Fixed in Come Overview

8/12/2019 Fixed in Come Overview

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Welcome to the Jungle:Fixed Income Topics

November 21, 2004

Zachary Emig

MBA Class of 2005

Ross School of Business Finance Club


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Todays Agenda

I. What is fixed income?

II. Duration

III. Yield Curves and Credit SpreadsIV. Swaps

V. Securitized Products


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What Is Fixed Income?

Technically, the word fixed income meansa security that has a set payment on a setsequence of days; i.e. straight debt.

The way it is used today, it means anyfinancial security that is not related toequity (stocks). This includes:

Treasury Bonds

Foreign Exchange

Corporate Bonds

Mortgage Backed Securities Commodities

Credit Derivatives

Interest Rate Options

And much,much, more!


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Fixed Income Covers a Lot!

As you can see, there are many productareas that fall under the fixed incomeumbrella. Which makes sense, because

Fixed Income rules the world (or at least iswhere most of investor money is at).


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Market Capitalization

The US is one of, if not the, most equityfriendly country in the world.

That said, compare market capitalizations:

NYSE $11.7 Trn Nasdaq$3.1 Trn

ABS$1.7 T

Munis$1.9 T

Agency$2.7 T

Treasury*$3.7 T

Corporate$4.6 T

Mortgage $8.7 T

What about monthlytrading volume:Agency MBS $3.9 T

AgencyDebt$1.5 T

Treasuries $9.6 T Corporates$0.4T

NYSE Nasdaq

NYSE

$0.8 T

NASDAQ

$0.6 T


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Market Capitalization

It is very hard to find official capitalization, volumedata on fixed income securities.

For trading volume, took average daily volumes andmultiplied by 20 trading days in a month.

Didnt include: derivative trading volumes (bothequity and FI), foreign exchange, commodities (FI).

The point: Both domestically and globally, FImarkets dwarf equity markets in capital and volume.

http://www.nyse.com/pdfs/movolume0410.pdfhttp://www.nasdaq.com/newsroom/stats/Performance_Report.stmhttp://www.bondmarkets.com/collection.asp?colid=191

http://www.bondmarkets.com/story.asp?id=296, ?id=96, ?id=1209, ?id=304, ?id=323
http://www.nyse.com/pdfs/movolume0410.pdfhttp://www.nasdaq.com/newsroom/stats/Performance_Report.stmhttp://www.bondmarkets.com/collection.asp?colid=191http://www.bondmarkets.com/story.asp?id=296http://www.bondmarkets.com/story.asp?id=296http://www.bondmarkets.com/collection.asp?colid=191http://www.nasdaq.com/newsroom/stats/Performance_Report.stmhttp://www.nyse.com/pdfs/movolume0410.pdf


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Todays Agenda

I. What is fixed income?

II. Duration




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Duration

One of the most important concepts to know is duration,which is basically the sensitivity of a bonds price to interestrate movements.

There are several closely related versions of duration, but its

usually defined as the % change in a bonds value for apercentage change in yield (measured in basis points).

Duration also represents the weighted average of allpayments of the bond. For zero coupon bonds, duration=time

to maturity. For coupon paying bonds, duration will be lessthan 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.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

UsingDCFs:

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

Vary theinterestrates a bit:

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 bonds price versus yield ishelpful to understand duration.

$0

$50

$100

$150

1%

2%

3%

4%

5%

7%

8%

9%

10%

11%

13%

14%

15%

16%

17%

19%

20%

21%

22%

IRs

PV of Cash Flows

$0

$50

$100

$150

1%

2%

3%

4%

6%

7%

8%

10%

11%

12%

14%

15%

16%

17%

19%

20%

21%

23%

IRs

PV of Cash Flows 30yr 4% BondDuration is essentiallythe slope at a point

on the P/Y line.

Note that duration isdifferent for different

bonds. 3.505.50

7.50

9.50

11.50

13.50

15.50

17.50

19.50

21.50

23.50

1%

2%

3%

4%

5%

6%

7%

8%

9%

10%

11%

12%

13%

14%

15%

16%

17%

18%

19%

20%

21%

22%

23%

Duration (for the 30yr)

Also note that duration changes with interest rates;this 2ndderivative is called convexity; for large

swings in rates, it can play a factor in prices.


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Real World Use: DV01For convenience, most traders use DV01 (PVBP): thedollar change in the bond price for a 1bp move inyield (very similar to yield).

This is the Bloomberg Yield Analysis (YA) for the

10yr Treasury Note.


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DV01 in ActionOn Nov. 16, at 8:30, the government published thePPI numbers, which came in much hotter thanexpected.

The yield on the 10yr

benchmark Treasuryimmediately jumped4.6bp

DV01 x 4.6bp = Price0.08103 x 4.6bp =$0.373

=12/32nds.


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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.


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Todays Agenda

I. What is fixed income?II. Duration




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Yield CurvesGenerically, a yield curve, is simply a plot of the

current yields at different maturity points.

When speaking oftheyield curve, most

traders mean the USTreasury yield curve,since Treasuries arethe riskfree

benchmark for alldebt instruments.

Bloomberg command: YCRV


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Yield QuestionBy the way, what is yield?

I would answer that it is the periodic discount ratethat, when applied to every payment in a bonds cashflow, returns the exact same price as the current

market price.


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Credit SpreadIn the FI world, many products are traded on a

spread off the Treasury yield curve.

The credit spreadis the difference in

AAA corporate debtyields and Treasuryyields; it is a real-time measurement

of the credit risktolerance of themarket.


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Breakeven InflationComparing the Treasury curve versus the TIPS

(Treasury Inflation Protected Securities) yield curvereveals the breakeven inflation level expected by themarket.

A word of caution on TIPS:they are a fairly newproduct, and do have someliquidity issues that couldlead to mispricing.


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Swap SpreadOther interesting spreads to observe: Agency spread

and swap spread.


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Todays Agenda





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Interest Rate SwapsInterest rate swaps (often called vanilla swaps) are

simply exchanges of a fixed rate of interest for afloating 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


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Todays Agenda





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SecuritizationSecuritization was one of the biggest financial

innovations of the last 40 years.

Definition: transforming illiquid/non-financialproducts into tradable financial securities.

Two most common methods:

Pooling: using large pools of securities todiminish the illiquidity/risk of a single one.

Tranching: dividing cash flows into separatetranches that have different risk levels, in orderto target differing investor appetites for risk.


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Mortgage Backed SecuritiesThe 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 werepopularized: securities whose coupons were supported bypools of [numerous] mortgage securities.

IndividualMortgage

Individual

Mortgage

Individual

Mortgage

Individual

Mortgage

Individual

Mortgage

Individual

Mortgag

e

Individual

Mortgage

Individual

Mortgage

Individual

Mortgage

Individual

Mortgage

Individual

Mortgage

Individual

Mortgage

Individual

Mortgage

Individual

Mortgage

Individual

Mortgag

e

IndividualMortgageIndividua

lMortgag

eIndividual

Mortgage

Individual

Mortgage


lMortgag

e

MBS Pass-Thru

Issuer

(Fannie Mae, FreddieMac, I-Banks)

Pass-Thru

Investors


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CMOsThe next step in securitization was tranching.

CMOs = Collateralized Mortgage Obligations.

Rather than divide all the pooled mortgage cash flows equallyamong investors, CMOs divide them into separate tranches ofsecurities with different payment profiles.

Commonly, the different tranches receive different timing ofpayments.

IndividualMortgage

Individua

lMortgage

Individual

Mortgage

Individual

Mortgage

Individual

Mortgage

Individual

Mortgage

Individual

Mortgage

Individual

Mortgage

Individual

Mortgage

Individual

Mortgage

Individual

Mortgage

Individual

Mortgage

Individual

Mortgage

Individual

Mortgage

Individual

Mortgage


lMortgag

e

Pass-Thru

Individual

Mortgage

Pass-Thru

Individual

Mortgage

CMOIssuer

(I-Banks)

Tranche AInvestors

18mos-36mosTranche BInvestors

Tranche CInvestors


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Todays Agenda




~ Fin ~

Fixed in Come Overview

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