fixed income securities

THE HANDBOOK OFFIXED INCOME

SECURITIES

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SECURITIESSeventh Edition

FRANK J. FABOZZI, Ph.D., CFA, CPA

Editor

With the assistance ofSTEVEN V. MANN, Ph.D.

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vC O N T E N T S

Preface xxiiiAcknowledgments xxvContributors xxvii

PART ONE

BACKGROUND

Chapter 1

Overview of the Types and Features of Fixed Income Securities 3Frank J. Fabozzi, Michael G. Ferri, and Steven V. Mann

Bonds 3Preferred Stock 15Residential Mortgage-Backed Securities 16Commercial Mortgage-Backed Securities 19Asset-Backed Securities 19Summary 20

Chapter 2

Risks Associated with Investing in Fixed Income Securities 21Ravi F. Dattatreya and Frank J. Fabozzi

Market, or Interest-Rate, Risk 22Reinvestment Risk 22Timing, or Call, Risk 23Credit Risk 24Yield-Curve, or Maturity, Risk 25Ination, or Purchasing Power, Risk 26Liquidity Risk 26Exchange-Rate, or Currency, Risk 27Volatility Risk 28

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Political or Legal Risk 28Event Risk 29Sector Risk 29Other Risks 29Summary 29

Chapter 3

The Primary and Secondary Bond Markets 31Frank J. Fabozzi and Frank J. Jones

Primary Market 31Secondary Markets 39Summary 51

Chapter 4

Bond Market Indexes 53Frank K. Reilly and David J. Wright

Uses of Bond Indexes 53Building and Maintaining a Bond Index 55Description of Alternative Bond Indexes 56Risk/Return Characteristics 61Correlation Relationships 65Summary 70

PART TWO

BASIC ANALYTICS

Chapter 5

Bond Pricing, Yield Measures, and Total Return 73Frank J. Fabozzi

Bond Pricing 73Conventional Yield Measures 86Total Return Analysis 97Summary 105

Chapter 6

Calculating Investment Returns 107Bruce J. Feibel

Single-Period Rate of Return 108Performance of an Investment: Money-Weighted Returns 119

vi Contents

Performance of the Investment Manager: Time-Weighted Returns 125Multiple-Period Return Calculation 129Summary 133

Chapter 7

The Structure of Interest Rates 135Frank J. Fabozzi

The Base Interest Rate 135Risk Premium 135The Term Structure of Interest Rates 139Summary 156

Chapter 8

Overview of Forward Rate Analysis 159Antti Ilmanen

Computation of Par, Spot, and Forward Rates 160Main Inuences on the Yield-Curve Shape 163Using Forward Rate Analysis in Yield-Curve Trades 171

Chapter 9

Measuring Interest-Rate Risk 183Frank J. Fabozzi, Gerald W. Buetow, Jr., and Robert R. Johnson

The Full-Valuation Approach 184Price Volatility Characteristics of Bonds 188Duration 197Modied Duration versus Effective Duration 203Convexity 210Price Value of a Basis Point 222The Importance of Yield Volatility 225

PART THREE

SECURITIES

Chapter 10

U.S. Treasury and Agency Securities 229Frank J. Fabozzi and Michael J. Fleming

Treasury Securities 229Agency Securities 242Summary 250

Contents vii

Chapter 11

Municipal Bonds 251Sylvan G. Feldstein, Frank J. Fabozzi, Alexander M. Grant, Jr., and Patrick M. Kennedy

Features of Municipal Securities 253Types of Municipal Obligations 255The Commercial Credit Rating of Municipal Bonds 264Municipal Bond Insurance 270Valuation Methods 271Tax Provisions Affecting Municipals 272Yield Relationships within the Municipal Bond Market 276Primary and Secondary Markets 278Bond Indexes 279Ofcial Statement 280Regulation of the Municipal Securities Market 280

Chapter 12

Private Money Market Instruments 285Frank J. Fabozzi, Steven V. Mann, and Richard S. Wilson

Commercial Paper 285Bankers Acceptances 289Large-Denomination Negotiable CDs 292Repurchase Agreements 295Federal Funds 301Summary 303

Chapter 13

Corporate Bonds 305Frank J. Fabozzi, Steven V. Mann, and Richard S. Wilson

The Corporate Trustee 306Some Bond Fundamentals 307Security for Bonds 312Alternative Mechanisms to Retire Debt before Maturity 320Credit Risk 327Event Risk 330High-Yield Bonds 331Default Rates and Recovery Rates 335

viii Contents

Chapter 14

Medium-Term Notes 339Leland E. Crabbe

Background of the MTN Market 340Mechanics of the Market 342The Economics of MTNs and Corporate Bonds 344Structured MTNs 347Euro-MTNs 349

Chapter 15

Ination-Linked Bonds 351John B. BrynjolfssonMechanics and Measurement 353Marketplace 361Valuation and Performance Dynamics 364Investors 364Issuers 369Other Issues 371Conclusion 372

Chapter 16

Floating-Rate Securities 373Frank J. Fabozzi and Steven V. Mann

General Features of Floaters and Major Product Types 374Call and Put Provisions 376Spread Measures 377Price Volatility Characteristics of Floaters 379Portfolio Strategies 382

Chapter 17

Nonconvertible Preferred Stock 385Frank J. Fabozzi and Steven V. Mann

Preferred Stock Issuance 386Preferred Stock Ratings 390Tax Treatment of Dividends 392

Contents ix

Chapter 18

International Bond Markets and Instruments 393Christopher B. Steward

The Instruments: Euro, Foreign, and Global 394U.S.-Pay International Bonds 395Foreign-Pay International Bonds 402Conclusion 408

Chapter 19

The Eurobond Market 409David Munves

Founding and the Early Years 410The Eurobond Market Post-EMU: The Drivers of Development 415The Corporate Eurobond Market Today 426Beyond High-Grade Euro Corporates: The Other Eurobond Sectors 434The Outlook for the Eurobond Market 439

Chapter 20

Emerging Markets Debt 441Jane Sachar Brauer

The Debt Universe 441Emerging Markets Debt Performance History 445Brady Bonds 449Defaults, Exchanges, Restructurings, Workouts, and Litigation 454Derivatives 464Credit-Linked Notes (CLNs) 466Valuation Methods 467Conclusion 469Collateralized Brady Bonds 469Noncollateralized Brady Bonds 470

Chapter 21

Stable Value Investments 471John R. Caswell and Karl Tourville

Stable Value Products 472The Evolution of Stable Value 477Stable Value Portfolio Management 480The Future of Stable Value 485

x Contents

Chapter 22

An Overview of Mortgages and the Mortgage Market 487Anand K. Bhattacharya and William S. Berliner

Product Denition and Terms 487Mechanics of Mortgage Loans 493The Mortgage Industry 497Generation of Mortgage Lending Rates 501Component Risks of Mortgage Products 507Conclusion 512

Chapter 23

Agency Mortgage-Backed Securities 513Andrew Davidson and Anne Ching

Mortgage Loans 513History of the Secondary Mortgage Market 517Agency Pool Programs 518Trading Characteristics 522Prepayment and Cash-Flow Behavior 526Prepayment Conventions 527Sources of Prepayments 527Prepayment Models 533Valuation 535Summary 539

Chapter 24

Collateralized Mortgage Obligations 541Alexander Crawford The CMO Market 541CMO Tranche Types 543Agency versus Nonagency CMOs 562CMO Analysis 568Pulling Up a CMO 577Alphabetical List of Some Useful Bloomberg Commands for CMOs 577

Chapter 25

Nonagency CMOs 579Frank J. Fabozzi, Anthony B. Sanders, David Yuen, and Chuck Ramsey

The Nonagency MBS Market 579Credit Enhancements 581

Contents xi

xii Contents

Compensating Interest 586Weighted-Average Coupon Dispersion 586Cleanup Call Provisions 588

Chapter 26

Residential Asset-Backed Securities 589John McElravey

Market Development 590Characteristics of Subprime Borrowers 592Prepayment Speeds 595Relative-Value Consequences 598Key Aspects of Credit Analysis 600Structural Considerations 604Conclusion 613

Chapter 27

Commercial Mortgage-Backed Securities 615Anthony B. Sanders

The CMBS Deal 615The Underlying Loan Portfolio 621The Role of the Servicer 625Loan Origination, the Lemons Market, and the Pricing of CMBS 627Summary 628

Chapter 28

Credit Card Asset-Backed Securities 629John McElravey

Securitization of Credit Card Receivables 629The Credit Card ABS Market 642Conclusion 645

Chapter 29

Securities Backed by Automobile Loans and Leases 647W. Alexander Roever

U.S. Auto Finance Industry 647Understanding Loan Collateral Performance 652Auto Loan ABS Structures 656Auto Lease Origination 659Auto Lease Securitization 662

Relative Value Analysis of Auto Loan and Lease ABS 666Conclusion 668

Chapter 30

Cash-Collateralized Debt Obligations 669Laurie S. Goodman, Frank J. Fabozzi, and Douglas J. Lucas

Family of CDOs 670Cash CDOs 670Cash-Flow Transactions 674Market-Value Transactions 678Synthetic CDOs 683Secondary Market Trading Opportunities 684Investment Principles for Managing a Portfolio of CDOs 689

Chapter 31

Synthetic CDOs 695Jeffrey T. Prince, Arturo Cifuentes, and Nichol Bakalar Growth and Evolution of the SCDO Market 696Synthetic CDOs from the Ground Up 698A Comparison with Cash CDOs 705Single-Tranche (Bespoke) Transactions 719Investors Guide to Synthetic CDOs 725Conclusion 728

PART FOUR

CREDIT ANALYSIS AND CREDIT RISK MODELING

Chapter 32

Credit Analysis for Corporate Bonds 733Frank J. Fabozzi

Approaches to Credit Analysis 733Industry Considerations 735Financial Analysis 740Indenture Provisions 750Utilities 756Finance Companies 763The Analysis of High-Yield Corporate Bonds 768Credit Scoring Models 775Conclusion 777

Contents xiii

Chapter 33

Credit Risk Modeling 779Tim Backshall, Kay Giesecke, and Lisa Goldberg

Structural Credit Models 780Reduced-Form Credit Models 790Incomplete-Information Credit Models 794

Chapter 34

Guidelines in the Credit Analysis of Municipal GeneralObligation and Revenue Bonds 799Sylvan G. Feldstein and Alexander M. Grant, Jr.

The Legal Opinion 800The Need to Know Who Really Is the Issuer 805On the Financial Advisor and Underwriter 806General Credit Indicators and Economic Factors in the

Credit Analysis 807Red Flags for the Investor 824

Chapter 35

Rating Agency Approach to Structured Finance 827Hedi Katz

Credit Committee Process 827Collateral Analysis 828Financial Review of Structure 830Legal Review of Structure 831Parties Review 833

PART FIVE

VALUATION AND ANALYSIS

Chapter 36

Fixed Income Risk Modeling 839Ronald N. Kahn

The Valuation Model 840The Risk Model 844Performance 847Portfolio Risk Characterization 849Summary 850

xiv Contents

Chapter 37

Valuation of Bonds with Embedded Options 851Frank J. Fabozzi, Andrew Kalotay, and Michael Dorigan

The Interest-Rate Lattice 852Calibrating the Lattice 856Using the Lattice for Valuation 860Fixed-Coupon Bonds with Embedded Options 860Valuation of Two More Exotic Structures 865Extensions 867Conclusion 872

Chapter 38

Valuation of Mortgage-Backed Securities 873Frank J. Fabozzi, Scott F. Richard, and David S. Horowitz

Static Valuation 874Dynamic Valuation Modeling 875Illustrations 883Summary 895

Chapter 39

OAS and Effective Duration 897David Audley, Richard Chin, and Shrikant Ramamurthy

The Price/Yield Relationship for Option-Embedded Bonds 898Effective Duration 902Effective Maturity 906Option-Adjusted Spreads 908Summary 911

Chapter 40

A Framework for Analyzing Yield-Curve Trades 913Antti Ilmanen

Forward Rates and Their Determinants 914Decomposing Expected Returns of Bond Positions 921

Chapter 41

The Market Yield Curve and Fitting the Term Structure of Interest Rates 939Moorad Choudhry

Basic Concepts 939The Concept of the Forward Rate 943

Contents xv

Spot and Forward Yield Curves 947The Term Structure 949Fitting the Yield Curve 954Nonparametric Methods 961Comparing Curves 965

Chapter 42

Hedging Interest-Rate Risk with Term-Structure Factor Models 967Lionel Martellini, Philippe Priaulet, and Frank J. Fabozzi

Dening Interest-Rate Risk(s) 968Hedging with Duration 969Relaxing the Assumption of a Small Shift 972Relaxing the Assumption of a Parallel Shift 974Comparative Analysis of Various Hedging Techniques 981Summary 985

PART SIX

BOND PORTFOLIO MANAGEMENT

Chapter 43

Introduction to Bond Portfolio Management 989Kenneth E. Volpert

Overview of Traditional Bond Management 989Overview of the Core/Satellite Approach 991Why Choose Indexing? 993Which Index Should Be Used? 996Primary Bond Indexing Risk Factors 999Enhancing Bond Indexing 1006Measuring Success 1012

Chapter 44

Quantitative Management of Benchmarked Portfolios 1017Lev Dynkin, Jay Hyman, and Vadim Konstantinovsky

Selection and Customization of Benchmarks 1018Diversication Issues in Benchmarks 1023Portfolio Analysis Relative to a Benchmark 1027Quantitative Approaches to Benchmark Replication 1033Controlling Issuer-Specic Risk in the Portfolio 1038

xvi Contents

Quantitative Methods for Portfolio Optimization 1042Tools for Quantitative Portfolio Management 1045Conclusion 1046

Chapter 45

Financing Positions in the Bond Market 1047Frank J. Fabozzi and Steven V. Mann

Repurchase Agreement 1048Dollar Rolls 1054Margin Buying 1057Securities Lending 1057

Chapter 46

Global Credit Bond Portfolio Management 1061Jack Malvey

Credit Relative-Value Analysis 1066Total-Return Analysis 1069Primary Market Analysis 1070Liquidity and Trading Analysis 1072Secondary Trade Rationales 1072Spread Analysis 1078Structural Analysis 1082Credit-Curve Analysis 1085Credit Analysis 1087Asset Allocation/Sector Rotation 1088Conclusion 1089

Chapter 47

Bond Immunization: An Asset/Liability Optimization Strategy 1091Frank J. Fabozzi

What Is an Immunized Portfolio? 1091Maturity-Matching: The Reinvestment Problem 1092Single-Period Immunization 1093Rebalancing Procedures 1096Multiperiod Immunization 1097Applications of the Immunization Strategy 1098Variations to Immunization 1100Conclusion 1101

Contents xvii

Chapter 48

Dedicated Bond Portfolios 1103Frank J. Fabozzi

The Need for a Broader Asset/Liability Focus 1103Cash-Flow Matching for Pension Funds 1104Role of Money Manager and Dealer Firm 1116Conclusion 1117

Chapter 49

International Bond Portfolio Management 1119Christopher B. Steward, J. Hank Lynch, and Frank J. Fabozzi

Investment Objectives and Policy Statements 1120Developing a Portfolio Strategy 1126Portfolio Construction 1134

Chapter 50

Transition Management 1147Daniel Gallegos

Overview of Fixed Income Transition Management 1147Processes of a Transition 1150Risk Management and Transition Management 1157Measuring Transition Performance 1158Points to Consider 1160

PART SEVEN

DERIVATIVES AND THEIR APPLICATIONS

Chapter 51

Introduction to Interest-Rate Futures andOptions Contracts 1163Frank J. Fabozzi, Steven V. Mann, and Mark Pitts

Basic Characteristics of Derivative Contracts 1163Representative Exchange-Traded Interest-Rate Futures Contracts 1166Representative Exchange-Traded Futures Options Contracts 1175OTC Contracts 1178Summary 1185

xviii Contents

Chapter 52

Pricing Futures and Portfolio Applications 1187Frank J. Fabozzi, Mark Pitts, and Bruce M. Collins

Pricing of Futures Contracts 1188Applications to Portfolio Management 1195Portable Alpha 1198Summary 1200

Chapter 53

Treasury Bond Futures Mechanics and Basis Valuation 1201David T. Kim

Mechanics of the Futures Contract 1202The Basis 1206Carry 1207Options 1209Conclusion 1223

Chapter 54

The Basics of Interest-Rate Options 1225William J. Gartland and Nicholas C. Letica

How Options Work 1225Options StrategiesReorganizing the Prot/Loss Graph 1238Classic Option Strategies 1239Practical Portfolio Strategies 1242Conclusion 1247

Chapter 55

Interest-Rate Swaps and Swaptions 1249Frank J. Fabozzi, Steven V. Mann, and Moorad Choudhry

Description of an Interest-Rate Swap 1249Interpreting a Swap Position 1251Terminology, Conventions, and Market Quotes 1253Valuing Interest-Rate Swaps 1255Primary Determinants of Swap Spreads 1272Nongeneric Interest-Rate Swaps 1274Canceling a Swap 1278

Contents xix

Credit Risk 1278Swaptions 1279

Chapter 56

Interest-Rate Caps and Floors and Compound Options 1283Anand K. Bhattacharya

Features of Interest-Rate Caps and Floors 1283Pricing of Caps and Floors 1284Interest-Rate Caps 1285Participating Caps 1287Interest-Rate Floors 1290Interest-Rate Collars 1291Interest-Rate Corridors 1293Cap/Floor Parity 1294Termination of Caps and Floors 1296Compound Options 1296Concluding Comments 1300

Chapter 57

Controlling Interest-Rate Risk with Futures and Options 1301Frank J. Fabozzi, Shrikant Ramamurthy, and Mark Pitts

Controlling Interest-Rate Risk with Futures 1301Hedging with Options 1320Summary 1334

Chapter 58

Introduction to Credit Derivatives 1337Dominic OKane

The Credit Derivatives Market 1338The Credit Default Swap 1339CDS Portfolio Products 1352Basket Default Swaps 1353Synthetic CDOs 1357Credit Derivative Options 1364Conclusions 1367

xx Contents

PART EIGHT

CONVERTIBLE SECURITIES

Chapter 59

Convertible Securities and Their Investment Characteristics 1371Chris P. Dialynas and John C. Ritchie, Jr.

General Characteristics of Convertibles 1372Advantages and Disadvantages to Issuing Firms 1375Advantages to the Investor 1376Disadvantages to the Investor 1377Alternative Forms of Convertible Financing 1378Types of Convertible Investors 1378Analysis of Convertible Securities 1379An Illustrative Analysis 1379Duration Management 1389Valuation of Convertibles 1389Summary 1392

Chapter 60

Convertible Securities and Their Valuation 1393Mihir Bhattacharya

Evolution in the Convertible Markets 1396Basic Characteristics of Convertible Securities 1416Traditional Valuation Method 1421Convertible Valuation Models 1424Exercising the Embedded Options 1436Looking Forward 1440Summary 1441

Appendix A

A Review of the Time Value of Money 1443Frank J. Fabozzi

Future Value 1443Present Value 1449Yield (Internal Rate of Return) 1453

Index 1459

Contents xxi

P R E F A C E

This book is designed to provide extensive coverage of the wide range ofxed income products and xed income portfolio management strategies. Eachchapter is written by an authority on the subject.

The seventh edition of the Handbook is divided into eight parts. Part 1 pro-vides general information about the investment features of xed income securities,the risks associated with investing in xed income securities, and background infor-mation about xed income primary and secondary markets. The basics of xedincome analyticsbond pricing, yield measures, spot rates, forward rates, totalreturn, and price volatility measures (duration and convexity)are described inPart 2.

Part 3 covers bonds (domestic and foreign), money market instruments, andstructured products (mortgages, mortgage-backed securities, and asset-backedsecurities). Credit analysis of corporate bonds, municipal bonds, and structuredproducts and credit risk modeling are covered in Part 4.

Part 5 builds on the analytical framework explained in Part 2. In this part,two methodologies for valuing xed income securities are discussed: the lat-tice model and the Monte Carlo model. A by-product of these models is theoption-adjusted spread. Comprehensive coverage on analyzing and tting the yieldcurve and measuring interest-rate risk for the purpose of controlling risk by hedgingare provided.

The more popular xed income portfolio management strategies are cov-ered in Part 6. In addition to active strategies and structured portfolio strate-gies (indexing, immunization, and dedication), coverage includes managinginternational xed income portfolios, transition management, and nancingpositions in the bond market.

Part 7 covers interest-rate derivative instruments and their portfolio man-agement applications. Derivative instruments include futures/forward contracts,options, interest-rate swaps, and interest-rate agreements (caps and oors). Thebasic feature of each instrument is described as well as how it is valued and usedto control the risk of a xed income portfolio. The basics of credit derivatives arealso explained.

xxiii

Copyright 2005, 2001, 1997, 1995, 1991, 1987, 1983 by The McGraw-Hill Companies, Inc. Click here for terms of use.

Part 8 has two chapters on equity-linked securities. Not only are the secu-rities described, but state-of-the-art valuation models and portfolio strategies areexplained.

The following 22 chapters are new to the seventh edition: The Primary and Secondary Bond Markets Calculating Investment Returns Overview of Forward Rate Analysis The Eurobond Market Emerging Markets Debt Stable Value Investments An Overview of Mortgages and the Mortgage Market Agency Mortgage-Backed Securities Collateralized Mortgage Obligations Residential Asset-Backed Securities Credit Card Asset-Backed Securities Cash-Collateralized Debt Obligations Synthetic CDOs Credit Risk Modeling Rating Agency Approach to Structured Finance A Framework for Analyzing Yield-Curve Trades The Market Yield Curve and Fitting the Term Structure of Interest Rates Hedging Interest-Rate Risk with Term-Structure Factor Models Quantitative Management of Benchmarked Portfolios Financing Positions in the Bond Market Transition Management Introduction to Credit Derivatives

Frank J. Fabozzi, Ph.D., CFA, CPAEditor

xxiv Preface

A C K N O W L E D G M E N T S

The rst edition of The Handbook of Fixed Income Securities was published twodecades ago. Over the years and seven editions of the book, I have beneted fromthe guidance of many participants in the various sectors of the bond market. Iwould like to extend my deep personal appreciation to the contributing authorsin all editions of the book. Steven Mann, in particular, coauthored eight of thechapters in the current edition with me.

There are two individuals whom I would like to single out who contributedto the rst six editions and are now retired from the industry: Jane Tripp Howeand Richard Wilson. Jane is widely recognized as one of the top corporate creditanalysts. She contributed not only to the Handbook but also to several otherbooks that I edited. She was my go to person when I needed a chapter on anyaspect of corporate credit analysis. In the seventh edition, I have revised thechapter by Jane on corporate bond credit analysis and thank her for grantingme permission to use the core of her chapter that appeared in the sixth edition.Let me add a historical footnote concerning another important contribution ofJane to the profession. In the rst edition of the Handbook, Jane contributed achapter entitled A Corporate Bond Index Fund based on her research thatappeared in the November 1978 Proceedings published by the Center forResearch Securities Prices, Graduate School of Business, University of Chicago.In that chapter, Jane made the argument for investing in a corporate bond indexand discussed the operational process of running a corporate bond indexed port-folio. At the time, this was a novel idea. While the notion of indexing in com-mon stock was being debated in the 1970s, little attention was given to this formof investing in the bond market.

Richard Wilson contributed several chapters to the various editions of theHandbook. When I began my study of the xed income market in the late1970s, he served as my mentor. There were so many nuances about the institu-tional aspects of the market that were not in print. His historical perspective andhis insights helped me form my view of the market. In addition, from his manycontacts in the industry, he identied for me potential contributors to the rstedition.

xxv


I also would like to acknowledge the following individuals who providedvarious forms of assistance in this project:

Scott Amero (BlackRock Financial Management) Keith Anderson (BlackRock Financial Management) Clifford Asness (AQR Capital Management) Peter L. Bernstein (Peter L. Bernstein Inc.)Dwight Churchill (Fidelity Management and Research)Peter DeGroot (Lehman Brothers)Gary Gastineau (ETF Consultants)Robert Gerber (Lord Abbett) Pat Gorman (FT Interactive Data)George P. Kegler (Cassian Market Consultants)Martin Leibowitz (Morgan Stanley)Donald R. Lipkin (Bear Stearns)Michael Marz (First Southwest) Ed Murphy (Merchants Mutual Insurance Company) Robert Reitano (John Hancock Mutual Life Insurance Company)Ehud Ronn (University of Texas at Austin) Ron Ryan (Ryan Labs)

Frank J. Fabozzi, Ph.D., CFA, CPA

xxvi Acknowledgments

C O N T R I B U T O R S

David Audley, Ph.D.Chief Operating OfcerWatch Hill Investment Partners

Tim BackshallDirector of Credit Market StrategyBarra Inc.

Nichol BakalarWilliam S. Berliner

Senior Vice PresidentCountrywide Securities Corporation

Anand K. Bhattacharya, Ph.D.Managing DirectorCountrywide Securities Corporation

Mihir Bhattacharya, Ph.D.Managing DirectorQuellos Capital Management

Jane Sachar BrauerDirectorMerrill Lynch

John B. Brynjolfsson, CFAManaging Director and Portfolio

ManagerPIMCO Real Return Bond FundPacic Investment Management Company

Gerald W. Buetow, Jr., Ph.D., CFAPresidentBFRC Services, LLC

John R. Caswell, CFAManaging PartnerGalliard Capital Management

Richard ChinPortfolio ManagerMortgage ArbitrageWatch Hill Investment Partners

Anne ChingSenior AnalystAndrew Davidson & Co., Inc.

Moorad ChoudhryHead of TreasuryKBC Financial Products

Arturo Cifuentes, Ph.D.Managing DirectorWachovia Securities

Leland E. Crabbe, Ph.D.Consultant

Alexander CrawfordManaging DirectorHead of Mortgage and Cross

Rates StrategyDeutsche Bank Securities, Inc.

Ravi F. Dattatreya, Ph.D.PresidentCapital MarketsPark Venture Advisors

Andrew Davidson PresidentAndrew Davidson & Co., Inc.

Chris P. DialynasManaging DirectorPacic Investment Management Company

Michael Dorigan, Ph.D.Consulting AssociateAndrew Kalotay Associates

Lev Dynkin, Ph.D.Managing DirectorLehman Brothers

Frank J. Fabozzi, Ph.D., CFA, CPAFrederick Frank Adjunct Professor of FinanceSchool of ManagementYale University

Bruce J. Feibel, CFADirectorEagle Investment Systems

xxvii


Sylvan G. Feldstein, Ph.D.DirectorInvestment DepartmentGuardian Life Insurance Company

of AmericaMichael G. Ferri, Ph.D.

Foundation Professor of FinanceGeorge Mason University

Michael J. Fleming, Ph.D.Assistant Vice PresidentFederal Reserve Bank of New York

Daniel GallegosWilliam J. Gartland, CFA

Vice PresidentBloomberg Financial Market

Kay Giesecke, Ph.D.Assistant ProfessorSchool of Operations ResearchCornell University

Lisa Goldberg, Ph.D.Vice President Credit ResearchBarra Inc.

Laurie S. Goodman, Ph.D.Managing DirectorCo-Head of Global Fixed IncomeUBS

Alexander M. Grant, Jr.Managing Director and Portfolio ManagerInvestment DepartmentGuardian Life Insurance Company

of AmericaDavid S. Horowitz, CFA

Managing DirectorMorgan Stanley Asset Management

Jay Hyman, Ph.D.Senior Vice PresidentLehman Brothers

Antti Ilmanen, Ph.D. Senior TraderBrevan Howard Asset Management LLP

Robert R. Johnson, Ph.D., CFAExecutive Vice PresidentCFA Institute

Frank J. Jones, Ph.D.Professor of Finance San Jose State University

Ronald N. Kahn, Ph.D.Managing DirectorBarclays Global Investors

Andrew Kalotay, Ph.D.PresidentAndrew Kalotay Associates

Hedi KatzManaging DirectorFitchRatings

Patrick M. KennedyConsultant

David T. KimTokai Bank

Vadim Konstantinovsky, CFASenior Vice PresidentLehman Brothers

Nicholas C. LeticaManaging DirectorDeutsche Bank Securities, Inc.

Douglas J. LucasDirector, Head of CDO ResearchUBS

J. Hank Lynch, CFAManaging DirectorGlobal Head of Currency OptionsState Street Global Markets

Jack Malvey, CFAManaging DirectorLehman Brothers

Steven V. Mann, Ph.D.Professor of FinanceMoore School of BusinessUniversity of South Carolina

Lionel Martellini, Ph.D.Professor of FinanceEDHEC Graduate School of BusinessScientic Director of EDHEC Risk and

Asset Management Research CenterJohn McElravey, CFA

Structured Products ResearchAAM

David Munves, CFAExecutive DirectorLehman Brothers International

Dominic OKaneSenior Vice PresidentHead of Fixed Income Quantitative

Research (Europe)Lehman Brothers

Mark Pitts, Ph.D.PrincipalWhite Oak Capital Management Corp.

xxviii Contributors

Philippe Priaulet, Ph.D.Fixed Income StrategistHSBC-CCFAssociate ProfessorMathematics DepartmentUniversity of Evry Val dEssonne

Jeffrey T. Prince, CFAVice PresidentWachovia Securities

Shrikant RamamurthyManaging DirectorRBS Greenwich Capital

Chuck RamseyCEOMortgageInformation.com

Frank K. Reilly, Ph.D., CFABernard J. Hank Professor

of FinanceUniversity of Notre Dame

Scott F. Richard, DBAManaging DirectorMorgan Stanley Asset Management

John C. Ritchie, Jr., Ph.D.Professor of FinanceTemple University

W. Alexander Roever, CFAManaging DirectorShort-Term Fixed Income StrategyJPMorgan Securities, Inc.

Anthony B. Sanders, Ph.D.Professor of Finance and

John W. Galbreath ChairThe Ohio State University

Christopher B. Steward, CFAVice PresidentWellington Management Company, LLP

Karl TourvilleManaging PartnerGalliard Capital Management

Kenneth E. Volpert, CFAPrincipal and Senior Portfolio ManagerThe Vanguard Group, Inc.

Richard S. WilsonConsultant

David J. Wright, Ph.D.Professor of FinanceUniversity of WisconsinParkside

David Yuen, CFADirector of Global Risk ManagementFranklin Templeton Investments

Contributors xxix


SECURITIES

PART

ONE

BACKGROUND


CHAPTER

ONE

OVERVIEW OF THE TYPES ANDFEATURES OF FIXED INCOME

SECURITIES

FRANK J. FABOZZI, PH.D., CFA, CPAFrederick Frank Adjunct Professor of Finance

School of ManagementYale University

MICHAEL G. FERRI, PH.D.Foundation Professor of Finance

George Mason University

STEVEN V. MANN, PH.D.Professor of Finance

The Moore School of BusinessUniversity of South Carolina

This chapter will explore some of the most important features of bonds, preferredstock, and structured products and provide the reader with a taxonomy of terms andconcepts that will be useful in the reading of the specialized chapters to follow.

BONDS

Type of Issuer

One important characteristic of a bond is the nature of its issuer. Although foreigngovernments and rms raise capital in U.S. nancial markets, the three largestissuers of debt are domestic corporations, municipal governments, and the feder-al government and its agencies. Each class of issuer, however, features addition-al and signicant differences.

Domestic corporations, for example, include regulated utilities as well asunregulated manufacturers. Furthermore, each rm may sell different kinds ofbonds: Some debt may be publicly placed, whereas other bonds may be solddirectly to one or only a few buyers (referred to as a private placement); somedebt is collateralized by specic assets of the company, whereas other debt may

3


be unsecured. Municipal debt is also varied: General obligation bonds (GOs)are backed by the full faith, credit, and taxing power of the governmental unitissuing them; revenue bonds, on the other hand, have a safety, or creditwor-thiness, that depends on the vitality and success of the particular entity (such astoll roads, hospitals, or water systems) within the municipal government issuingthe bond.

The U.S. Treasury has the most voracious appetite for debt, but the bondmarket often receives calls from its agencies. Federal government agenciesinclude federally related institutions and government-sponsored enterprises(GSEs).

It is important for the investor to realize that, by law or practice or both,these different borrowers have developed different ways of raising debt capitalover the years. As a result, the distinctions among the various types of issuers cor-respond closely to differences among bonds in yield, denomination, safety ofprincipal, maturity, tax status, and such important provisions as the call privilege,put features, and sinking fund. As we discuss the key features of xed incomesecurities, we will point out how the characteristics of the bonds vary with theobligor or issuing authority. A more extensive discussion is provided in laterchapters in this book that explain the various instruments.

Maturity

A key feature of any bond is its term-to-maturity, the number of years duringwhich the borrower has promised to meet the conditions of the debt (which arecontained in the bonds indenture). A bonds term-to-maturity is the date onwhich the debt will cease and the borrower will redeem the issue by paying theface value, or principal. One indication of the importance of the maturity is thatthe code word or name for every bond contains its maturity (and coupon). Thusthe title of the Anheuser Busch Company bond due, or maturing, in 2016 is givenas Anheuser Busch 85/8s of 2016. In practice, the words maturity, term, andterm-to-maturity are used interchangeably to refer to the number of years remain-ing in the life of a bond. Technically, however, maturity denotes the date the bondwill be redeemed, and either term or term-to-maturity denotes the number ofyears until that date.

A bonds maturity is crucial for several reasons. First, maturity indicates theexpected life of the instrument, or the number of periods during which the holderof the bond can expect to receive the coupon interest and the number of yearsbefore the principal will be paid. Second, the yield on a bond depends substantial-ly on its maturity. More specically, at any given point in time, the yield offeredon a long-term bond may be greater than, less than, or equal to the yield offeredon a short-term bond. As will be explained in Chapter 7, the effect of maturity onthe yield depends on the shape of the yield curve. Third, the volatility of a bondsprice is closely associated with maturity: Changes in the market level of rateswill wrest much larger changes in price from bonds of long maturity than from

4 PART 1 Background

otherwise similar debt of shorter life.1 Finally, as explained in Chapter 2, there areother risks associated with the maturity of a bond.

When considering a bonds maturity, the investor should be aware of anyprovisions that modify, or permit the issuer to modify, the maturity of a bond.Although corporate bonds (referred to as corporates) are typically term bonds(issues that have a single maturity), they often contain arrangements by which theissuing rm either can or must retire the debt early, in full or in part. Some cor-porates, for example, give the issuer a call privilege, which permits the issuingrm to redeem the bond before the scheduled maturity under certain conditions(these conditions are discussed below). Municipal bonds may have the same pro-vision. Although the U.S. government no longer issues bonds that have a callprivilege, there are a few outstanding issues with this provision. Many industrialsand some utilities have sinking-fund provisions, which mandate that the rmretire a substantial portion of the debt, according to a prearranged schedule, dur-ing its life and before the stated maturity. Municipal bonds may be serial bondsor, in essence, bundles of bonds with differing maturities. (Some corporates areof this type, too.)

Usually, the maturity of a corporate bond is between 1 and 30 years. Thisis not to say that there are not outliers. In fact, nancially sound rms have begunto issue longer-term debt in order to lock in long-term attractive nancing. Forexample, in the late 1990s, there were approximately 90 corporate bonds issuedwith maturities of 100 years.

Although classifying bonds as short term, intermediate term, andlong term is not universally accepted, the following classication is typicallyused. Bonds with a maturity of 1 to 5 years are generally considered short term;bonds with a maturity between 5 and 12 years are viewed as intermediate term(and are often called notes). Long-term bonds are those with a maturity greaterthan 12 years.

Coupon and Principal

A bonds coupon is the periodic interest payment made to owners during the lifeof the bond. The coupon is always cited, along with maturity, in any quotation ofa bonds price. Thus one might hear about the IBM 6.5 due in 2028 or theCampell Soup 8.875 due in 2021 in discussions of current bond trading. Inthese examples, the coupon cited is in fact the coupon rate, that is, the rate ofinterest that, when multiplied by the principal, par value, or face value of thebond, provides the dollar value of the coupon payment. Typically, but not univer-sally, for bonds issued in the United States, the coupon payment is made in semi-annual installments. An important exception is mortgage-backed and asset-backed securities that usually deliver monthly cash ows. In contrast, for bondsissued in some European bond markets and all bonds issued in the Eurobond

C H A P T E R 1 Overview of the Types and Features of Fixed Income Securities 5

1. Chapter 9 discusses this point in detail.

market, the coupon payment is made annually. Bonds may be bearer bonds or reg-istered bonds. With bearer bonds, investors clip coupons and send them to theobligor for payment. In the case of registered issues, bond owners receive the pay-ment automatically at the appropriate time. All new bond issues must be registered.

There are a few corporate bonds (mostly railroad issues), called incomebonds, that contain a provision permitting the rm to omit or delay the paymentof interest if the rms earnings are too low. They have been issued as part ofbankruptcy reorganizations or to replace a preferred-stock offering of the issuer.A variant of this bond type, deferrable bonds (also called trust preferred anddebt/equity hybrids), witnessed explosive growth in the 1990s. Deferrable bondsare deeply subordinated debt instruments that give the issuer the option to defercoupon payment up to ve years in the event of nancial distress.

Zero-coupon bonds have been issued by corporations and municipalitiessince the early 1980s. For example, Coca-Cola Enterprises has a zero-couponbond outstanding due June 20, 2020 that was issued on May 9, 1995. Althoughthe U.S. Treasury does not issue zero-coupon debt with a maturity greater thanone year, such securities are created by government securities dealers. MerrillLynch was the rst to do this with its creation of Treasury Investment GrowthReceipts (TIGRs) in August 1982. The most popular zero-coupon Treasury secu-rities today are those created by government dealer rms under the TreasurysSeparate Trading of Registered Interest and Principal Securities (STRIPS)Program. Just how these securitiescommonly referred to as Treasury stripsare created will be explained in Chapter 10. The investor in a zero-coupon secu-rity typically receives interest by buying the security at a price below its princi-pal, or maturity value, and holding it to the maturity date. The reason for theissuance of zero-coupon securities is explained in Chapter 10. However, somezeros are issued at par and accrue interest during the bonds life, with the accruedinterest and principal payable at maturity.

Governments and corporations also issue ination-indexed bonds whosecoupon payments are tied to an ination index. These securities are designed to pro-tect bondholders from the erosion of purchasing power of xed nominal couponpayments due to ination. For example, in January 1997, the U.S. Treasury auc-tioned a 10-year Treasury note whose semiannual coupon interest depends on therate of ination as measured by the Consumer Price Index for All Urban Consumers(i.e., CPI-U). The coupon payments are adjusted annually. These issues are referredto as Treasury Ination-Protection Securities (TIPS). As of this writing, theTreasury issues TIPS with 5-year, 10-year, and 20-year maturities. Some corpora-tions followed the Treasury and issued ination-indexed bonds of their own.2

6 PART 1 Background

2. For examples of these issues, see Andrew Rossen, Michael Schumacher, and John Cassaudoumecq,Corporate and Agency Ination-Linked Securities, Chapter 18 in John Brynjolfsson andFrank J. Fabozzi (eds.), Handbook of Ination-Indexed Bonds (New Hope, PA: Frank J.Fabozzi Associates, 1999).

There are securities that have a coupon rate that increases over time. Thesesecurities are called step-up notes because the coupon rate steps up over time.For example, a six-year step-up note might have a coupon rate that is 5% for therst two years, 5.8% for the next two years, and 6% for the last two years.Alternatively, there are securities that have a coupon rate that can decrease overtime but never increase. For example, in June 1998, the Tennessee Valley Authorityissued 30-year 6.75% putable automatic rate reset securities (PARRS), also knownas ratchet bonds. Beginning ve years after issuance and annually thereafter, thebonds coupon rate is automatically reset to either the current 30-year constant matu-rity Treasury yield plus 94 basis points or to 6.75%, whichever is lower. The couponrate may decline if Treasury yields decline, but it will never increase. This bond alsocontains a contingent put option such that if the coupon rate is lowered, the bond isputable at par. Ratchet bonds were designed as substitutes for callable bonds.

In contrast to a coupon rate that is xed for the bonds entire life, the termoating-rate security or oater encompasses several different types of securitieswith one common feature: The coupon rate will vary over the instruments life. Thecoupon rate is reset at designated dates based on the value of some reference rateadjusted for a spread. For example, consider a oating-rate note issued inSeptember 2003 by Columbus Bank & Trust that matured on March 15, 2005. Theoater delivers cash ows quarterly and has a coupon formula equal to the three-month LIBOR plus 12 points.

Typically, oaters have coupon rates that reset more than once a year (e.g.,semiannually, quarterly, or monthly). Conversely, the term adjustable-rate orvariable-rate security refers to those issues whose coupon rates reset not more fre-quently than annually.

There are several features about oaters that deserve mention. First, a oatermay have a restriction on the maximum (minimum) coupon rate that will be paid atany reset date called a cap (oor). Second, while the reference rate for most oatersis a benchmark interest rate or an interest rate index, a wide variety of reference ratesappear in the coupon formulas. A oaters coupon could be indexed to movementsin foreign exchange rates, the price of a commodity (e.g., crude oil), movements inan equity index (e.g., the S&P 500), or movements in a bond index (e.g., the MerrillLynch Corporate Bond Index). Third, while a oaters coupon rate normally movesin the same direction as the reference rate moves, there are oaters whose couponrate moves in the opposite direction from the reference rate. These securities arecalled inverse oaters or reverse oaters. As an example, consider an inverse oaterissued by the Federal Home Loan Bank in April 1999. This issue matured in April2002 and delivered quarterly coupon payments according to the following formula:

18% 2.5 (three-month LIBOR)This inverse oater had a oor of 3% and a cap of 15.5%. Finally, range notes areoaters whose coupon rate is equal to the reference rate (adjusted for a spread) aslong as the reference rate is within a certain range on the reset date. If the referencerate is outside the range, the coupon rate is zero for that period. Consider a range


note issued by Sallie Mae in August 1996 that matured in August 2003. This issuemade coupon payments quarterly. The investor earned three-month LIBOR + 155basis points for every day during this quarter that the three-month LIBOR wasbetween 3% and 9%. Interest accrued at 0% for each day that the three-monthLIBOR was outside this range. As a result, this range note had a oor of 0%.

Structures in the high-yield (junk bond) sector of the corporate bond mar-ket have introduced variations in the way coupon payments are made. For exam-ple, in a leveraged buyout or recapitalization nanced with high-yield bonds, theheavy interest payment burden the corporation must bear places severe cash-owconstraints on the rm. To reduce this burden, rms involved in leveraged buy-outs (LBOs) and recapitalizations have issued deferred-coupon structures thatpermit the issuer to defer making cash interest payments for a period of three toseven years. There are three types of deferred-coupon structures: (1) deferred-interest bonds, (2) step-up bonds, and (3) payment-in-kind bonds. These struc-tures are described in Chapter 13.

Another high-yield bond structure allows the issuer to reset the coupon rateso that the bond will trade at a predetermined price. The coupon rate may resetannually or reset only once over the life of the bond. Generally, the coupon ratewill be the average of rates suggested by two investment banking rms. The newrate will then reect the level of interest rates at the reset date and the creditspread the market wants on the issue at the reset date. This structure is called anextendible reset bond. Notice the difference between this bond structure and theoating-rate issue described earlier. With a oating-rate issue, the coupon rateresets based on a xed spread to some benchmark, where the spread is speciedin the indenture and the amount of the spread reects market conditions at thetime the issue is rst offered. In contrast, the coupon rate on an extendible resetbond is reset based on market conditions suggested by several investment bank-ing rms at the time of the reset date. Moreover, the new coupon rate reects thenew level of interest rates and the new spread that investors seek.

One reason that debt nancing is popular with corporations is that the inter-est payments are tax-deductible expenses. As a result, the true after-tax cost ofdebt to a protable rm is usually much less than the stated coupon interest rate.The level of the coupon on any bond is typically close to the level of yields forissues of its class at the time the bond is rst sold to the public. Some bonds areissued initially at a price substantially below par value (called original-issue dis-count bonds, or OIDs), and their coupon rate is deliberately set below the currentmarket rate. However, rms usually try to set the coupon at a level that will makethe market price close to par value. This goal can be accomplished by placing thecoupon rate near the prevailing market rate.

To many investors, the coupon is simply the amount of interest they willreceive each year. However, the coupon has another major impact on an investorsexperience with a bond. The coupons size inuences the volatility of the bondsprice: The larger the coupon, the less the price will change in response to a change

8 PART 1 Background

in market interest rates. Thus the coupon and the maturity have opposite effectson the price volatility of a bond. This will be illustrated in Chapter 9.

The principal, par value, or face value of a bond is the amount to be repaidto the investor either at maturity or at those times when the bond is called orretired according to a repayment schedule or sinking-fund provisions. But theprincipal plays another role, too: It is the basis on which the coupon or periodicinterest rests. The coupon is the product of the principal and the coupon rate. Formost corporate issues, the face value is $1,000; many government bonds havelarger principals starting with $10,000; and most municipal bonds come indenominations of $5,000.

Participants in the bond market use several measures to describe the poten-tial return from investing in a bond: current yield, yield-to-maturity, yield-to-callfor a callable bond, and yield-to-put for a putable bond. A yield-to-worst is oftenquoted for bonds. This is the lowest yield of the following: yield-to-maturity,yields to all possible call dates, and yields to all put dates. The calculation andlimitations of these yield measures are explained and illustrated in Chapter 5.

The prices of most bonds are quoted as percentages of par or face value. Toconvert the price quote into a dollar gure, one simply divides the price by 100(converting it to decimal) and then multiplies by the par value. The followingtable illustrates this.

Price as aPar Value Price Quote Percentage of Par Price in Dollars

$ 1,000 913/4 91.75 $ 917.50

5,000 1021/2 102.5 5,125.00

10,000 871/4 87.25 8,725.00

25,000 1003/4 100.875 25,218.75

100,000 719/32 71.28125 71,281.25

500,000 975/32 97.078125 485,390.63

1,000,000 88111/256 88.43359375 884,335.94

There is a unique way of quoting pricing in the secondary market forTreasury bonds and notes. This convention is explained in Chapter 10.

Call and Refunding Provisions

If a bonds indenture contains a call feature or call provision, the issuer retainsthe right to retire the debt, fully or partially, before the scheduled maturity date.The chief benet of such a feature is that it permits the borrower, should marketrates fall, to replace the bond issue with a lower-interest-cost issue. The call fea-ture has added value for corporations and municipalities. It may in the future helpthem to escape the restrictions that frequently characterize their bonds (about thedisposition of assets or collateral). The call feature provides an additional benet


to corporations, which might want to use unexpectedly high levels of cash toretire outstanding bonds or might wish to restructure their balance sheets.

The call provision is detrimental to investors, who run the risk of losing ahigh-coupon bond when rates begin to decline. When the borrower calls the issue,the investor must nd other outlets, which presumably would have lower yieldsthan the bond just withdrawn through the call privilege. Another problem for theinvestor is that the prospect of a call limits the appreciation in a bonds price thatcould be expected when interest rates decline.

Because the call feature benets the issuer and places the investor at a dis-advantage, callable bonds carry higher yields than bonds that cannot be retiredbefore maturity. This difference in yields is likely to grow when investors believethat market rates are about to fall and that the borrower may be tempted to replacea high-coupon debt with a new low-coupon bond. (Such a transaction is calledrefunding.) However, the higher yield alone is often not sufcient compensationto the investor for granting the call privilege to the issuer. Thus the price at whichthe bond may be called, termed the call price, is normally higher than the princi-pal or face value of the issue. The difference between call price and principal isthe call premium, whose value may be as much as one years interest in the rstfew years of a bonds life and may decline systematically thereafter.

An important limitation on the borrowers right to call is the period of callprotection, or deferment period, which is a specied number of years in the earlylife of the bond during which the issuer may not call the debt. Such protection isanother concession to the investor, and it comes in two forms. Some bonds arenoncallable (often abbreviated NC) for any reason during the deferment period;other bonds are nonrefundable (NF) for that time. The distinction lies in the factthat nonrefundable debt may be called if the funds used to retire the bond issueare obtained from internally generated funds, such as the cash ow from opera-tions or the sale of property or equipment, or from nondebt funding such as thesale of common stock. Thus, although the terminology is unfortunately confus-ing, a nonrefundable issue may be refunded under the circumstances justdescribed and, as a result, offers less call protection than a noncallable bond,which cannot be called for any reason except to satisfy sinking-fund require-ments, explained later. Beginning in early 1986, a number of corporations issuedlong-term debt with extended call protection, not refunding protection. A numberare noncallable for the issues life, such as Dow Chemical Companys 85/8s duein 2006. The issuer is expressly prohibited from redeeming the issue prior tomaturity. These noncallable-for-life issues are referred to as bullet bonds. If abond does not have any protection against an early call, then it is said to be cur-rently callable.

Since the mid-1990s, an increasing number of public debt issues include aso-called make-whole call provision. Make-whole call provisions have appearedroutinely in privately placed issues since the late 1980s. In contrast to the stan-dard call feature that contains a call price xed by a schedule, a make-whole callprice varies inversely with the level of interest rates. A make-whole call price

10 PART 1 Background

(i.e., redemption amount) is typically the sum of the present values of the remain-ing coupon payments and principal discounted at a yield on a Treasury securitythat matches the bonds remaining maturity plus a spread. For example, on January22, 1998, Aluminum Company of America (Alcoa) issued $300 million in bondswith a make-whole call provision that mature on January 15, 2028. These bondsare redeemable at any time in whole or in part at the issuers option. The redemp-tion price is the greater of (1) 100% of the principal amount plus accrued interestor (2) the make-whole redemption amount plus accrued interest. In this case, themake-whole redemption amount is equal to the sum of the present values of theremaining coupon and principal payments discounted at the Adjusted TreasuryRate plus 15 basis points.3 The Adjusted Treasury Rate is the bond-equivalentyield on a U.S. Treasury security having a maturity comparable to the remainingmaturity of the bonds to be redeemed. Each holder of the bonds will be notied atleast 30 days but not more than 60 days prior to the redemption date. This issue iscallable at any time, as are most issues with make-whole call provisions. Note thatthe make-whole call price increases as interest rates decrease, so if the issuer exer-cises the make-whole call provision when interest rates have decreased, the bond-holder receives a higher call price. Make-whole call provisions thus provideinvestors with some protection against reinvestment rate risk.

A key question is, When will the rm nd it protable to refund an issue?It is important for investors to understand the process by which a rm decideswhether to retire an old bond and issue a new one. A simple and brief examplewill illustrate that process and introduce the reader to the kinds of calculations abondholder will make when trying to predict whether a bond will be refunded.

Suppose that a rms outstanding debt consists of $300 million par value ofa bond with a coupon of 10%, a maturity of 15 years, and a lapsed deferment peri-od. The rm can now issue a bond with a similar maturity for an interest rate of7.8%. Assume that the issuing expenses and legal fees amount to $2 million. Thecall price on the existing bond issue is $105 per $100 par value. The rm must pay,adjusted for taxes, the sum of call premium and expenses. To simplify the calcu-lations, assume a 30% tax rate. This sum is then $11,190,000.4 Such a transactionwould save the rm a yearly sum of $4,620,000 in interest (which equals the inter-est of $30 million on the existing bond less the $23.4 million on the new, adjustedfor taxes) for the next 15 years.5 The rate of return on a payment of $11,900,000now in exchange for a savings of $4,620,000 per year for 15 years is about 38%.


3. A 30/360 day-count convention is employed in this present-value calculation.4. Both expenses are tax deductible for the rm. The total expense is the call premium of $15 million

plus the issuing expenses and legal fees of $2 million. The after-tax cost is equal to the before-tax cost times (1 tax rate). Hence the after-tax cost is $17 million times (1 0.3), or$11,900,000.

5. The new interest expense would be $300 million times 0.078. The after-tax cost of the interest sav-ing is $6.6 million times (1 0.3).

This rate far exceeds the rms after-tax cost of debt (now at 7.8% times 0.7, or5.46%) and makes the refunding a protable economic transaction.

In municipal securities, refunding often refers to something different,although the concept is the same. Municipal bonds can be prerefunded prior tomaturity (usually on a call date). Here, instead of issuing new bonds to retire thedebt, the municipality will issue bonds and use the proceeds to purchase enoughrisk-free securities to fund all the cash ows on the existing bond issue. It placesthese in an irrevocable trust. Thus the municipality still has two issues outstand-ing, but the old bonds receive a new labelthey are prerefunded. If Treasurysecurities are used to prerefund the debt, the cash ows on the bond are guaran-teed by Treasury obligations in the trust. Thus they become AAA rated and tradeat higher prices than previously. Municipalities often nd this an effective meansof lowering their cost of debt.

Sinking-Fund Provision

The sinking-fund provision, which is typical for publicly and privately issued indus-trial bonds and not uncommon among certain classes of utility debt, requires theobligor to retire a certain amount of the outstanding debt each year. Generally, theretirement occurs in one of two ways. The rm may purchase the amount of bondsto be retired in the open market if their price is below par, or the company maymake payments to the trustee who is empowered to monitor the indenture and whowill call a certain number of bonds chosen by lottery. In the latter case, the investorwould receive the prearranged call price, which is usually par value. The scheduleof retirements varies considerably from issue to issue. Some issuers, particularly inthe private-placement market, retire most, if not all, of their debt before maturity. Inthe public market, some companies may retire as little as 20 to 30% of the out-standing par value before maturity. Further, the indenture of many issues includes adeferment period that permits the issuer to wait ve years or more before beginningthe process of sinking-fund retirements.

There are three advantages of a sinking-fund provision from the investorsperspective. The sinking-fund requirement ensures an orderly retirement of the debtso that the nal payment, at maturity, will not be too large. Second, the provisionenhances the liquidity of some debt, especially for smaller issues with thin second-ary markets. Third, the prices of bonds with this requirement are presumably morestable because the issuer may become an active participant on the buy side whenprices fall. For these reasons, the yields on bonds with sinking-fund provisions tendto be less than those on bonds without them.

The sinking fund, however, can work to the disadvantage of an investor.Suppose that an investor is holding one of the early bonds to be called for a sinkingfund. All the time and effort put into analyzing the bond has now been wasted, andthe investor will have to choose new instruments for purchase. Also, an investor hold-ing a bond with a high coupon at the time rates begin to fall is still forced to relinquishthe issue. For this reason, in times of high interest rates, one might nd investorsdemanding higher yields from bonds with sinking funds than from other debt.


The sinking-fund provision also may harm the investors position throughthe optional acceleration feature, a part of many corporate bond indentures.With this option, the corporation is free to retire more than the amount of debtthe sinking fund requires (and often a multiple thereof) and to do it at the callprice set for sinking-fund payments. Of course, the rm will exercise this optiononly if the price of the bond exceeds the sinking-fund price (usually near par),and this happens when rates are relatively low. If, as is typically the case, thesinking-fund provision becomes operative before the lapse of the call-defermentperiod, the rm can retire much of its debt with the optional acceleration featureand can do so at a price far below that of the call price it would have to pay inthe event of refunding. The impact of such activity on the investors position isobvious: The rm can redeem at or near par many of the bonds that appear to beprotected from call and that have a market value above the face value of the debt.

Put Provisions

A putable bond grants the investor the right to sell the issue back to the issuer atpar value on designated dates. The advantage to the investor is that if interestrates rise after the issue date, thereby reducing the value of the bond, the investorcan force the issuer to redeem the bond at par. Some issues with put provisionsmay restrict the amount that the bondholder may put back to the issuer on anyone put date. Put options have been included in corporate bonds to deterunfriendly takeovers. Such put provisions are referred to as poison puts.

Put options can be classied as hard puts and soft puts. A hard put is onein which the security must be redeemed by the issuer only for cash. In the case ofa soft put, the issuer has the option to redeem the security for cash, commonstock, another debt instrument, or a combination of the three. Soft puts are foundin convertible debt, which we describe next.

Convertible or Exchangeable Debt

A convertible bond is one that can be exchanged for specied amounts of com-mon stock in the issuing rm: The conversion cannot be reversed, and the termsof the conversion are set by the company in the bonds indenture. The mostimportant terms are conversion ratio and conversion price. The conversion ratioindicates the number of shares of common stock to which the holder of the con-vertible has a claim. For example, Amazon.com issued $1.25 billion in convert-ibles in January 1999 that mature in 2009. These convertibles carry a 4.75%coupon with a conversion ratio of 6.408 shares for each bond. This translates to aconversion price of $156.055 per share ($1,000 par value divided by the conversionratio 6.408) at the time of issuance. The conversion price at issuance is alsoreferred to as the stated conversion price.

The conversion privilege may be permitted for all or only some portion ofthe bonds life. The conversion ratio may decline over time. It is always adjust-ed proportionately for stock splits and stock dividends. Convertible bonds are


typically callable by the issuer. This permits the issuer to force conversion of theissue. (Effectively, the issuer calls the bond, and the investor is forced to convertthe bond or allow it to be called.) There are some convertible issues that have callprotection. This protection can be in one of two forms: Either the issuer is notallowed to redeem the issue before a specied date, or the issuer is not permittedto call the issue until the stock price has increased by a predetermined percentageprice above the conversion price at issuance.

An exchangeable bond is an issue that can be exchanged for the commonstock of a corporation other than the issuer of the bond. For example, BellAtlantic Corp. issued 5.75% coupon exchangeable bonds in February 1998 thatcan be exchanged for shares in Telecom Corp. of New Zealand. There are a hand-ful of issues that are exchangeable into more than one security.

One signicant innovation in the convertible bond market was the LiquidYield Option Note (LYON) developed by Merrill Lynch Capital Markets in1985. A LYON is a zero-coupon, convertible, callable, and putable bond.

Techniques for analyzing convertible and exchangeable bonds aredescribed in Chapters 59 and 60.

Medium-Term Notes

Medium-term notes are highly exible debt instruments that can be easily struc-tured in response to changing market conditions and investor tastes. Mediumterm is a misnomer because these securities have ranged in maturity from ninemonths to 30 years and longer. Since the latter part of the 1980s, medium-termnotes have become an increasingly important nancing vehicle for corporationsand federal agencies. Typically, medium-term notes are noncallable, unsecured,senior debt securities with xed-coupon rates that carry an investment-gradecredit rating. They generally differ from other bond offerings in their primarydistribution process, as will be discussed in Chapter 14. Structured medium-termnotes, or simply structured notes, are debt instruments linked to a derivativeposition. For example, structured notes are usually created with an underlyingswap transaction. This hedging swap allows the issuer to create securities withinteresting risk/return features demanded by bond investors.

Warrants

A warrant is an option a rm issues that permits the owner to buy from the rma certain number of shares of common stock at a specied price. It is not uncom-mon for publicly held corporations to issue warrants with new bonds.

A valuable aspect of a warrant is its rather long life: Most warrants are ineffect for at least two years from issuance, and some are perpetual.6 Another key


6. This long life contrasts sharply with the short life during which many exchange-traded call optionson common stock, similar to warrants, are exercisable.

feature of the warrant is the exercise price, the price at which the warrant holdercan buy stock from the corporation. This price is normally set at about 15% abovethe market price of common stock at the time the bond, and thus the warrant, isissued. Frequently, the exercise price will rise through time, according to theschedule in the bonds indenture. Another important characteristic of the warrantis its detachability. Detachable warrants are often actively traded on theAmerican Stock Exchange. Other warrants can be exercised only by the bond-holder, and these are called nondetachable warrants. The chief benet to theinvestor is the nancial leverage the warrant provides.

PREFERRED STOCK

Preferred stock is a class of stock, not a debt instrument, but it shares character-istics of both common stock and debt. Like the holder of common stock, the pre-ferred stockholder is entitled to dividends. Unlike those on common stock, how-ever, preferred stock dividends are a specied percentage of par or face value.7The percentage is called the dividend rate; it need not be xed but may oat overthe life of the issue.

Failure to make preferred stock dividend payments cannot force the issuerinto bankruptcy. Should the issuer not make the preferred stock dividend pay-ment, usually paid quarterly, one of two things can happen, depending on theterms of the issue. First, the dividend payment can accrue until it is fully paid.Preferred stock with this feature is called cumulative preferred stock. Second, ifa dividend payment is missed and the security holder must forgo the payment, thepreferred stock is said to be noncumulative preferred stock. Failure to make div-idend payments may result in imposition of certain restrictions on management.For example, if dividend payments are in arrears, preferred stockholders might begranted voting rights.

Unlike debt, payments made to preferred stockholders are treated as a distri-bution of earnings. This means that they are not tax deductible to the corporationunder the current tax code. (Interest payments, on the other hand, are tax deductible.)Although the after-tax cost of funds is higher if a corporation issues preferred stockrather than borrowing, there is a factor that reduces the cost differential: A provisionin the tax code exempts 70% of qualied dividends from federal income taxation ifthe recipient is a qualied corporation. For example, if Corporation A owns the pre-ferred stock of Corporation B, for each $100 of dividends received by A, only $30will be taxed at As marginal tax rate. The purpose of this provision is to mitigatethe effect of double taxation of corporate earnings. There are two implications of


7. Almost all preferred stock limits the security holder to the specied amount. Historically, therehave been issues entitling the preferred stockholder to participate in earnings distributionbeyond the specied amount (based on some formula). Preferred stock with this feature isreferred to as participating preferred stock.

this tax treatment of preferred stock dividends. First, the major buyers of pre-ferred stock are corporations seeking tax-advantaged investments. Second, thecost of preferred stock issuance is lower than it would be in the absence of the taxprovision because the tax benets are passed through to the issuer by the will-ingness of buyers to accept a lower dividend rate.

Preferred stock has some important similarities with debt, particularly inthe case of cumulative preferred stock: (1) The payments to preferred stockhold-ers promised by the issuer are xed, and (2) preferred stockholders have priorityover common stockholders with respect to dividend payments and distribution ofassets in the case of bankruptcy. (The position of noncumulative preferred stockis considerably weaker than cumulative preferred stock.) It is because of this sec-ond feature that preferred stock is called a senior security. It is senior to commonstock. On a balance sheet, preferred stock is classied as equity.

Preferred stock may be issued without a maturity date. This is called per-petual preferred stock. Almost all preferred stock has a sinking-fund provision,and some preferred stock is convertible into common stock. A trademark productof Morgan Stanley is the Preferred Equity Redemption Cumulative Stock(PERCS). This is a preferred stock with a mandatory conversion at maturity.

Historically, utilities have been the major issuers of preferred stock, makingup more than half of each years issuance. Since 1985, major issuers have been inthe nancial industrynance companies, banks, thrifts, and insurance companies.

There are three types of preferred stock: (1) xed-rate preferred stock, (2)adjustable-rate preferred stock, and (3) auction and remarketed preferred stock.The dividend rate on an adjustable-rate preferred stock (ARPS) is reset quarterlyand based on a predetermined spread from the highest of three points on theTreasury yield curve. Most ARPS are perpetual, with a oor and ceiling imposedon the dividend rate of most issues. For auction preferred stock (APS), the divi-dend rate is reset periodically, as with ARPS, but the dividend rate is establishedthrough an auction process. In the case of remarketed preferred stock (RP), thedividend rate is determined periodically by a remarketing agent who resets thedividend rate so that any preferred stock can be tendered at par and be resold(remarketed) at the original offering price. An investor has the choice of dividendresets every 7 days or every 49 days.

RESIDENTIAL MORTGAGE-BACKED SECURITIES

A residential mortgage-backed security (MBS) is an instrument whose cash owdepends on the cash ows of an underlying pool of mortgages. There are threetypes of mortgage-backed securities: (1) mortgage pass-through securities, (2)collateralized mortgage obligations, and (3) stripped mortgage-backed securi-ties. This chapter provides an overview of these securities. A detailed discussionof the structure and analysis of these securities is presented in Chapters 2225of this book.


Mortgage Cash Flows

Because the cash ow for these securities depends on the cash ow from theunderlying pool of mortgages, the rst thing to dene is a mortgage. A mortgageis a pledge of real estate to secure the loan originated for the purchase of that realestate. The mortgage gives the lender (mortgagee) the right to foreclose on theloan and seize the property in order to ensure that the loan is paid off if the bor-rower (mortgagor) fails to make the contracted payments. The types of real estateproperties that can be mortgaged are divided into two broad categories: residen-tial and nonresidential (i.e., commercial and farm properties). The mortgage loanspecies the interest rate of the loan, the frequency of payment, and the numberof years to maturity. Each monthly mortgage payment consists of the monthlyinterest, a scheduled amount in excess of the monthly interest that is applied toreduce the outstanding loan balance (this is called the scheduled repayment ofprincipal), and any payments in excess of the mortgage payment. The latter pay-ments are called prepayments.

In effect, the lender has granted the homeowner the right to prepay (orcall) all or part of the mortgage balance at any time. Homeowners prepay theirmortgages for one of several reasons. First, they prepay the entire mortgage whenthey sell their home. Homes are sold for many reasons, among them a change ofemployment that requires moving or the purchase of a more expensive home.Second, if mortgage rates drop substantially after the mortgage loan wasobtained, it may be benecial for the homeowner to renance the loan (even afterpaying all renancing costs) at the lower interest rate. Third, if homeowners can-not meet their mortgage obligations, their property is repossessed and sold. Theproceeds from the sale are used to pay off the mortgage loan. Finally, if the prop-erty is destroyed by re or another insured catastrophe occurs, the insurance pro-ceeds are used to pay off the mortgage.

Mortgage Pass-Through Securities

A mortgage pass-through security (or simply pass-through) is created when one ormore holders of mortgages form a collection (pool) of mortgages and sell shares orparticipation certicates in the pool. A pool may consist of several thousand mort-gages or only a few mortgages. The cash ow of a pass-through depends on the cashow of the underlying mortgages, which, as just explained, consists of monthlymortgage payments representing interest, the scheduled repayment of principal, andany prepayments. Payments are made to security holders each month.

There are three major types of pass-through securities, guaranteed by thefollowing organizations: Government National Mortgage Association (GinnieMae), Federal Home Loan Mortgage Corporation (Freddie Mac), and FederalNational Mortgage Association (Fannie Mae). The last two are government-sponsored entities. The Government National Mortgage Association is a federal


government agency within the Department of Housing and Urban Development.The securities associated with these three entities are known as agency pass-through securities. There are also nonagency pass-through securities, issued bythrifts, commercial banks, and private conduits that are not backed by any agency.

Collateralized Mortgage Obligations

The collateralized mortgage obligation (CMO) structure was developed tobroaden the appeal of mortgage-backed products to traditional xed incomeinvestors. A CMO is a security backed by a pool of pass-throughs or a pool ofmortgage loans. CMOs are structured so that there are several classes of bond-holders with varying maturities. The different bond classes are called tranches.The rules for the distribution of the principal payments and the interest from theunderlying collateral among the tranches are specied in the prospectus. Byredirecting the cash ow (i.e., principal payments and interest) from the under-lying collateral, issuers have created classes of bonds that have different degreesof prepayment and interest rate risk and are thereby more attractive to institu-tional investors to satisfy asset/liability objectives than a pass-through.

Numerous innovations in structuring CMOs have created classes of bondswith one or more of the following characteristics: (1) greater stability of cash owover a wide range of prepayment speeds, (2) better matching of oating-rate lia-bilities, (3) substantial upside potential in a declining interest-rate environmentbut less downside risk in a rising interest-rate environment, or (4) properties thatallow them to be used for hedging mortgage-related products.

The various types of bonds include sequential-pay bonds, planned amortiza-tion class (PAC) bonds, accrual (or Z) bonds, oating-rate bonds, inverse oating-rate bonds, targeted amortization class (TAC) bonds, support bonds, and veryaccurately determined maturity (VADM) bonds.

Stripped Mortgage-Backed Securities

A pass-through divides the cash ow from the underlying collateral on a pro ratabasis to the security holders. Stripped mortgage-backed securities, introduced byFannie Mae in 1986, are created by altering the distribution of principal and inter-est from a pro rata distribution to an unequal distribution.

Why are stripped mortgage-backed securities created? It is sufcient to sayat this juncture that the risk/return characteristics of these instruments makethem attractive for the purpose of hedging a portfolio of pass-throughs and mort-gage loans.

There are two types of stripped MBSs: synthetic-coupon pass-throughs andinterest-only/principal-only securities. The rst generation of stripped mortgage-backed securities consisted of the synthetic-coupon pass-throughs because theunequal distribution of coupon and principal resulted in a synthetic coupon rate thatwas different from the underlying collateral. In early 1987, stripped MBSs began tobe issued in which all the interest is allocated to one class (the interest-only, or IO,


class) and all the principal to the other class (the principal-only, or PO, class). TheIO class receives no principal payments, and the PO class receives no interest.

COMMERCIAL MORTGAGE-BACKED SECURITIES

Commercial mortgage-backed securities (CMBSs) are backed by a pool of com-mercial mortgage loans on income-producing propertymultifamily properties(i.e., apartment buildings), ofce buildings, industrial properties (including ware-houses), shopping centers, hotels, and health care facilities (i.e., senior housingcare facilities). The basic building block of the CMBS transaction is a commer-cial loan that was originated either to nance a commercial purchase or to re-nance a prior mortgage obligation. There are two major types of CMBS dealstructures that have been of interest to bond investors, multiproperty single bor-rowers and multiproperty conduits. The fastest-growing segment of the CMBS isconduit-originated transactions. Conduits are commercial-lending entities that areestablished for the sole purpose of generating collateral to securitize.

Unlike residential mortgage loans, where the lender relies on the ability ofthe borrower to repay and has recourse to the borrower if the payment terms arenot satised, commercial mortgage loans are nonrecourse loans. This means thatthe lender can only look to the income-producing property backing the loan forinterest and principal repayment. If there is a default, the lender looks to the pro-ceeds from the sale of the property for repayment and has no recourse to the bor-rower for any unpaid balance. Basically, this means that the lender must vieweach property as a stand-alone business and evaluate each property using meas-ures that have been found useful in assessing credit risk.

ASSET-BACKED SECURITIES

Asset-backed securities are securities collateralized by assets that are not mort-gage loans. In structuring an asset-backed security, issuers have drawn from thestructures used in the mortgage-backed securities market. Asset-backed securitieshave been structured as pass-throughs and as structures with multiple bond class-es called pay-throughs, which are similar to CMOs. Credit enhancement is pro-vided by letters of credit, overcollateralization, or senior/subordination.

Three common types of asset-backed securities are those backed by creditcard receivables, home equity loans, and automobile loans. Chapters 2729 coverthese securities. There are also asset-backed securities supported by a pool ofmanufactured homes, Small Business Administration (SBA) loans, student loans,boat loans, equipment leases, recreational vehicle loans, senior bank loans, andpossibly, the future royalties of your favorite entertainer.

A collateralized debt obligation (CDO) is an asset-backed securitybacked by a diversied pool of one or more of the following types of debt obli-gations: U.S. domestic investment-grade and high-yield corporate bonds,


emerging market bonds, residential mortgage-backed securities, commercialmortgage-backed securities, asset-backed securities, real estate investment trustsdebt, U.S. domestic bank loans, special situation loans and distressed debt, for-eign bank loans, or other CDOs. CDOs are classied as either cash CDOs orsynthetic CDOs. A cash CDO is backed by a pool of cash market debt instru-ments and is discussed in Chapter 30, along with the motivation for their cre-ation. A synthetic CDO is a CDO where the investor has economic exposure toa pool of debt instrument, but this exposure is realized via credit derivativeinstruments rather than the purchase of the cash market instruments. SyntheticCDOs are discussed in Chapter 31.

SUMMARY

This chapter has provided an overview of the types of xed income securities andhas explored the key features of these securities. It is our hope that this chapterwill equip the reader with a general knowledge of the instruments and provide aconceptual and terminological background for the chapters that will investigate inmore detail the features of these securities and the associated risks and returns.


CHAPTER

TWO

RISKS ASSOCIATED WITHINVESTING IN FIXED INCOME

SECURITIES

RAVI F. DATTATREYA, PH.D.President, Capital Markets

Park Venture Advisors

FRANK J. FABOZZI, PH.D., CFA, CPAFrederick Frank Adjunct Professor of Finance

School of ManagementYale University

The return obtained from a xed income security from the day it is purchased tothe day it is sold can be divided into two parts: (1) the market value of the secu-rity when it is eventually sold and (2) the cash ows received from the securityover the time period that it is held, plus any additional income from reinvestmentof the cash ow. Several environmental factors affect one or both of these twoparts. We can dene the risk in any security as a measure of the impact of thesemarket factors on the return characteristics of the security.

The different types of risk that an investor in xed income securities isexposed to are as follows:

Market, or interest-rate, risk Reinvestment risk Timing, or call, risk Credit risk Yield-curve, or maturity, risk Ination, or purchasing-power, risk Liquidity risk Exchange-rate, or currency, risk Volatility risk Political or legal risk

21


Event risk Sector risk

Each risk is described in this chapter. They will become more clear as thesecurities are described in other chapters of this book.

MARKET, OR INTEREST-RATE, RISK

The price of a typical xed income security moves in the opposite direction of thechange in interest rates: As interest rates rise (fall), the price of a xed incomesecurity will fall (rise).1 This property is illustrated in Chapter 9. For an investorwho plans to hold a xed income security to maturity, the change in its pricebefore maturity is not of concern; however, fo

fixed income securities

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