Welcome to the Jungle:
Fixed Income Topics
November 21, 2004
Zachary Emig
MBA Class of 2005
Ross School of Business Finance Club
1
Today’s Agenda
I. What is fixed income?
II. Duration
III. Yield Curves and Credit Spreads
IV. Swaps
V. Securitized Products
2
What Is Fixed Income?
Technically, the word “fixed income” means a
security that has a set payment on a set
sequence of days; i.e. straight debt.
The way it is used today, it means “any
financial security that is not related to
equity (stocks).” This includes:
Treasury Bonds
Corporate Bonds
Mortgage Backed Securities
Credit Derivatives
Interest Rate Options
Foreign Exchange
Commodities
And much,
much, more!
3
Fixed Income Covers a Lot!
As you can see, there are many product
areas that fall under the fixed income
umbrella. Which makes sense, because
…Fixed Income rules the world (or at least is
where most of investor money is at).
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Market Capitalization
The US is one of, if not the, most equity
friendly country in the world.
That said, compare market capitalizations:
NYSE
ABS
$1.7 T
$11.7 Trn
Nasdaq
$3.1 Trn
Munis
$1.9 T
Agency
$2.7 T
Treasury*
$3.7 T
Corporate
Mortgage
$8.7 T
$4.6 T
What about monthly trading volume:
Treasuries
NYSE
NYSE NASDAQ
$0.8 T
$9.6 T
Agency MBS
$3.9 T
Agency
Debt
$1.5 T
Corporates
$0.4T
Nasdaq
$0.6 T
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Market Capitalization
•It is very hard to find official capitalization, volume
data on fixed income securities.
•For trading volume, took average daily volumes and
multiplied by 20 trading days in a month.
•Didn’t include: derivative trading volumes (both
equity and FI), foreign exchange, commodities (FI).
•The point: Both domestically and globally, FI
markets dwarf equity markets in capital and volume.
http://www.nyse.com/pdfs/movolume0410.pdf
http://www.nasdaq.com/newsroom/stats/Performance_Report.stm
http://www.bondmarkets.com/collection.asp?colid=191
http://www.bondmarkets.com/story.asp?id=296, ?id=96, ?id=1209, ?id=304, ?id=323
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Today’s Agenda
I. What is fixed income?
II. Duration
III. Yield Curves and Credit Spreads
IV. Swaps
V. Securitized Products
7
Duration
One of the most important concepts to know is duration,
which is basically the sensitivity of a bond’s price to interest
rate movements.
•There are several closely related versions of duration, but it’s
usually defined as the % change in a bond’s value for a
percentage change in yield (measured in basis points).
•Duration also represents the weighted average of all
payments of the bond. For zero coupon bonds, duration=time
to maturity. For coupon paying bonds, duration will be less
than the time to maturity.
http://www.investorwords.com/1602/duration.html
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Duration Example
5 year bond, non-callable, 4% annual coupons, $100 par.
Using
DCFs:
Vary the
interest
rates a bit:
T=
1
2
3
4
5
Payment
$4.00
$4.00
$4.00
$4.00
$104.00
Interest Rate PV at T=1 PV at T=2 PV at T=3 PV at T=4 PV at T=5 Total PV
4.00%
$3.85
$3.70
$3.56
$3.42
$85.48
$100.00
T=
1
2
3
4
5
Payment
$4.00
$4.00
$4.00
$4.00
$104.00
Interest Rate PV at T=1 PV at T=2 PV at T=3 PV at T=4 PV at T=5 Total PV
3.90%
$3.85
$3.71
$3.57
$3.43
$85.89
$100.45
4.00%
$3.85
$3.70
$3.56
$3.42
$85.48
$100.00
4.10%
$3.84
$3.69
$3.55
$3.41
$85.07
$99.56
Divide the % change in price by the bp change in rates:
T=
1
2
3
4
5
Payment
$4.00
$4.00
$4.00
$4.00
$104.00
Interest Rate PV at T=1 PV at T=2 PV at T=3 PV at T=4 PV at T=5 Total PV PV change Rate change Duration
3.90%
$3.85
$3.71
$3.57
$3.43
$85.89
$100.45
-0.44%
0.10%
4.44
4.00%
$3.85
$3.70
$3.56
$3.42
$85.48
$100.00
-0.44%
0.10%
4.44
4.10%
$3.84
$3.69
$3.55
$3.41
$85.07
$99.56
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Duration Example (cont.)
Often, a graph of a bond’s price versus yield is
helpful to understand duration.
23.50$150
21.50
$100
19.50
21%
21%
22%
23%
19%
20%
20%
17%
16%
14%
14%
15%
15%
IRs
5%
6%
7%
7%
8%
8%
9%
10%
10%
11%
11%
12%
13%
9.50
$0
3%
3%
4%
4%
11.50
7.50
5.50
Also note that duration changes with interest rates;
this “2nd derivative” is called convexity; for large
swings in rates, it can play a factor in prices.
10
23%
22%
21%
20%
19%
18%
17%
16%
15%
14%
13%
12%
11%
10%
9%
8%
7%
6%
5%
4%
3%
3.50
1%
Note that duration is
different for different
bonds.
13.50
$50
2%
15.50
1%
17.50
2%
Duration is essentially
the slope at a point
on the P/Y line.
Duration
theFlows
30yr)
PV
of(for
Cash
PV of Cash
Flows
30yr 4% Bond
Real World Use: DV01
For convenience, most traders use DV01 (PVBP): the
dollar change in the bond price for a 1bp move in
yield (very similar to yield).
This is the Bloomberg Yield Analysis (YA) for the
10yr Treasury Note.
11
DV01 in Action
On Nov. 16, at 8:30, the government published the
PPI numbers, which came in much hotter than
expected.
The yield on the 10yr
benchmark Treasury
immediately jumped
4.6bp
DV01 x 4.6bp = Price
0.08103 x 4.6bp =
$0.373
…=12/32nds.
12
DV01 in Action
As expected, the price dropped by 37¢ ($12/32).
…A trader long $50MM of 10 years just lost
27¢ x 50,000 = $18,637. Ouch.
13
Today’s Agenda
I. What is fixed income?
II. Duration
III. Yield Curves and Credit Spreads
IV. Swaps
V. Securitized Products
14
Yield Curves
Generically, a “yield curve”, is simply a plot of the
current yields at different maturity points.
When speaking of
the yield curve, most
traders mean the US
Treasury yield curve,
since Treasuries are
the “riskfree”
benchmark for all
debt instruments.
Bloomberg command: YCRV
15
Yield Question
By the way, what is yield?
I would answer that it is the periodic discount rate
that, when applied to every payment in a bond’s cash
flow, returns the exact same price as the current
market price.
16
Credit Spread
In the FI world, many products are traded on a
“spread” off the Treasury yield curve.
The credit spread
is the difference in
AAA corporate debt
yields and Treasury
yields; it is a realtime measurement
of the credit risk
tolerance of the
market.
17
Breakeven Inflation
Comparing the Treasury curve versus the TIPS
(Treasury Inflation Protected Securities) yield curve
reveals the breakeven inflation level expected by the
market.
A word of caution on TIPS:
they are a fairly new
product, and do have some
liquidity issues that could
lead to mispricing.
18
Swap Spread
Other interesting spreads to observe: Agency spread
and swap spread.
19
Today’s Agenda
I. What is fixed income?
II. Duration
III. Yield Curves and Credit Spreads
IV. Swaps
V. Securitized Products
20
Swaps: At their most basic
As their name implies, swaps are simply contractual
agreements between two counterparties to exchange
different cash flows.
The number of swaps are greatly expanding. A
truncated list:
•Currency swaps
•Interest rate swaps
•Credit Default Swaps
•Volatility Swaps
•Total Return Swaps
ISDA:
For interest rate swaps, rate
options, and currency swaps, at
mid-year 2004, the notional
amount outstanding was:
$164.49 Trillion
http://www.isda.org/statistics/recent.html#2004mid
21
Interest Rate Swaps
Interest rate swaps (often called vanilla swaps) are
simply exchanges of a fixed rate of interest for a
floating rate, both paid on a fixed notional amount.
Things to remember:
•Buying (going long) a swap = paying fixed rate,
receiving floating
•Selling (going short) a swap = paying floating,
receiving fixed
22
Today’s Agenda
I. What is fixed income?
II. Duration
III. Yield Curves and Credit Spreads
IV. Swaps
V. Securitized Products
23
Securitization
•Securitization was one of the biggest financial
innovations of the last 40 years.
•Definition: transforming illiquid/non-financial
products into tradable financial securities.
•Two most common methods:
•Pooling: using large pools of securities to
diminish the illiquidity/risk of a single one.
•Tranching: dividing cash flows into separate
“tranches” that have different risk levels, in order
to target differing investor appetites for risk.
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Mortgage Backed Securities
•The history of MBS is an excellent example of both
processes.
•Problems with investing in individual mortgages: small size
(to an institutional investor) and prepayment risk (at the
“whim” of the homeowner).
•In the late 70s and early 80s, Mortgage Pass-Thrus were
popularized: securities whose coupons were supported by
pools of [numerous] mortgage securities.
Individua
Individua
Individual
l l
Mortgag
Individua
Individual
Mortgag
Individua
Individual
Mortgag
Individua
e
l eMortgage
Individua
l
Mortgage
Individua
e
l
Mortgag
Individua
l
Individua
Individua
Individual
leMortgag
Mortgag
Individua
l
Mortgag
Individua
l ee
Mortgage
Mortgag
l lIndividua
Mortgag
Individua
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ll e
Mortgag
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Mortgag
l l Mortgag
eMortgag
e el l
e
Mortgag
Mortgag
ee
Mortgag
Mortgag
e e
ee
MBS Pass-Thru
Issuer
(Fannie Mae, Freddie
Mac, I-Banks)
PassThru
Investors
25
CMOs
•The next step in securitization was tranching.
•CMOs = Collateralized Mortgage Obligations.
•Rather than divide all the pooled mortgage cash flows equally
among investors, CMOs divide them into separate “tranches” of
securities with different payment profiles.
•Commonly, the different tranches receive different timing of
payments.
Tranche A
Investors
Individua
Individua
Individual
l l
Mortgag
Individua
Mortgag
Individua
Individual
Pass-Thru
Mortgag
Individua
e
l e Individua
l
Mortgage
Individua
e
l
Mortgag
Individua
Individua
Individua
Individual
leMortgagl
Mortgag
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Individua
el
lIndividua
l eMortgag
Mortgage
Mortgag
l
Mortgag
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ll e
Mortgag
Mortgag
e Individua
Mortgag
l PassMortgag
eMortgag
e el l
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ee
Thru Mortgag
Mortgag
e
ee
CMO
Issuer
18mos-36mos
Tranche B
Investors
(I-Banks)
Tranche C
Investors26
Today’s Agenda
I. What is fixed income?
II. Duration
III. Yield Curves and Credit Spreads
IV. Swaps
V. Securitized Products
~ Fin ~
27