the handbook of european fixed income securities · chapter 1 introduction to european fixed income...

The Handbook ofEuropean Fixed

Income SecuritiesFRANK J. FABOZZI

MOORAD CHOUDHRYEDITORS

John Wiley & Sons, Inc.

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Income Securities

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THE FRANK J. FABOZZI SERIES

Fixed Income Securities, Second Edition by Frank J. FabozziFocus on Value: A Corporate and Investor Guide to Wealth Creation by James L.

Grant and James A. AbateHandbook of Global Fixed Income Calculations by Dragomir KrginManaging a Corporate Bond Portfolio by Leland E. Crabbe and Frank J. FabozziReal Options and Option-Embedded Securities by William T. MooreCapital Budgeting: Theory and Practice by Pamela P. Peterson and Frank J. FabozziThe Exchange-Traded Funds Manual by Gary L. GastineauProfessional Perspectives on Fixed Income Portfolio Management, Volume 3 edited

by Frank J. FabozziInvesting in Emerging Fixed Income Markets edited by Frank J. Fabozzi and

Efstathia PilarinuHandbook of Alternative Assets by Mark J. P. AnsonThe Exchange-Traded Funds Manual by Gary L. GastineauThe Global Money Markets by Frank J. Fabozzi, Steven V. Mann, and

Moorad ChoudhryThe Handbook of Financial Instruments edited by Frank J. FabozziCollateralized Debt Obligations: Structures and Analysis by Laurie S. Goodman

and Frank J. FabozziInterest Rate, Term Structure, and Valuation Modeling edited by Frank J. FabozziInvestment Performance Measurement by Bruce J. FeibelThe Handbook of Equity Style Management edited by T. Daniel Coggin and

Frank J. FabozziThe Theory and Practice of Investment Management edited by Frank J. Fabozzi and

Harry M. MarkowitzFoundations of Economic Value Added: Second Edition by James L. GrantFinancial Management and Analysis: Second Edition by Frank J. Fabozzi and

Pamela P. PetersonMeasuring and Controlling Interest Rate and Credit Risk: Second Edition by

Frank J. Fabozzi, Steven V. Mann, and Moorad ChoudhryProfessional Perspectives on Fixed Income Portfolio Management, Volume 4 edited

by Frank J. Fabozzi

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Income SecuritiesFRANK J. FABOZZI

MOORAD CHOUDHRYEDITORS

John Wiley & Sons, Inc.

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Copyright © 2004 by Frank J. Fabozzi. All rights reserved.

Published by John Wiley & Sons, Inc., Hoboken, New JerseyPublished simultaneously in Canada

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v

Contents

PREFACE ixABOUT THE EDITORS xiCONTRIBUTING AUTHORS xiii

SECTION ONE

Background 1

CHAPTER 1Introduction to European Fixed Income Securities and Markets 3Moorad Choudhry, Frank J. Fabozzi, and Steven V. Mann

CHAPTER 2Bondholder Value versus Shareholder Value 23Claus Huber

CHAPTER 3Bond Pricing and Yield Measures 41Frank J. Fabozzi and Steven V. Mann

CHAPTER 4Measuring Interest Rate Risk 89Frank J. Fabozzi and Steven V. Mann

SECTION TWO

Products 141

CHAPTER 5The Euro Government Bond Market 143Antonio Villarroya

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vi Contents

CHAPTER 6The Eurobond Market 167David Munves

CHAPTER 7The German Pfandbrief and European Covered Bonds Market 201Graham “Harry” Cross

CHAPTER 8European Inflation-Linked Bonds 229Barclays Capital Inflation-Linked Research Team

CHAPTER 9The United Kingdom Gilts Market 283Moorad Choudhry

CHAPTER 10The European Repo Market 307Moorad Choudhry

CHAPTER 11European Residential Mortgage-Backed Securities 355Phil Adams

CHAPTER 12European Commercial Mortgage-Backed Securities 391Phil Adams

CHAPTER 13European Credit Card ABS 407Markus Niemeier

CHAPTER 14European Auto and Consumer Loan ABS 431Markus Niemeier

CHAPTER 15Structured Credit: Cash Flow and Synthetic CDOs 453Oldrich Masek and Moorad Choudhry

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Contents vii

SECTION THREE

Interest Rate and Credit Derivatives 493

CHAPTER 16European Interest Rate Futures: Instruments and Applications 495Brian A. Eales

CHAPTER 17Interest Rate Options 525Lawrence Galitz

CHAPTER 18Pricing Options on Interest Rate Instruments 569Brian A. Eales and Radu Tunaru

CHAPTER 19Interest Rate Swaps 601Frank J. Fabozzi and Steven V. Mann

CHAPTER 20A Practical Guide to Swap Curve Construction 631Uri Ron

CHAPTER 21Credit Derivatives 653Richard Pereira, Rod Pienaar, and Moorad Choudhry

CHAPTER 22The Pricing of Credit Default Swaps and SyntheticCollateralized Debt Obligations 691Greg Gentile, David Jefferds, and Warren Saft

SECTION FOUR

Portfolio Management 723

CHAPTER 23Fixed Income Risk Modeling for Portfolio Managers 725Ludovic Breger

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viii Contents

CHAPTER 24An Empirical Analysis of the Domestic and Euro Yield Curve Dynamics 753Lionel Martellini, Philippe Priaulet, and Stéphane Priaulet

CHAPTER 25Tracking Error 775William Lloyd, Bharath K. Manium, and Mats Gustavsson

CHAPTER 26Portfolio Strategies for Outperforming a Benchmark 803William T. Lloyd and Bharath K. Manium

CHAPTER 27Credit in Bond Portfolios 835Claus Huber and Helmut Kaiser

CHAPTER 28Default and Recovery Rates in the Emerging European High-Yield Market 849Mariarosa Verde

CHAPTER 29Analysis and Evaluation of Corporate Bonds 873Christoph Klein

SECTION FIVE

Legal Considerations 889

CHAPTER 30Legal and Documentation Issues on Bonds Issuances 891Lourdes Villar-Garcia and Trusha Patel

CHAPTER 31Trust and Agency Services in the Debt Capital Markets 935Nick Procter and Edmond Leedham

INDEX 955

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ix

Preface

he Handbook of European Fixed Income Securities provides extensiveand in-depth coverage of every aspect of the European fixed income

markets and their derivatives. It includes a description of products and con-ventions as well as quantitative coverage of valuation and analysis of eachinstrument. Its focus is on the diversity of the product range across the mar-kets, which presents features of interest for institutional investors world-wide. The emphasis is on both developed markets, such as the UnitedKingdom and Germany government and corporate bond markets as well asemerging markets in Eastern Europe, and includes instruments and institu-tions. Both plain “vanilla” and structured finance bond instruments are dis-cussed in detail. There is also an extensive coverage of ancillary areas ofimportance such as trust and agency services, and legal documentationissues. The audience is primarily European institutional investors and port-folio managers worldwide who are diversifying into European instruments,as well as US-based researchers and academics. A secondary audience isstudents and market practitioners based in Europe, for whom no one bookcovering all aspects of the European market currently exists.

This last point was behind the motivation for compiling this book.We feel that there is no one book, aimed at both investors and practitio-ners, that covers every aspect of the European debt capital markets,which in terms of diversity, if not size, is the key capital market in theworld. In our view there is a dearth of books written by Europeanauthors and aimed at market practitioners that cover this market. Tofacilitate this, we have assembled a field of over 30 authors, all leadingnames in their field, who have contributed chapters to this book. Theyrepresent investment bankers, traders, researchers, academics, and legalcounsel. With only a few exceptions, all contributors are based inEurope. The diversity of contributors’ backgrounds reflects the natureof our topic and helps us serve two different markets at once, practitio-ners (including investors and bankers) and students, each having theirown reason for buying this book.

Another motivation for this book was the importance of the marketitself. The advent of the euro currency has created a bond market of

T

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x Preface

roughly equal size to the US dollar market; this is an important marketfor global investors. There is also a growing interest in European mar-kets among US and Asian investors: for instance, market statistics showan increasing share of European issues held by US portfolio managers,generating greater need for market information in this field. This wehope we have achieved.

The book is grouped into the following sections:

Within this broad field there is detailed coverage of specific areas of impor-tance to institutional investors.

We would like to thank all authors for their contributions, as well asRuth Kentish and Paula Jacobsen for assistance with the editorial process,and Dr. Chee Hau at JPMorgan Chase for reviewing drafts of MooradChoudhry’s chapters. Special thanks to Professor Steven Mann at the Uni-versity of South Carolina, for assisting us in several aspects of thisproject, in addition to his contribution of four chapters to this book.

Frank FabozziMoorad Choudhry

Section One: BackgroundSection Two: ProductsSection Three: Interest Rate and Credit DerivativesSection Four: Portfolio ManagementSection Five: Legal Considerations

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xi

About the Editors

Frank J. Fabozzi, Ph.D., CFA, CPA is the Frederick Frank Adjunct Profes-sor of Finance in the School of Management at Yale University. Prior tojoining the Yale faculty, he was a Visiting Professor of Finance in theSloan School at MIT. Professor Fabozzi is a Fellow of the InternationalCenter for Finance at Yale University and the editor of the Journal ofPortfolio Management. He earned a doctorate in economics from the CityUniversity of New York in 1972. In 1994 he received an honorary doctor-ate of Humane Letters from Nova Southeastern University and in 2002was inducted into the Fixed Income Analysts Society’s Hall of Fame. He isthe honorary advisor to the Chinese Asset Securitization Web site.

Moorad Choudhry is Head of Treasury at KBC Financial Products (UK)Limited in London. He previously worked as a government bond traderand Treasury trader at ABN Amro Hoare Govett Limited and HambrosBank Limited, and in structured finance services at JPMorgan ChaseBank. Moorad is a Fellow of the Centre for Mathematical Trading andFinance, CASS Business School, and a Fellow of the Securities Institute.He is author of The Bond and Money Markets: Strategy, Trading, Analy-sis, and editor of the Journal of Bond Trading and Management.

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xiii

Contributing Authors

Phil Adams Barclays CapitalLudovic Breger Barra, Inc.Moorad Choudhry CASS Business School, LondonGraham “Harry” Cross YieldCurve.comBrian A. Eales London Metropolitan UniversityFrank J. Fabozzi Yale University Lawrence Galitz ACF Consultants Ltd.Greg Gentile Lehman BrothersMats Gustavsson Barclays CapitalClaus Huber Deutsche BankInflation-Linked

Research TeamBarclays Capital

David Jefferds CREDITEX, Inc.Helmut Kaiser Deutsche BankChristoph Klein Deutsche Asset ManagementEdmond Leedham JPMorgan Chase BankWilliam T. Lloyd Barclays CapitalBharath K. Manium Barclays CapitalSteven V. Mann University of South CarolinaLionel Martellini University of Southern California and

EDHEC Risk and Asset ManagementResearch Center

Oldrich Masek JPMorgan Securities Ltd.David Munves Lehman Brothers InternationalMarkus Niemeier Barclays CapitalTrusha Patel CIBC World Markets PLCRichard Pereira Dresdner Kleinwort Wasserstein, LondonRod Pienaar Deutsche Bank AG, LondonPhilippe Priaulet HSBC-CCF and

University of Evry Val d’EssonneStéphane Priaulet AXA Investment ManagersNick Procter JPMorgan Chase BankUri Ron Bank of Canada

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xiv Contributing Authors

Warren Saft CREDITEX, Inc.Radu Tunaru London Metropolitan UniversityMariarosa Verde Fitch RatingsLourdes Villar-Garcia CIBC World Markets PLCAntonio Villarroya Merrill Lynch

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SECTION

OneBackground

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CHAPTER 1

3

Introduction to European FixedIncome Securities and Markets

Moorad ChoudhrySenior Fellow

Centre for Mathematical Trading and FinanceCASS Business School, London

Frank J. Fabozzi, Ph.D., CFAFrederick Frank Adjunct Professor of Finance

School of ManagementYale University

Steven V. Mann, Ph.D.Professor of Finance

Moore School of BusinessUniversity of South Carolina

bond is a debt capital market instrument issued by a borrower, who isthen required to repay to the lender/investor the amount borrowed plus

interest, over a specified period of time. Bonds are also known as fixedincome instruments, or fixed interest instruments in the sterling markets.Usually bonds are considered to be those debt securities with terms tomaturity of over one year. Debt issued with a maturity of less than one yearis considered to be money market debt. There are many different types ofbonds that can be issued. The most common bond is the conventional (orplain vanilla or bullet) bond. This is a bond paying periodic interest pay-

A

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4 BACKGROUND

ments at a fixed rate over a fixed period to maturity or redemption, withthe return of principal (the par or nominal value of the bond) on the matu-rity date. All other bonds will be variations of this basic structure.

A bond is therefore a financial contract from the person or body thathas issued the bond, that is, the borrowed funds. Unlike shares or equitycapital, bonds carry no ownership privileges. The bond remains an inter-est-bearing obligation of the issuer until it is repaid, which is usually onits maturity date.

There is a wide range of participants involved in the Europeanfixed-income markets. We can group them broadly into borrowers andinvestors, plus the institutions and individuals who are part of the busi-ness of bond trading. Borrowers access the bond markets as part of theirfinancing requirements; hence borrowers can include sovereign govern-ments, local authorities, public sector organisations and corporations.Virtually all businesses operate with a financing structure that is a mix-ture of debt and equity finance. The debt finance may well contain aform of bond finance, so it is easy to see what an important part of theglobal economy the bond markets are.

The different types of bonds in the European market reflect the dif-ferent types of issuers and their respective requirements. Some bonds aresafer investments than others. The advantage of bonds to an investor isthat they represent a fixed source of current income, with an assuranceof repayment of the loan on maturity. Bonds issued by developed coun-try governments are deemed to be guaranteed investments in that thefinal repayment is virtually certain. For a corporate bond, in the event ofdefault of the issuing entity, bondholders rank above shareholders forcompensation payments. There is lower risk associated with bonds com-pared to shares as an investment, and therefore almost invariably alower return in the long term.

In this chapter, we will provide a basic description of the various typesof fixed-income instruments encountered in the European markets as wellas the definitions of some key terms and concepts that will assist the readerthroughout the remainder of the book. Important groups of investors inthese markets are briefly discussed in the last section of the chapter.

DESCRIPTION OF THE BASIC FEATURES

A bond, like any security, can be thought of as a package of cash flows.A bond’s cash flows come in two forms—coupon interest payments andthe maturity value or par value. In European markets, many bondsdeliver annual cash flows. As an illustration, consider a 6% coupon


Introduction to European Fixed Income Securities and Markets 5

bond issued by the Spanish government that matures on 31 January2008. Exhibit 1.1 presents the Bloomberg Security Description Screenfor this issue. The coupon rate is the rate of interest that is multiplied bythe maturity value to determine the size of the bond’s coupon payments.Note that this bond delivers annual coupon payments. Suppose oneowns this bond in June 2003, what cash flows can the bondholderexpect between now and the maturity date assuming the maturity valueis

A100? On each 31 January for the years 2004 through 2008, thebondholder will receive annual coupon payments of

A6. Moreover, onthe maturity date, the bondholder receives the maturity value of

A100,which is the bond’s terminal cash flow.

Type of IssuerA primary distinguishing feature of a bond is its issuer. The nature ofthe issuer will affect the way the bond is viewed in the market. There arefour issuers of bonds: sovereign governments and their agencies, localgovernment authorities, supranational bodies such as the World Bank,and corporations. Within the corporate bond market there is a wide

EXHIBIT 1.1 Bloomberg Security Description Screen for a Spanish Government Bond

Source: Bloomberg Financial Markets.


6 BACKGROUND

range of issuers, each with differing abilities to satisfy their contractualobligations to investors. The largest bond markets are those of sover-eign borrowers, the government bond markets.

The most actively traded government securities for various maturi-ties are called benchmark issues. Yields on these issues serve as referenceinterest rates which are used extensively for pricing other securities.1

Exhibit 1.2 is a Bloomberg screen of the benchmark bonds issued by thegovernment of the Netherlands. European government bonds will bediscussed in Chapter 5. As an illustration of a corporate bond, Exhibit1.3 shows a Bloomberg Security Description screen for 4.875% couponbond issued by Pirelli SPA that matures on 21 October 2008.

Term to MaturityThe term to maturity of a bond is the number of years after which theissuer will repay the obligation. During the term the issuer will also

1 In some European countries, swap curves are used as a benchmark for pricing se-curities.

EXHIBIT 1.2 Bloomberg Screen of the Benchmark Government Bonds of The Netherlands




make periodic interest payments on the debt. The maturity of a bondrefers to the date that the debt will cease to exist, at which time theissuer will redeem the bond by paying the principal. The practice in themarket is often to refer simply to a bond’s “term” or “maturity.” Theprovisions under which a bond is issued may allow either the issuer orinvestor to alter a bond’s term to maturity after a set notice period, andsuch bonds need to be analysed in a different way. The term to maturityis an important consideration in the makeup of a bond. It indicates thetime period over which the bondholder can expect to receive the couponpayments and the number of years before the principal will be paid infull. The bond’s yield also depends on the term to maturity. Finally, theprice of a bond will fluctuate over its life as yields in the market changeand as it approaches maturity. As we will discover later, the volatility ofa bond’s price is dependent on its maturity; assuming other factors con-stant, the longer a bond’s maturity the greater the price volatility result-ing from a change in market yields.

One common way to distinguish between different sectors of thedebt markets is by the maturity of the instruments. The money market is

EXHIBIT 1.3 Bloomberg Security Description Screen for a Corporate Bond Issued by Pirelli



8 BACKGROUND

the market for short-term debt instruments with original maturities ofone year or less. This market includes such instruments as short-termgovernment debt, commercial paper, some medium-term notes, bankers’acceptances, most certificates of deposit, and repurchase agreements.According to the European Central Bank, as March 2003, the totalshort-term debt outstanding (maturities of one year or less) in the Euroarea was

A783.6 billion. Although this is an important sector of thedebt market, money market instruments are not covered in this book.2

Instead, our focus is on the capital market, which includes debt instru-ments that have original maturities of greater than one year.

Coupon TypesAs noted, the coupon rate is the interest rate the issuer agrees to payeach year. The coupon rate is used to determine the annual coupon pay-ment which can be delivered to the bondholder once per year or in twoor more equal installments. As noted, for bonds issued in Europeanbond markets and the Eurobond markets, coupon payments are madeannually. Conversely, in the United Kingdom, United States, and Japan,the usual practice is for the issuer to pay the coupon in two semiannualinstallments. An important exception is structured products (e.g., asset-backed securities) which often deliver cash flows more frequently (e.g.,quarterly, monthly).

Certain bonds do not make any coupon payments at all and theseissues are known as zero-coupon bonds. A zero-coupon bond has only onecash flow which is the maturity value. Zero-coupon bonds are issued bycorporations and governments. Exhibit 1.4 shows a Bloomberg SecurityDescription screen of a zero-coupon bond issued by the French bank BNPParibus that matures March 11, 2005. Since the maturity value is

A1,000,the price will be at a discount to

A1,000. The difference between the pricepaid for the bond and the maturity value is the interest realized by thebondholder. One important type of zero-coupon bond is called strips. Inessence, strips are government zero-coupon bonds. However, strips areissued by governments directly but are created by dealer firms. Conven-tional coupon bonds can be stripped or broken apart into a series of indi-vidual cash flows which would then trade separately as zero-couponbonds. This is a common practice in European government bond markets.Exhibit 1.5 presents a Bloomberg screen of some German government cou-pon strips. Since zero-coupon bonds can created from coupon payments orthe maturity value, a distinction is made between the two.

2 For a complete treatment of the money markets, see Frank J. Fabozzi, Steven V.Mann, and Moorad Choudhry, The Global Money Markets (Hoboken, NJ: JohnWiley & Sons, Inc., 2002).



EXHIBIT 1.4 Bloomberg Security Description Screen for a Zero-Coupon Bond Issued by BNP Paribus


EXHIBIT 1.5 Bloomberg Screen of German Government Coupon Strips



10 BACKGROUND

In contrast to a coupon rate that remains unchanged for the bond’sentire life, a floating-rate security or floater is a debt instrument whosecoupon rate is reset at designated dates based on the value of some ref-erence rate. Thus, the coupon rate will vary over the instrument’s life.The coupon rate is almost always determined by a coupon formula. Forexample, a floater issued by Aareal Bank AG in Denmark (due in May2007) has a coupon formula equal to three month EURIBOR plus 20basis points and delivers cash flows quarterly.

There are several features about floaters that deserve mention. First,a floater may have a restriction on the maximum (minimum) couponrate that be paid at any reset date called a cap (floor). Second, while afloater’s coupon rate normally moves in the same direction as the refer-ence rate moves, there are floaters whose coupon rate moves in theopposite direction from the reference rate. These securities are calledinverse floaters. As an example, consider an inverse floater issued by theRepublic of Austria. This issue matures in April 2005 and delivers semi-annual coupon payments according to the following formula:

12.125% – 6-month EURIBOR.

An index-linked bond has its coupon or maturity value or some-times both linked to a specific index. When governments issue index-linked bonds, the cash flows are linked to a price index such as con-sumer or commodity prices. Corporations have also issued index-linkedbonds that are connected to either an inflation index or a stock marketindex. For example, Kredit Fuer Wiederaufbau, a special purpose bankin Denmark, issued a floating-rate note in March 2003 whose couponrate will be linked to the Eurozone CPI (excluding tobacco) beginning inSeptember 2004. Inflation-indexed bonds are detailed in Chapter 8.

Currency DenominationThe cash flows of a fixed-income security can be denominated in anycurrency. For bonds issued by countries within the European Union, theissuer typically makes both coupon payments and maturity value pay-ments in euros. However, there is nothing that prohibits the issuer frommaking payments in other currencies. The bond’s indenture can specifythat the issuer may make payments in some other specified currency.There are some issues whose coupon payments are in one currency andwhose maturity value is in another currency. An issue with this featureis called a dual-currency issue.



NONCONVENTIONAL BONDS

The definition of bonds given earlier in this chapter referred to conven-tional or plain vanilla bonds. There are many variations on vanillabonds and we can introduce a few of them here.

Securitised BondsThere is a large market in bonds whose interest and principal paymentsare backed by an underlying cash flow from another asset. By securitis-ing the asset, a borrower can provide an element of cash flow backing toinvestors. For instance, a mortgage bank can use the cash inflows itreceives on its mortgage book as asset backing for an issue of bonds.Such an issue would be known as a mortgage-backed security (MBS).Because residential mortgages rarely run to their full term, but are usu-ally paid off earlier by homeowners, the notes that are backed by mort-gages are also prepaid ahead of their legal final maturity. This featuremeans that MBS securities are not bullet bonds like vanilla securities,but are instead known as amortising bonds. Other asset classes that canbe securitised include credit card balances, car loans, equipment leasereceivables, nursing home receipts, museum or leisure park receipts, andso on. Securitised bonds are usually called structured finance productsor structured products, and the market in MBS, asset-backed securities(ABS), collateralised debt obligations (CDOs), and asset-backed com-mercial paper (AB-CP) is known as the structured finance market. Someof the more popular structured products are described in later chapters.

Bonds with Embedded OptionsSome bonds include a provision in their offer particulars that gives eitherthe bondholder and/or the issuer an option to enforce early redemption ofthe bond. The most common type of option embedded in a bond is a callfeature. A call provision grants the issuer the right to redeem all or part ofthe debt before the specified maturity date. An issuing company may wishto include such a feature as it allows it to replace an old bond issue with alower coupon rate issue if interest rates in the market have declined. As acall feature allows the issuer to change the maturity date of a bond it isconsidered harmful to the bondholder’s interests; therefore the marketprice of the bond at any time will reflect this. A call option is included inall asset-backed securities based on mortgages, for obvious reasons.

A bond issue may also include a provision that allows the investorto change the maturity of the bond. This is known as a put feature andgives the bondholder the right to sell the bond back to the issuer at paron specified dates. The advantage to the bondholder is that if interest


12 BACKGROUND

rates rise after the issue date, thus depressing the bond’s value, theinvestor can realise par value by putting the bond back to the issuer.

Bonds with embedded call and put options comprise a relativelysmall percentage of the European bond market. Exhibit 1.6 shows thepercentage of the market value of the Euro Corporate Index and Pan-Euro Corporate Index attributable to bullets (i.e., option-free bonds),callable and putable bonds from the late 1990s through 31 May 2003.Accordingly, our discussion of bonds with embedded options in theremainder of the book will be confined to structured products.

A convertible bond is an issue giving the bondholder the right toexchange the bond for a specified amount of shares (equity) in the issu-ing company. This feature allows the investor to take advantage offavourable movements in the price of the issuer’s shares. Exhibit 1.7shows a Bloomberg Security Description screen of a convertible bondissued by Siemens Finance BV that matures in June 2010. This bond isconvertible into 1,780.37 shares as can be seen in the upper left-handcorner of the screen in the box labeled “Convertible Information.”

EXHIBIT 1.6 Euro Corporate Index by Structure 1998 through 31 May 2003

Pan-Euro Corporate Index by Structure 1999 through 31 May 2003

Source: Lehman Brothers Fixed Income Research.

Market Value Percent (%) of Euro Corporate Index

Bullets Callables Putables Total

1998 94.0% 5.7% 0.4% 100.0%1999 98.4% 1.5% 0.1% 100.0%2000 98.8% 1.1% 0.1% 100.0%2001 99.5% 0.5% 0.1% 100.0%2002 99.1% 0.8% 0.1% 100.0%May 31, 2003 99.3% 0.6% 0.1% 100.0%

Market Value Percent (%) of Pan-Euro Corporate Index

Bullets Callables Putables Total

1999 98.2% 1.7% 0.1% 100.0%2000 97.9% 2.0% 0.1% 100.0%2001 99.4% 0.5% 0.1% 100.0%2002 99.1% 0.9% 0.1% 100.0%May 31, 2003 99.1% 0.8% 0.1% 100.0%



EXHIBIT 1.7 Bloomberg Security Description Screen of a Convertible Bond Issued by Siemens Financial BV


The presence of embedded options in a bond makes valuation morecomplex compared to plain vanilla bonds.

PRICING A CONVENTIONAL BOND

The principles of pricing in the bond market are exactly the same as thosein other financial markets, which states that the price of any financialinstrument is equal to the net present value today of all the future cashflows from the instrument. In Chapter 3, bond pricing will be explained.In this chapter we will just present the basic elements of bond pricing.

A bond price is expressed as per 100 nominal of the bond, or “percent.” So for example if the all-in price of a euro-denominated bond isquoted as “98.00”, this means that for every

A100 nominal of the bonda buyer would pay

A98. The interest rate or discount rate used as partof the present value (price) calculation is key to everything, as it reflectswhere the bond is trading in the market and how it is perceived by themarket. All the determining factors that identify the bond—those dis-


14 BACKGROUND

cussed earlier in this chapter and including the type of issuer, the matu-rity, the coupon, and the currency—influence the interest rate at which abond’s cash flows are discounted, which will be roughly similar to therate used for comparable bonds.

Since the price of a bond is equal to the present value of its cashflows, first we need to know the bond’s cash flows before then determin-ing the appropriate interest rate at which to discount the cash flows. Wecan then compute the price of the bond.

A conventional bond’s cash flows are the interest payments or cou-pons that are paid during the life of the bond, together with the finalredemption payment. It is possible to determine the cash flows with cer-tainty only for conventional bonds of a fixed maturity. So for example,we do not know with certainty what the cash flows are for bonds thathave embedded options and can be redeemed early.

The interest rate that is used to discount a bond’s cash flows (there-fore called the discount rate) is the rate required by the bondholder. It istherefore known as the bond’s yield. The required yield for any bondwill depend on a number of political and economic factors, includingwhat yield is being earned by other bonds of the same class. Yield isalways quoted as an annualised interest rate.

The fair price of a bond is the present value of all its cash flows. Theformulas that can be used for determining the fair price are presented inChapter 3.

The date used as the point for calculation is the settlement date forthe bond, the date on which a bond will change hands after it is traded.For a new issue of bonds the settlement date is the day when the bondstock is delivered to investors and payment is received by the bondissuer. The settlement date for a bond traded in the secondary market isthe day that the buyer transfers payment to the seller of the bond andwhen the seller transfers the bond to the buyer. Different markets willhave different settlement conventions; for example, UK gilts normallysettle one business day after the trade date (the notation used in bondmarkets is T + 1) whereas Eurobonds settle on T + 3. The term valuedate is sometimes used in place of settlement date, however the twoterms are not strictly synonymous. A settlement date can only fall on abusiness date, so that a gilt traded on a Friday will settle on a Monday.However a value date can sometimes fall on a nonbusiness day.

ACCRUED INTEREST, CLEAN PRICE, AND DIRTY PRICE

All bonds coupon-paying bonds accrue interest on a daily basis, and thisis then paid out on the coupon date. In determination of the fair price


the handbook of european fixed income securities · chapter 1 introduction to european fixed income...

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