Fixed Income Analysis (CFA Institute Investment Series)

907 Pages·2022·17.726 MB·English

by  Barbara S. Petitt

FIXED INCOME
ANALYSIS
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CFA Institute is the premier association for investment professionals around the world, with
more than 150,000 CFA charterholders worldwide in 165+ countries and regions. Since 1963
the organization has developed and administered the renowned Chartered Financial Analyst®
Program. With a rich history of leading the investment profession, CFA Institute has set the
highest standards in ethics, education, and professional excellence within the global investment
community and is the foremost authority on investment profession conduct and practice.
Each book in the CFA Institute Investment Series is geared toward industry practitioners along
with graduate-level finance students and covers the most important topics in the industry. The
authors of these cutting-edge books are themselves industry professionals and academics and
bring their wealth of knowledge and expertise to this series.
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FIXED INCOME
ANALYSIS
Fifth Edition
James F. Adams, PhD, CFA
Donald J. Smith, PhD
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Cover image: Background © maxkrasnov/iStock.com
Cover design: Wiley
Copyright © 2022 by CFA Institute. All rights reserved.
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ISBN 978-1-119-85054-0 (Hardcover)
ISBN 978-1-119-85055-7 (ePDF)
ISBN 978-1-119-85056-4 (ePub)
Printed in the United States of America.
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CONTENTS
Preface xv
Acknowledgments xvii
About the CFA Institute Series xix
PART I
Fixed Income Essentials
CHAPTER 1
Fixed-Income Securities: Defining Elements 3
Learning Outcomes 3
1. Introduction and Overview of a Fixed-Income Security 3
1.1. Overview of a Fixed-Income Security 4
2. Bond Indenture 10
2.1. Bond Indenture 10
3. Legal, Regulatory, and Tax Considerations 18
3.1. Tax Considerations 20
4. Principal Repayment Structures 22
4.1. Principal Repayment Structures 22
5. Coupon Payment Structures 27
5.1. Floating-Rate Notes 27
5.2. Step-Up Coupon Bonds 28
5.3. Credit-Linked Coupon Bonds 28
5.4. Payment-in-Kind Coupon Bonds 29
5.5. Deferred Coupon Bonds 29
5.6. Index-Linked Bonds 29
6. Callable and Putable Bonds 33
6.1. Callable Bonds 33
6.2. Putable Bonds 35
7. Convertible Bonds 36
Summary 39
Practice Problems 41
v
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vi Contents
CHAPTER 2
Fixed-Income Markets: Issuance, Trading, and Funding 45
Learning Outcomes 45
1. Introduction 45
2. Classification of Fixed-Income Markets 46
2.1. Classification of Fixed-Income Markets 46
2.2. Fixed-Income Indexes 53
2.3. Investors in Fixed-Income Securities 53
3. Primary Bond Markets 55
3.1. Primary Bond Markets 55
4. Secondary Bond Markets 59
5. Sovereign Bonds 62
5.1. Characteristics of Sovereign Bonds 62
5.2. Credit Quality of Sovereign Bonds 63
5.3. Types of Sovereign Bonds 64
6. Non-Sovereign, Quasi-Government, and Supranational Bonds 66
6.1. Non-Sovereign Bonds 66
6.2. Quasi-Government Bonds 66
6.3. Supranational Bonds 67
7. Corporate Debt: Bank Loans, Syndicated Loans, and Commercial Paper 68
7.1. Bank Loans and Syndicated Loans 68
7.2. Commercial Paper 69
8. Corporate Debt: Notes and Bonds 71
8.1. Maturities 71
8.2. Coupon Payment Structures 72
8.3. Principal Repayment Structures 72
8.4. Asset or Collateral Backing 73
8.5. Contingency Provisions 73
8.6. Issuance, Trading, and Settlement 74
9. Structured Financial Instruments 75
9.1. Capital Protected Instruments 76
9.2. Yield Enhancement Instruments 76
9.3. Participation Instruments 77
9.4. Leveraged Instruments 77
10. Short-Term Bank Funding Alternatives 78
10.1. Retail Deposits 79
10.2. Short-Term Wholesale Funds 79
11. Repurchase and Reverse Repurchase Agreements 81
11.1. Structure of Repurchase and Reverse Repurchase Agreements 81
11.2. Credit Risk Associated with Repurchase Agreements 82
Summary 84
Practice Problems 86
CHAPTER 3
Introduction to Fixed-Income Valuation 91
Learning Outcomes 91
1. Introduction 91
2. Bond Prices and the Time Value of Money 92
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Contents vii
2.1. Bond Pricing with a Market Discount Rate 92
2.2. Yield-to-Maturity 96
2.3. Relationships between the Bond Price and Bond Characteristics 97
2.4. Pricing Bonds Using Spot Rates 101
3. Prices and Yields: Conventions For Quotes and Calculations 104
3.1. Flat Price, Acc rued Interest, and the Full Price 104
3.2. Matrix Pricing 108
3.3. Annual Yields for Varying Compounding Periods in the Year 111
3.4. Yield Measures for Fixed-Rate Bonds 113
3.5. Yield Measures for Floating-Rate Notes 116
3.6. Yield Measures for Money Market Instruments 120
4. The Maturity Structure of Interest Rates 125
5. Yield Spreads 133
5.1. Yield Spreads over Benchmark Rates 133
5.2. Yield Spreads over the Benchmark Yield Curve 136
Summary 137
Practice Problems 140
CHAPTER 4
Introduction to Asset-Backed Securities 149
Learning Outcomes 149
1. Introduction: Benefits of Securitization 149
1.1. Benefits of Securitization for Economies and Financial Markets 150
2. How Securitization Works 151
2.1. An Example of a Securitization 152
2.2. Parties to a Securitization and Their Roles 153
3. Structure of a Securitization 155
3.1. Key Role of the Special Purpose Entity 157
4. Residential Mortgage Loans 160
4.1. Maturity 161
4.2. Interest Rate Determination 161
4.3. Amortization Schedule 162
4.4. Prepayment Options and Prepayment Penalties 162
4.5. Rights of the Lender in a Foreclosure 163
5. Mortgage Pass-Through Securities 164
5.1. Mortgage Pass-Through Securities 165
6. Collateralized Mortgage Obligations and Non-Agency RMBS 171
6.1. Sequential-Pay CMO Structures 172
6.2. CMO Structures Including Planned Amortization Class and
Support Tranches 173
6.3. Other CMO Structures 176
6.4. Non-Agency Residential Mortgage-Backed Securities 177
7. Commercial Mortgage-Backed Securities 178
7.1. Credit Risk 178
7.2. CMBS Structure 179
8. Non-Mortgage Asset-Backed Securities 183
8.1. Auto Loan ABS 183
8.2. Credit Card Receivable ABS 186
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viii Contents
9. Collateralized Debt Obligations 187
9.1. CDO Structure 188
9.2. An Example of a CDO Transaction 188
10. Covered Bonds 191
Summary 192
Practice Problems 194
CHAPTER 5
Understanding Fixed-Income Risk and Return 201
Learning Outcomes 201
1. Introduction 202
2. Sources of Return 202
3. Macaulay and Modified Duration 210
3.1. Macaulay, Modified, and Approximate Duration 210
4. Approximate Modified and Macaulay Duration 215
5. Effective and Key Rate Duration 218
5.1. Key Rate Duration 221
6. Properties of Bond Duration 221
7. Duration of a Bond Portfolio 227
8. Money Duration and the Price Value of a Basis Point 230
9. Bond Convexity 232
10. Investment Horizon, Macaulay Duration, and Interest Rate Risk 240
10.1. Yield Volatility 241
10.2. Investment Horizon, Macaulay Duration, and Interest Rate Risk 242
11. Credit and Liquidity Risk 246
12. Empirical Duration 248
Summary 249
Reference 251
Practice Problems 252
CHAPTER 6
Fundamentals of Credit Analysis 257
Learning Outcomes 257
1. Introduction 257
2. Credit Risk 258
3. Capital Structure, Seniority Ranking, and Recovery Rates 260
3.1. Capital Structure 260
3.2. Seniority Ranking 260
3.3. Recovery Rates 262
4. Rating Agencies, Credit Ratings, and Their Role in the Debt Markets 265
4.1. Credit Ratings 266
4.2. Issuer vs. Issue Ratings 267
4.3. ESG Ratings 269
4.4. Risks in Relying on Agency Ratings 269
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