate Risk
2. Reinvestment Risk
3. Call Risk
4. Credit Risk
5. Inflation Risk
6. Exchange Rate Risk
7. Liquidity Risk
8. Volatility Risk

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Risks Associated with Investing in Bonds
1. Interest-Rate Risk
 Interest-rate risk or market risk refers to an investor
having to sell a bond prior to the maturity date.
 An increase in interest rates will mean the realization of a
capital loss because the bond sells below the purchase
price.
 Interest-rate risk is by far the major risk faced by an
investor in the bond market.

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Risks Associated with Investing in Bonds
2. Reinvestment Risk
 Reinvestment risk is the risk that the interest rate at which
interim cash flows can be reinvested will fall.
 Reinvestment risk is greater for longer holding periods, as
well as for bonds with large, early, cash flows, such as
high-coupon bonds.
 It should be noted that interest-rate risk and reinvestment
risk have offsetting effects.

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Risks Associated with Investing in Bonds
3. Call Risk
 Call risk is the risk that a callable bond will be called when
interest rates fall.
 Many bonds include a provision that allows the issuer to
retire or “call” all or part of the issue before the maturity
date; for investors, there are three disadvantages to call
provisions:
 cash flow pattern cannot be known with certainty
 investor is exposed to reinvestment risk
 bond’s capital appreciation potential will be reduced

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Risks Associated with Investing in Bonds
4. Credit Risk
 Credit risk is the default risk that the bond issuer will fail to
satisfy the terms of the obligation with respect to the
timely payment of interest and principal.
 Credit spread is the part of the risk premium or spread
attributable to default risk.
 Credit spread risk is the risk that a bond price will decline
due to an increase in the credit spread.

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Risks Associated with Investing in Bonds
5. Inflation Risk
 Inflation risk arises because of the variation in the value of
cash flows from a security due to changes in purchasing
power.
 If investors purchase a bond on which they can realize a
coupon rate of 7% but the rate of inflation is 8%, the
purchasing power of the cash flow falls.
 Except for floating-rate bonds, an investor is exposed to
inflation risk because the interest rate the issuer promises
to make is fixed for the life of the issue.

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Risks Associated with Investing in Bonds
6. Exchange Risk
 Exchange-rate risk refers to the unexpected change in
one currency compared to another currency.
 From the perspective of a U.S. investor, a non-dollar-
denominated bond (i.e., a bond whose payments occur in
a foreign currency) has unknown U.S. dollar cash flows.
 The dollar cash flows are dependent on the exchange rate
at the time the payments are received.
 The risk of the exchange rate causing smaller cash flows
is the exchange rate risk or currency risk.

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Risks Associated with Investing in Bonds
7. Liquidity Risk
 Liquidity risk or marketability risk depends on the ease
with which an issue can be sold at or near its value.
 The primary measure of liquidity is the size of the spread
between the bid price and the ask price quoted by a
dealer.
 The wider the dealer spread, the more the liquidity risk.

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Risks Associated with Investing in Bonds
8. Volatility Risk
 Volatility risk is the risk that a change in volatility will
adversely affect the price of a bond.
 The value of an option rises when expected interest-rate
volatility increases.
 For example, consider the case of a callable bond where
the borrower has an embedded option, the price of the
bond falls when interest rates fall due to increased
downward volatility in interest rates.

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APPENDIX

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Money Markets - Money Markets Instruments

• Markets for short term debt

• Highly marketable (liquid)

• Low risk

• Very large denominations

• MM mutual funds accessible

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Bloomberg “BTMM” function to monitor Money
Markets

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Bloomberg “BTMM” function on Money Markets

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Money Markets - US Treasury Bills (or T-Bills)

• Treasury bills: short term government debt

• Primary market: Auction
- Competitive bid: specify quantity and price (hope to
bid low, not get ‘shut-out’)
- Non-competitive bid: specify quantity (receive
quantity at ‘average price’)
• Secondary market
- Very liquid (low transactions costs)
- Denomination = $10,000

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Money Markets - CDs and CPs
• Certificate of Deposit (CD)
- Time deposit (penalty for early withdrawal)
- Insured by Federal Deposit Insurance Corporation
(FDIC) for $100,000
• Commercial Paper
- Company borrows from public
- Short term, unsecured
• Repurchase Agreements (Repo’s)
- Effectively an overnight, collateralized loan
- Sell government securities, with promise to repurchase
at slightly higher price tomorrow

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Money Markets - Repurchase Agreements
https://www.youtube.com/watch?v=I9UIumKX7Mw
• A repo is a way for an investor to borrow money
- A commitment by the seller of a security (usually
government security) to buy it back from the buyer at a
specified price and at a given future date
- Can be viewed as a collateralized loan, the collateral being
the security
• A reverse repo is a way for an investor to lend money
- A reverse repo agreement is the same transaction viewed
from the buyer's perspective
- The repo desk acts as the intermediary between investors
who want to borrow cash and lend securities and
investors who want to lend cash and borrow securities
- The repo rate is computed on an Actual/360 day-count
basis
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Money Markets - Repurchase Agreements

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Money Markets Repo - Example
• A German investor needs to borrow € 1 million
- German investor owns : 10-year Bund benchmark bond
(i.e., the Bund 5% 07/04/2011 with a quoted price of
104.11, on 10/29/2001) …
- He lends this bond for € 1 million over 1 month.
- 1 month repo rate at 4%p.a.
- There is 160 days' accrued interest as of the starting date
of the transaction

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Money Markets Repo - Example
• Cash payments
- At the beginning of the transaction, German investor
receives an amount of cash equal to the gross (dirty)
price of the bond times the nominal of the loan, that is
(104.11+5%x160/360) x €1,000,000= €1,063,322
- At the end of the transaction, in order to repurchase the
securities he will pay the amount of cash borrowed plus
the repo interest due over the period, that is
€1,063,322 + €1,063,322 x 4% x 30/360= €
1,066,866

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Money Markets Repo - Examples

• Trading consideration - Financing a long position

- An investor wants to finance a long position of € 1 million
Bund with coupon 5% and maturity date 07/04/2011
- Can purchase these securities and then lend them (repo
transaction)
- He will gain the coupon income of the securities he
owns, that is
€ 1,000,000 x 5%/360 = € 138.89 a day
- He will lose the repo rate, that is
€ 1,063,322 x 4%/360 = € 118.15 a day
- His net gain per day equals $138.89 - 118.15 = € 20.74

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Money Markets Repo - Examples
• Trading consideration - Financing a short position
- An investor has to make a delivery of € 1 million Bund
on his short sale position
- He can borrow the securities through a reverse repo
transaction, and then lend the money resulting from the
short sale to the repo desk as collateral
- Suppose the reverse repo rate is 4%, his net loss (or
cost) per day amounts to € 20.74

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An example of Reverse Repo used by PBOC
• The People's Bank of China (PBOC) used 7-day reverse
repos for the first time in 5 months on July 30 2013 to
inject $2.8 billion into the financial system.
• The PBOC added a further $5.5 billion through 14-day
reverse repos on Aug 1 2013.

What happened to the corporate bond yield curve?

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An example of Repo recently used by PBOC
This has an impact on the
corporate bonds. Using
Bloomberg, we monitor
the China Interbank AAA
Corps Fixed Rate Curve.
The curve comprises of
RMB-denominated, fixed- This shows the liquidity
rate corporate bonds that squeeze caused yields to
are traded on the China surge for corporate
Interbank exchange, and bonds, with shorter-tenor
are rated AAA by local bonds most affected.
rating agencies.

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