Welcome to the Jungle: Fixed Income Topics

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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 Spreads
IV. Swaps
V. Securitized Products
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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
Mortgage Backed Securities
Commodities
Corporate Bonds
Credit Derivatives
And much, much, more!
Foreign Exchange
Interest Rate Options
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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 11.7 Trn
Nasdaq3.1 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 monthly trading volume
Agency MBS 3.9 T
Agency Debt 1.5 T
Treasuries 9.6 T
NYSE
Nasdaq
NYSE 0.8 T
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.
• Didnt 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//w
ww.nasdaq.com/newsroom/stats/Performance_Report.st
m http//www.bondmarkets.com/collection.asp?colid
191 http//www.bondmarkets.com/story.asp?id296,
?id96, ?id1209, ?id304, ?id323
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Todays Agenda

• I. What is fixed income?

II. Duration
III. Yield Curves and Credit Spreads
IV. Swaps
V. Securitized Products
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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 interest rate movements.
• There are several closely related versions of
  duration, but its usually defined as the
  change in a bonds 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,
  durationtime 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
Divide the change in price by the bp change in
rates
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Duration Example (cont.)
Often, a graph of a bonds price versus yield is
helpful to understand duration.
Duration is essentially the slope at a point on
the P/Y line.
Note that duration is different for different
bonds.
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.
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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.
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DV01 in Action
On Nov. 16, at 830, 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.
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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
III. Yield Curves and Credit Spreads
IV. Swaps
V. Securitized Products
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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
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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
bonds cash flow, returns the exact same price as
the current market price.
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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 real-time measurement of the credit risk
tolerance of the market.
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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.
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Swap Spread
Other interesting spreads to observe Agency
spread and swap spread.
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Todays Agenda

• I. What is fixed income?

II. Duration
III. Yield Curves and Credit Spreads
IV. Swaps
V. Securitized Products
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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.htm
l2004mid
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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

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Todays Agenda

• I. What is fixed income?

II. Duration
III. Yield Curves and Credit Spreads
IV. Swaps
V. Securitized Products
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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.

MBS Pass-Thru Issuer (Fannie Mae, Freddie Mac,
I-Banks)
Pass-Thru Investors
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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
First 18mos payments
CMO Issuer (I-Banks)
18mos-36mos
Tranche B Investors
36mos
Tranche C Investors
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Todays Agenda

• I. What is fixed income?

II. Duration
III. Yield Curves and Credit Spreads
IV. Swaps
V. Securitized Products
Fin