i

CFA Prep Course

Level - I

Fixed Income

Study Notes

ii
Preface
Quintedge's series of CFA Exam Notes is crafted with the vision of guiding aspiring financial analysts through the rigorous and
intellectually demanding Chartered Financial Analyst (CFA) Program. Understanding the depth and breadth of knowledge
required to excel in this program, our company, operated by CFA Qualified Professionals, aims to demystify the complex world
of finance and investment.

The CFA credential symbolizes a commitment to excellence, ethical standards, and a deep understanding of financial analysis
and portfolio management. It's a path that demands not just theoretical knowledge but the ability to apply these concepts in
real-world scenarios. Every Study Note in our series is dedicated to one of the ten subjects within the CFA curriculum, ensuring a
comprehensive and focused study experience.

Our approach sets us apart. Quintedge is committed to real-life learning, integrating practical examples and contemporary case
studies to illustrate theoretical concepts. We believe that true understanding comes from seeing these theories in action, which
is why each note is filled with real-world scenarios and examples from the current financial markets. This method ensures that
learners are not just memorizing information but are truly comprehending and able to apply it.

Our team, comprising CFA Charterholders and industry experts, brings a wealth of knowledge and personal experience to the
table. They've navigated the challenges of the CFA Program themselves and understand what it takes to succeed. Their insights
have shaped these Study Notes into more than just summaries.

Quintedge is dedicated to your success. We understand the commitment you're making and the challenges ahead. As such, our
series is designed to be a companion in your journey, transforming the daunting task of preparing for the CFA exams into an
achievable goal. We stand with you, ready to turn hard work into achievement and ambition into success.

Thank you for entrusting your CFA journey to Quintedge.

Disclaimer : Quintedge’s CFA Exam Notes should be used in conjunction with the original readings as set forth by CFA Institute
in their 2024 Level I CFA Study Guide. The information contained in these Notes covers topics contained in the readings
referenced by CFA Institute and is believed to be accurate. However, their accuracy cannot be guaranteed nor is any warranty
conveyed as to your ultimate exam success.

iii
Table of Contents

Fixed Income Instrument Features ........................................................................................................... 1

1. Introduction ...................................................................................................................................................... 1
2. Features Of Fixed-Income Securities ................................................................................................................. 1
2.1. Issuer ...............................................................................................................................................................................2
2.2. Maturity ..........................................................................................................................................................................2
2.3. Principal (Par or Face Value) ...........................................................................................................................................2
2.4. Coupon Rate and Frequency ...........................................................................................................................................3
2.5. Seniority ..........................................................................................................................................................................3
2.6. Contingency Provisions ...................................................................................................................................................3
2.7. Yield Measures ................................................................................................................................................................3
2.8. Yield Curves .....................................................................................................................................................................3
3. Bond Indentures And Covenants ....................................................................................................................... 4
3.1. Bond Indentures ..............................................................................................................................................................4
3.2. Sources of Repayment ....................................................................................................................................................5
3.3. Bond Covenants ..............................................................................................................................................................5

Fixed-Income Cash Flows and Types ......................................................................................................... 6

1. Introduction ...................................................................................................................................................... 6
2. Fixed Income Cash Flow Structures ................................................................................................................... 6
2.1. Bullet bond ......................................................................................................................................................................6
2.2. Amortizing Debt ..............................................................................................................................................................6
2.3. Variable Interest Debt .....................................................................................................................................................8
2.4. Zero-Coupon Structures ..................................................................................................................................................8
2.5. Deferred Coupon Structures ...........................................................................................................................................9
3. Fixed Income Contingency Provisions ............................................................................................................... 9
3.1. Callable Bonds .................................................................................................................................................................9
3.2. Putable Bonds .................................................................................................................................................................9
3.3. Convertible Bonds ...........................................................................................................................................................9
4. Legal, Regulatory & Tax Considerations .......................................................................................................... 10
4.1. Legal & Regulatory Considerations ...............................................................................................................................10
4.2. Tax Considerations ........................................................................................................................................................11

Fixed-Income Issuance and Trading........................................................................................................ 13

1. Introduction .................................................................................................................................................... 13
2. Fixed-Income Segments, Issuers, And Investors ............................................................................................. 13
3. Fixed Income Indexes ...................................................................................................................................... 14
4. Primary And Secondary Fixed-Income Markets .............................................................................................. 14
4.1. Primary Fixed-Income Markets .....................................................................................................................................15
4.2. Secondary Fixed-Income Markets .................................................................................................................................15

Fixed-Income Markets for Corporate Issuers .......................................................................................... 16

1. Introduction .................................................................................................................................................... 16
2. Short-Term Funding Alternatives .................................................................................................................... 16
2.1. External Loan Financing.................................................................................................................................................16
2.2. External, Security-Based Financing ...............................................................................................................................17
2.3. Short-Term Funding Alternatives for Financial Institutions ..........................................................................................17
3. Repurchase Agreements ................................................................................................................................. 19
3.1. Repurchase Agreement Applications and Benefits .......................................................................................................20
3.2. Risks Associated with Repurchase Agreements ............................................................................................................21

iv
 4. Long-Term Corporate Debt ............................................................................................................................. 21
4.1. Similarities between Long-Term Investment-Grade (IG) and High-Yield (HY) Issuance ...............................................21
4.2. Differences between IG and HY Issuance ......................................................................................................................22

Fixed-Income Market for Government Issuers ........................................................................................ 23

1. Introduction .................................................................................................................................................... 23
2. Sovereign Debt ................................................................................................................................................ 23
3. Sovereign Debt Issuance And Trading ............................................................................................................. 25
4. Non-Sovereign, Quasi-Government, And Supranational Agency Debt ........................................................... 26
4.1. Government Agencies ...................................................................................................................................................26
4.2. Local and Regional Government Authorities.................................................................................................................26
4.3. Supranational Organizations .........................................................................................................................................26

Fixed-Income Bond Valuation - Price and Yield ....................................................................................... 27

1. Introduction .................................................................................................................................................... 27
2. Bond Pricing and the Time Value of Money .................................................................................................... 27
2.1. Bond Pricing with a Market Discount Rate....................................................................................................................27
2.2. Yield-to-Maturity ...........................................................................................................................................................29
2.3. Flat Price, Accrued Interest, and the Full Price .............................................................................................................29
3. Relationships between Bond Prices and Bond Features ................................................................................. 30
3.1. Inverse Relationship ......................................................................................................................................................30
3.2. Coupon Effect ................................................................................................................................................................30
3.3. Maturity Effect ..............................................................................................................................................................31
3.4. Constant-Yield Price Trajectory .....................................................................................................................................31
3.5. Convexity Effect.............................................................................................................................................................31
4. Matrix Pricing .................................................................................................................................................. 31
4.1. Matrix Pricing Process ...................................................................................................................................................32

Yield and Yield Spread Measures for Fixed-Rate Bonds .......................................................................... 33

1. Introduction .................................................................................................................................................... 33
2. Periodicity and Annualized Yields.................................................................................................................... 33
3. Other Yield Measures, Conventions, and Accounting for Embedded Options................................................ 35
3.1. Other Yield Measures and Conventions ........................................................................................................................35
3.2. Bonds with Embedded Options .....................................................................................................................................36
4. Yield Spread Measures for Fixed-Rate Bonds and Matrix Pricing ................................................................... 37
4.1. Yield Spreads over Benchmark Rates ............................................................................................................................37
4.2. Yield Spreads over the Benchmark Yield Curve .............................................................................................................39

Yield and Yield Spread Measures for Floating Rate Instruments ............................................................. 41
1. Introduction .................................................................................................................................................... 41
2. Yield And Yield Spread Measures For Floating-Rate Notes ............................................................................. 41
2.1. Yield and Yield Spread Measures for Floating-Rate Instruments ..................................................................................41
3. Yield Measures For Money Market Instruments ............................................................................................. 43

The Term Structure of Interest Rates: Spot, Par, and Forward Curves ..................................................... 46
1. Introduction .................................................................................................................................................... 46
2. Maturity Structure Of Interest Rates And Spot Rates ..................................................................................... 46
2.1. Maturity Structure of Interest Rates .............................................................................................................................46
2.2. Bond Pricing Using Spot Rates.......................................................................................................................................47
3. Par And Forward Rates .................................................................................................................................... 48
v
 3.1. Par Rates from Spot Rates .............................................................................................................................................48
3.2. Forward Rates from Spot Rates.....................................................................................................................................49
3.3. Spot Rates from Forward Rates and Bond Pricing with Forward Rates ........................................................................49
4. Spot, Par, And Forward Yield Curves And Interpreting Their Relationship ..................................................... 50

Interest Rate Risk and Return ................................................................................................................ 53

1. Introduction .................................................................................................................................................... 53
2. Sources Of Return From Investing In A Fixed-Rate Bond ................................................................................ 53
2.1. Case 1 ............................................................................................................................................................................53
2.2. Case 2 ............................................................................................................................................................................53
2.3. Case 3 ............................................................................................................................................................................54
3. Investment Horizon And Interest Rate Risk .................................................................................................... 54
4. Macaulay Duration .......................................................................................................................................... 56

Yield-Based Bond Duration Measures and Properties ............................................................................. 58

1. Introduction .................................................................................................................................................... 58
2. Modified Duration ........................................................................................................................................... 58
2.1. Approximate Modified Duration ...................................................................................................................................59
3. Money Duration And Price Value Of A Basis Point .......................................................................................... 60
3.1. Yield Duration of Zero-Coupon and Perpetual Bonds ...................................................................................................60
3.2. Duration of Floating-Rate Notes and Loans ..................................................................................................................61
4. Properties Of Duration .................................................................................................................................... 61

Yield-Based Bond Convexity and Portfolio Properties ............................................................................. 64

1. Introduction .................................................................................................................................................... 64
2. Bond Convexity And Convexity Adjustment .................................................................................................... 64
2.1. Spreadsheet ..................................................................................................................................................................65
2.2. Approximation Method .................................................................................................................................................65
3. Bond Risk And Return Using Duration And Convexity ..................................................................................... 66
4. Portfolio Duration And Convexity ................................................................................................................... 67

Curve-Based and Empirical Fixed-Income Risk Measures ........................................................................ 69

1. Introduction .................................................................................................................................................... 69
2. Curve-Based Interest Rate Risk Measures ....................................................................................................... 69
3. Bond Risk And Return Using Curve-Based Duration And Convexity................................................................ 71
4. Key Rate Duration As A Measure Of Yield Curve Risk ..................................................................................... 72
5. Empirical Duration ........................................................................................................................................... 73

Credit Risk ............................................................................................................................................. 75

1. Introduction .................................................................................................................................................... 75
2. Sources Of Credit Risk ..................................................................................................................................... 75
2.1. Sources of Credit Risk ....................................................................................................................................................76
2.2. Measuring Credit Risk ...................................................................................................................................................77
3. Credit Rating Agencies And Credit Ratings ...................................................................................................... 78
3.1. Credit Ratings ................................................................................................................................................................79
3.2. Credit Rating Considerations .........................................................................................................................................79
4. Factors Impacting Yield Spreads...................................................................................................................... 80
4.1. Macroeconomic Factors ................................................................................................................................................80
vi
 4.2. Market Factors ..............................................................................................................................................................80
4.3. Issuer-Specific Factors ...................................................................................................................................................81
4.4. The Price Impact of Spread Changes .............................................................................................................................81

Credit Analysis for Government Issuers .................................................................................................. 84

1. Introduction .................................................................................................................................................... 84
2. Sovereign Credit Analysis ................................................................................................................................ 84
2.1. Qualitative Factors ........................................................................................................................................................84
2.2. Quantitative Factors ......................................................................................................................................................85
3. Non-Sovereign Credit Risk ............................................................................................................................... 86
3.1. Non-Sovereign Government Debt .................................................................................................................................86
3.2. Agencies ........................................................................................................................................................................86
3.3. Government Sector Banks and Development Financing Institutions ............................................................................86
3.4. Supranational Issuers ....................................................................................................................................................87
3.5. Regional Government Issuers .......................................................................................................................................87

Credit Analysis for Corporate Issuers ...................................................................................................... 89

1. Introduction .................................................................................................................................................... 89
2. Assessing Corporate Creditworthiness ............................................................................................................ 89
2.1. Qualitative Factors ........................................................................................................................................................89
2.2. Quantitative Factors ......................................................................................................................................................90
3. Financial Ratios In Corporate Credit Analysis .................................................................................................. 90
4. Seniority Rankings, Recovery Rates, And Credit Ratings ................................................................................. 91
4.1. Seniority Rankings .........................................................................................................................................................91
4.2. Secured versus Unsecured Debt ...................................................................................................................................92
4.3. Recovery Rates ..............................................................................................................................................................92
4.4. Issuer and Issue Ratings ................................................................................................................................................92

Fixed-Income Securitization ................................................................................................................... 94

1. Introduction .................................................................................................................................................... 94
2. The Benefits of Securitization.......................................................................................................................... 94
2.1. Benefits to Issuers .........................................................................................................................................................95
2.2. Benefits to Investors .....................................................................................................................................................95
2.3. Benefits to Economies and Financial Markets ..............................................................................................................96
3. The Securitization Process ............................................................................................................................... 96
3.1. An Example of a Securitization ......................................................................................................................................96
3.2. Parties to a Securitization..............................................................................................................................................97
3.3. The Role of the SPE .......................................................................................................................................................97

Asset-Backed Security (ABS) Instrument and Market Features ............................................................... 99

1. Introduction .................................................................................................................................................... 99
2. Covered Bonds ................................................................................................................................................ 99
3. ABS Structures To Address Credit Risk .......................................................................................................... 100
3.1. Credit Enhancement....................................................................................................................................................100
3.2. Credit Tranching ..........................................................................................................................................................100
4. Non-Mortgage Asset-Backed Securities ........................................................................................................ 101
4.1. Credit Card Receivable ABS .........................................................................................................................................102
4.2. Solar ABS .....................................................................................................................................................................103
5. Collateralized Debt Obligations ..................................................................................................................... 103
5.1. Generic CLO Structure .................................................................................................................................................104

vii
Mortgage-Backed Security (MBS) Instrument and Market Features ..................................................... 106
1. Introduction .................................................................................................................................................. 106
2. Time Tranching .............................................................................................................................................. 106
2.1. Prepayment Risk..........................................................................................................................................................106
3. Mortgage Loans And Their Characteristic Features ...................................................................................... 107
3.1. Agency and Non-Agency RMBS ...................................................................................................................................107
3.2. Mortgage Contingency Features .................................................................................................................................107
4. Residential Mortgage-Backed Securities (RMBS) .......................................................................................... 108
4.1. Collateralized Mortgage Obligations (CMOs) ..............................................................................................................109
4.2. Other CMO Structures .................................................................................................................................................110
5. Commercial Mortgage-Backed Securities (CMBS)......................................................................................... 110
5.1. CMBS Structure ...........................................................................................................................................................111
5.2. CMBS Risks ..................................................................................................................................................................111

viii
Fixed Income - Learning Module 1
for the CFAâ exam
Fixed Income Instrument Features
Learning Outcomes :

The candidate should be able to:

a) Describe the features of a fixed-income security

b) Describe the contents of a bond indenture and contrast affirmative and negative covenants

1. Introduction

Fixed-income instruments, such as loans and bonds, are commonly used for financing by businesses, governments, and not-
for-profits. They promise to pay interest and repay borrowed principal to investors. Loans are used between individuals or
companies and banks, while bonds are standardized instruments traded more easily and are issued by larger entities. Bonds
are widely held by investors like mutual funds, pension plans, insurance companies, and central banks. This module explains
the features of fixed-income instruments and their legal contracts.

2. Features Of Fixed-Income Securities

LOS (a) : Describe the features of a fixed-income security

Fixed-income instruments are debt instruments like loans and bonds. Loans are private agreements between individuals or
companies and financial intermediaries, while bonds or fixed-income securities are standardized agreements between larger
issuers and investors. Bond issuers borrow money for operations or capital expenditures, and bond investors lend money in
exchange for interest payments and repayment of principal. Corporate issuers typically have multiple types of debt obligations
with different features such as time to maturity, seniority, and currency

Which liabilities are fixed-income instruments?

The balance sheets of corporate issuers composed of assets and the liabilities and equity that finance them. Liabilities are broadly defined by
accounting standards as present obligations to transfer economic resources as a result of past events. This definition encompasses many types
of obligations, including amounts that an issuer owes to suppliers, customers, employees, governments, retirees, lessors, and so on.

Not all liabilities are fixed-income instruments (or “debt”), but all fixed-income instruments are liabilities. In the modules on fixed income, from
the perspective of a corporate issuer, we focus only on loans and bonds: instruments that can be settled in cash and for which the counterparty
is an investor or a bank. Other liabilities, particularly leases and pension obligations, share some characteristics with fixed-income instruments
but are outside the scope of these modules

Note that government issuers tend to be financed by bonds, not by loans, though some exceptions exist—for example, loans from supranational
organizations such as the International Monetary Fund (IMF).

1
The committed periodic cash flows of a bond distinguish it from equity securities.

The adjoining image shows the cash flows of a fixed-

rate bond issued by a BRWA corporation. Investors
initially purchase a bond by providing cash equal to
the bond's principal or par value. This par value
represents the amount borrowed. Subsequently, on
each interest payment date, the issuer commits to
paying bond investors an interest payment, or
coupon, which is calculated by multiplying the coupon
rate by the par value of the bond. If the bond has a
maturity period shorter than a year, the annual
coupon amount is divided into smaller equal periodic
payments. Finally, on the bond's maturity date, the
issuer repays the final fixed coupon and the principal
amount to investors.

Key bond features (as shown below) include the issuer, time to maturity, principal amount, coupon rate and frequency, seniority,
and contingency provisions.

2.1. Issuer

Bond issuers can be any legal entity like government entities or private companies and is liable for all interest and principal
payments. Government issuers include national and local governments, supranational organizations (like World Bank), and quasi-
government entities (like national railways or postal services). Sovereign bonds are considered low-risk due to the backing of
taxation and fiscal power of the issuing government. Private sector issuers include corporate issuers and special purpose entities
tied to assets like loans or receivables using Asset backed securities (discussed further).

2.2. Maturity

Bonds have a maturity date which is the date of the final payment to investors, while the tenor refers to the remaining time to
maturity. Money market securities have a tenor of one year or less at issuance, while capital market securities have a longer
tenor at issuance. Perpetual bonds have no stated maturity and can be issued by public sector entities, local governments, local
authorities, and banks for regulatory capital requirements. Distinct from equities, perpetual bonds have defined cash flows, no
voting rights, and greater seniority in the capital structure

2.3. Principal (Par or Face Value)

2
Principal is the amount an issuer agrees to repay to investors at maturity. In some cases, the principal may be repaid in equal or
variable increments over time, such as with a mortgage loan where principal is repaid over time and not as a lump-sum at maturity.

2.4. Coupon Rate and Frequency

A bond’s interest can be paid as

o a fixed coupon paid on specified dates,

o a variable coupon determined and paid on specified dates, or
o part of a single payment with the principal at maturity

Fixed-coupon bond payments are typically made regularly on a monthly, quarterly, semi-annual, or annual basis, with corporate
bonds usually paying semi-annually.

Floating-rate notes (FRNs) are bonds with variable interest payments. The coupon rate of an FRN is determined by a combination
of a market reference rate (MRR) and an issuer- specific credit spread. The MRR is a standard borrowing or lending rate for low
default risk issuers, while the credit spread represents the issuer’s credit quality (higher quality equates to lower spread), is set at
the time of issuance and remains constant throughout the bond's life. The MRR resets periodically based on market factors,
causing the coupon rate and interest payment to change accordingly.

Zero-coupon bonds are bonds that don't pay interest periodically but instead pay interest and principal together at maturity. They
are usually issued at a discount to par value, with the difference between the price paid and the par value representing the
cumulative interest payment.

2.5. Seniority

Debt seniority determines the order in which debts are repaid, with senior debt having priority over junior debt in case of
bankruptcy or liquidation.

2.6. Contingency Provisions

A contingency provision is a clause in a legal agreement that allows for a specific action based on certain events or circumstances.
In bonds, common contingency provisions include options for call, put, and conversion to equity. These embedded options cannot
be traded separately from the bond, but their value can be calculated by comparing the value of the bond with this provision to
that of a similar standard bond from the same issuer.

We can use the features of a bond issue to model its cash flows. (Will be discussed in the next module)

2.7. Yield Measures

Given a bond’s expected cash flows and its price, return or yield measures can be calculated. Current yield (CY), is one such
measure which is equal to the bond’s annual coupon divided by the bond’s price and expressed as a percentage . For example, if
a 5- year bond with annual coupon rate of 3.2% were trading at a price of USD101 per USD100 in face value at time t, its current
yield would be:

è CYt = Annual Coupont/Bond pricet = 3.2%/1.01 = 3.168%.

The current yield is analogous to the dividend yield for an equity security.

Yield-to-maturity (YTM) is a little complex but a more common measure of a bond's yield, calculated using the bond's price and
expected cash flows. It is analogous to IRR discussed in an earlier module and it represents the investor's rate of return only if

o all scheduled payments are received,

o the bond is held until maturity, and
o all cash flows are reinvested at the YTM.

If any of these assumptions are not met, the investor's actual rate of return will differ from the YTM. Notice that these are the
same IRR assumptions discussed in earlier modules.

2.8. Yield Curves

3
A yield curve (as shown in the image below) is a graphical representation of the yield to maturity (YTM) on an issuer's debt
instruments with similar features, plotted against their respective times to maturity. For example an issuer has six bond issues
outstanding (identified by the dots where the X-Y co-ordinates represent the YTM and Time-to-maturity). The 3.2%, five-year bond
is the third point from the left

This example indicates that due to higher risks with longer maturities, Investors demand higher returns for longer-maturity bonds.

To measure credit risk (i.e. default risk in debt securities), we can compare an issuing corporations yield curve to that of
comparable sovereign bonds (which are usually free from default-risks). The image below shows the yield curve for a US
corporation versus the yield curve for comparable sovereign bonds in the United States, which are US Treasuries.

The yield-to-maturity difference between the five-year corporate bond and the five- year US Treasury bond is 90 bps (= 3.2% −
2.3%), which reflects compensation that investors demand for taking the additional credit risk.

3. Bond Indentures And Covenants

LOS (b) : Describe the contents of a bond indenture and contrast affirmative and negative covenants

3.1. Bond Indentures

4
The bond indenture is a legal contract that outlines the features of a bond discussed earlier, along with the issuer's obligations,
and the bondholders' rights. It also specifies the sources of repayment, commitments to bondholders, and provisions to ensure
full debt repayment

3.2. Sources of Repayment

The sources of bond repayment determine a bond's risk. Government bonds have the highest credit quality due to their ability to
tax economic activity and print currency, making them less likely to default. They are used as a benchmark for bond market risk.
Local or regional governments can use taxes or fees from infrastructure projects (toll roads, public transit systems) to repay bond
issues.
Investors in corporate bonds depend on the firm's operating cash flows for interest and principal payments.

Higher credit quality corporate issuers usually issue unsecured bonds, relying solely on cash flows for repayment. Less stable
issuers may offer secured bonds with a legal claim (pledge) on specific assets, providing a secondary source of repayment. In
default, secured debtholders have priority in receiving the value of designated assets, while unsecured debtholders receive funds
after this allocation. Junior unsecured bondholders are the last creditors in line in cases of default because all secured and senior
unsecured would be settled first.
Investors consider operating cash flows and collateral when assessing credit quality. Collateral can include physical assets, cash
flows, or financial guarantees. Issuers need to balance the benefits of credit enhancements with reduced operating flexibility.

3.3. Bond Covenants

Bondholders have limited influence compared to equity investors who have voting rights, except when there are legally
enforceable rules or bond covenants in place. Affirmative covenants outline what issuers must do, while negative covenants
specify what they are not allowed to do.

Affirmative covenants are administrative in nature and include provisions such as using bond proceeds correctly, providing
financial reports, and allowing bondholders to redeem bonds at a premium if the issuer is acquired. Affirmative covenant examples
include Pari passu clause which ensures equal treatment for debt obligations of similar seniority, cross-default clause which
considers a borrower to default if it default on another debt obligation. These covenants do not impose costs or restrict the issuer's
business operations significantly

Negative covenants are restrictions placed on issuers to protect bondholders. These restrictions can include limitations on -
investments, asset disposal, or issuing debt senior to existing obligations (this is known as a negative pledge clause). The purpose
of negative covenants is to ensure that the issuer can make interest and principal payments. However, overly restrictive covenants
may not be beneficial for bondholders if they force the issuer into default. Violating covenants can lead to consequences such as
changes in financial terms, increased interest rates, accelerated debt payments, or termination of the debt agreement.

Lower credit quality issuers face additional covenants to protect bondholders in case of financial deterioration. In these cases
certain financial ratios are monitored and the ability to pay dividends to shareholders, repurchase shares, and / or take on
additional debt is restricted unless tighter financial restrictions are met. This is put under an incurrence test section of the
indenture and examples include “Test is met if issuer has (a) Net Interest Bearing Debt to EBITDA not greater than 4.50× and (b)
Interest Coverage Ratio greater than 3.0× for each financial reporting period “

The following table shows a Prospectus Summary for 6.5 % ABC incorporated Seven-Year Callable Notes (The “Notes”)

Issuer: ABC Incorporated

Settlement Date: [T + 3 Business Days]
Maturity Date: [Seven Years from Settlement Date]
Principal Amount: USD400 million
Interest: 6.5% fixed coupon
Interest Payment: Starting six months from [Settlement Date] to be paid semi-annually with final payment on [Maturity Date]
The Notes are secured and unsubordinated obligations of VIVU and rank pari passu with all other secured and
Seniority:
unsubordinated debt
The Issuer may redeem some or all of the Notes on any Business Day before [Maturity] starting three years
Call Provision: after [Settlement] based on the Call Price Schedule as a percentage of the Principal Amount plus accrued
interest
103.25% [Three to Four Years after Settlement] 102.50% [Four to Five Years after Settlement] 101.75% [Five to
Call Price Schedule:
Six Years after Settlement] 101.00% [Six to Seven Years after Settlement]
Transaction Security: The Notes are secured by a pledge of certain assets as identified in the Indenture.

5
 for the CFAâ exam

Restriction on Additional Unless the Incurrence Test is met, the Issuer shall not issue additional debt unless it is (a) subordinated or (b)
Debt: a working capital facility up to 20% of the Principal Amount of Notes outstanding.
Restrictions on Dividends The Issuer shall not (i) pay any dividend in respect of its shares, (ii) repurchase any of its own shares, or (iii)
and Distributions: reduce share capital with repayment to shareholders unless the Incurrence Test is met.
Issuer must maintain (a) Net Interest Bearing Debt to EBITDA not greater than 5.00× and (b) Interest Coverage
Debt Restriction Test:
Ratio greater than 2.50× for each financial reporting period.
Test is met if issuer has (a) Net Interest Bearing Debt to EBITDA not greater than 4.50× and (b) Interest Coverage
Incurrence Test:
Ratio greater than 3.0× for each financial reporting period.

Fixed Income - Learning Module 2

Fixed-Income Cash Flows and Types
Learning Outcomes :

The candidate should be able to:

a) Describe common cash flow structures of fixed-income instruments and contrast cash flow contingency provisions that
benefit issuers and investors
b) Describe how legal, regulatory, and tax considerations a affect the issuance and trading of fixed-income securities

1. Introduction

Every fixed income instrument like a loan or a bond etc. has certain features which determine the amount and timing of the
associated cash flows. Here we will discuss some common cash flow structures/schedules and understand their implication for
issuers and investors. Finally we’ll discuss the legal, regulatory and tax considerations across jurisdictions faced by fixed-income
issuers and investors.

2. Fixed Income Cash Flow Structures

LOS (a) : Describe common cash flow structures of fixed-income instruments and contrast cash flow contingency provisions that
benefit issuers and investors

2.1. Bullet bond

Most common bond cash flow structure is of the standard fixed-

coupon bond. The original principle is paid back at maturity and
all the intermediate payments are only interest payments.
Adjoined image shows the bullet bond structure of a 5 year, $300
million, 3.2% semi-annual coupon bond.

2.2. Amortizing Debt

These are fixed-income instruments that periodically repay a portion of the principal amount before maturity, such as commercial
& real estate mortgage loans. Allows borrowers to evenly distribute their payments over time, benefits investors with higher cash
flows in the near term compared to bullet bonds, reduces credit risk as the borrower's liability decreases but increases
reinvestment risks for the investors. It is primarily of 2 types :

o Full amortisation : The entire principal amount is retired over time

o Partial amortisation : A portion of the principal amount is retired through the periodic payments and the remaining portion
is retired at maturity
6
 Example
Full amortisation vs Partial amortisation

Consider the same bond as in the earlier bullet payment structure i.e. 5 year, $300 million, 3.2% semi-annual coupon rate.

Case 1 : Full Amortisation Case 2 : Partial Amortisation

o Has an equal semi-annual payment consisting of interest and o A contractual provision where the issuer makes a balloon
principal payment equal to let’s say half the principal amount, to be paid
o Periodic payment given by the formula : at maturity, remaining principal would be retired periodically
as if it was a full amortisation on the remaining principal
o Essentially, this provision combines the bullet and full
amortisation structure
Where, o The above implies :
A = periodic payment o $150 balloon payment at maturity
r = interest rate per period ( 3.2% / 2 ) o A 5 year full amortised $150 notional instrument
Principal = Principal amount of bond/loan ( $300million) o The sum of present value of these two should be equal to the
N = Number of payment periods ( 5 x 2 = 10 ) bond price. Let’s say the bond was purchased at par value

A = $32.70 million every 6 months Since, PV of the balloon payment = $150 / ( 1 + 3.2%/2 )^10
= $127.98
First payment breakdown : Thus, principal payment to be amortised = $300 - $127.98 = $172

Interest portion = $300 x (3.2%)/2 = $4.80 The periodic payment = $18.75 =

Principal portion = $32.70 - $4.80 = 27.90
Remaining principal = $300 - $27.90 = $272.10 The payment breakdowns would be similar to full amortisation case
with initial principal of $172
Second payment breakdown :

Interest portion = $272.10 x (3.2%)/2 = $4.35

( New principal would be used ) o As shown in the image below, the green and blue portions
Principal portion = $32.70 - $4.35 = $28.35 represent the interest and principle payments respectively. The
( Periodic payment remains same ) final $168.75 payment is the sum of $18.75 periodic payment
Remaining principal = $272.10 - $28.35 = $243.75 and the $150 balloon payment

o Similarly for the remaining 8 payments. Over time, the interest

portion declines while principle portion increases. This can be
seen in the image below : The green portion is the interest and
the blue portion is the principle payment respectively

The following table compares the different payment structures :

Year Bullet Bond Partially Amortizing Bond Fully Amortizing Loan

0 –300 –300 –300
0.5 4.8 18.75 32.7
1 4.8 18.75 32.7
1.5 4.8 18.75 32.7
7
 2 4.8 18.75 32.7
2.5 4.8 18.75 32.7
3 4.8 18.75 32.7
3.5 4.8 18.75 32.7
4 4.8 18.75 32.7
4.5 4.8 18.75 32.7
5 304.8 168.75 32.7

There are two other commonly used bond amortization arrangements:

2.2.1. Sinking Funds

Primarily used by government and some corporate issuers to periodically retire a bond's outstanding principal. It involves
the issuer setting aside funds over time in an escrow account to pay off the bond early as per agreed terms. The issuer
can repurchase bonds from among investors at random. Sinking funds reduce credit risk but increase reinvestment risk
for associated investors.

2.2.2. Waterfall Structures

Assigns different investor classes with varying
priority of claims to the same cash flows.
Interest / coupon payments are typically
distributed equally amongst all but principal
repayment occurs sequentially. The most
senior investor class in the capital structure
receives principal payments first, followed by
the second-highest ranked investors once the
senior class is fully repaid. Commonly used in asset-backed securities and mortgage-backed securities.

2.3. Variable Interest Debt

Some bonds and loans have variable interest payments based on a market reference rate (MRR) and a credit spread. Attractive to
investors looking to benefit from rising interest rates or financial intermediaries like banks looking to balance interest rate
exposure of assets (mortgages) vs liabilities (deposits). Variable-rate instruments reduce interest rate risk but still carrying credit
risk. Variable-rate instruments may have predetermined or event-based adjustment mechanisms where the bond coupon
increases by specified margins at specific dates. Known as step-up bonds, these can protect against rising interest rates or an
issuers deteriorating credit quality. Coupon changes may also be linked to financial covenants or credit ratings, known as credit-
linked notes.

2.3.1. Payment in-Kind (PIK) Feature

Issuers concerned about future cash flow issues may add a PIK feature to a loan or bond. This allows a cash strapped issuer
to convert periodic interest payment into higher bond principal.

2.3.2. Index-Linked Bonds

These bonds have interest and/or principal payments linked to a specified index. Inflation-linked bonds, tied to consumer
price indices, are the most common type. They protect against inflation by providing inflation-adjusted cash flows. Examples
include Treasury Inflation-Protected Securities (TIPS) in the US. These are of two types :

o Capital-Indexed Bonds: These bonds, like TIPS, have periodic principal adjustments based on a price index,
protecting the real value of debt principal. In case of deflation which causes principal to decline, investors usually
receive the greater of the inflation-adjusted principal or par at maturity.
o Interest-Indexed Bonds: These bonds pay a fixed nominal principal amount at maturity but have an index-linked
coupon that adjusts for inflation. They are more commonly issued by private financial intermediaries than by
governments.

2.4. Zero-Coupon Structures

Also known as discount bonds, repay only the principal at maturity and have no periodic coupon payments. These bonds are priced
below par when interest rates are positive. Investors earn a return from the difference between the purchase price and the

8
principal amount, which represents cumulative interest paid at maturity. From investors perspective, useful for funding fixed
future obligations as reduce reinvestment risk associated with the coupon paying debt instruments

2.5. Deferred Coupon Structures

Delay interest payments in the initial years and provide higher coupons later in the bond's life. They are typically issued by entities
looking to conserve immediate cash, possibly indicating lower credit quality or financing a project without immediate income. Like
zero-coupon bonds, deferred coupon bonds are usually priced below par because the higher future coupon doesn't compensate
for the missed interest in the earlier periods.

3. Fixed Income Contingency Provisions

LOS (a) : Describe common cash flow structures of fixed-income instruments and contrast cash flow contingency provisions that
benefit issuers and investors

Contingency provisions are clauses in legal agreements that enable specific actions in response to events or circumstances. In the
context of bonds, common contingency provisions, often referred to as embedded options, allow the issuer or bondholders to
take specific actions as outlined in the bond indenture. These embedded options are integrated with the bond contract and cannot
be traded separately. Their value is determined by comparing bonds with contingency provisions to those without them. The most
common types of bonds with contingency provisions are callable bonds, putable bonds and convertible bonds.

3.1. Callable Bonds

A callable bond provides the issuer the right to buy back the bond from investors before its maturity date. This feature provides
the issuer with the flexibility to refinance debt if market interest rates fall. Callable bonds often have a specified call protection
period during which the call feature cannot be used. During the call period i.e. the period where it can be called, either a schedule
specifies the call price or a predetermined fixed call price can be used.

The value of the call feature depends on the relationship between the bond's yield to maturity (YTM) and its coupon rate :

o YTM > Coupon Rate : No benefit to issuer, the callable bond behaves like a non-callable one.
o YTM < Coupon Rate : Beneficial for issuer, callable bond’s price capped according to the call price where non-callable
continue to rise

Due to this asymmetry in favour of issuer, Investors demand higher yields and pay lower prices for callable bonds due to the
uncertainty of when they might be called. This uncertainty is also known as call risk.

3.2. Putable Bonds

Putable bond provides the bondholder with the right to surrender the bond to the issuer at a predetermined price ( usually the
par value of the bond ).

The value of the put feature depends on the relationship between the bond's yield to maturity (YTM) and its coupon rate :

o YTM > Coupon Rate : Beneficially to investor, able to put back the bond to the issuer and able to reinvest the proceeds at
higher rates. The issuer is forced to refinance at higher rates. The put price provides a floor to the falling prices.
o YTM < Coupon Rate : No benefit to investor, price movement similar to non-putable bond

Asymmetry in favour of investor, hence bonds are issued at premium relative to similar non-putable bonds.

3.3. Convertible Bonds

A convertible bond is a debt instrument that allows bondholders to exchange it for the issuer's common shares in the future at a
predetermined price known as the conversion price. The conversion feature becomes more valuable to investors as the share
price appreciates, and compared to callable & putable bonds, this feature replaces debt with equity when exercised. Investors
may accept a low or even zero yield in exchange for conversion rights.

The conversion ratio determines how many common shares a bond can be converted into based on a specific par value & is given
by
9
 è Conversion ratio = Convertible bond par value / Conversion price

To determine the value of this conversion feature, the convertible bond’s price can be compared with its share value if converted
immediately. This conversion value is calculated as :

è Conversion value = Conversion ratio x Current share price

Convertible bond prices generally follow the issuer's share price. If the share price is below the conversion price, the convertible
bond behaves like a standard non-convertible bond. If the share price is significantly higher, the bond's price aligns with its
conversion value.

These bonds are commonly used by growth companies looking to raise equity at a higher conversion price in the future. They may
include features like a call provision that allows issuers to redeem bonds early to limit investor gains from share price appreciation.

3.3.1. Warrants
Some issuers may issue warrants with bonds. They grant bondholders the option to purchase the issuer's stock at a fixed
exercise price until the warrant's expiration date. Since they are attached to the bond rather than embedded with it, they
are traded separately in financial markets. Used by investors for potential yield enhancement by using the conversion
feature.

3.3.2. Contingent convertible bonds (CoCos)

They are a type of convertible bonds that automatically converts into equity if specific events, like a drop in the issuer's
capital ratio, occur. Unlike simple convertibles which are voluntarily exercised when price levels change, Cocos are
automatically triggered on the downside if a specific event like ‘breach of minimum regulatory capital requirement’ occurs.
CoCos are designed to reduce systemic risk in the financial system & offer investors higher yields than otherwise similar
bonds.

Example
Company ABC Convertible Bond Term sheet

Maturity Date: 5 Years from Settlement Date unless the Notes are redeemed earlier in a Conversion
Principal Amount: EUR300 million
Interest: 1.25% fixed coupon to be paid annually starting One Year from the Settlement Date with the final coupon paid at
Maturity
Seniority: These Notes are an unsecured obligation of ZTGB and rank equivalent with other unsecured debt
Conversion Provision: An Investor has, at its sole option, the right to convert a portion or the full sum of the Principal Amount, or any
part outstanding at any time at the Conversion Price during the Conversion Period
Current Share Price: EUR28.00 per ABC common equity share
Conversion Price: EUR42.00 per ABC common equity share
Conversion Period: Any Business Day starting One Year from the Settlement Date through the Maturity Date

Conversion ratio = Convertible bond par value / Conversion price

If ABC bond trades in EUR1,000 face value units, then Conversion ratio = EUR1000/EUR42 = 23.81 shares per Convertible bond

Conversion value = Conversion ratio x Current Share price = 23.81 x Current Share price

This conversion value would be compared with the market price of the bond to decide the use of the conversion feature

4. Legal, Regulatory & Tax Considerations

LOS (b) : Describe how legal, regulatory, and tax considerations affect the issuance and trading of fixed-income securities

4.1. Legal & Regulatory Considerations

10
Fixed-income securities are subject to different legal and regulatory requirements depending on where they are issued and traded,
as well as who holds them. Based on the jurisdictions of the issuer and the issuance, a bond can be classified as a domestic, foreign,
or Eurobond.

4.1.1. Domestic Bonds

Bonds issued by entities within the same country in which they are issued and traded are called domestic bonds.

4.1.2. Foreign Bonds

Those issued by entities from other countries are termed foreign bonds. Corporate issuers often use foreign bonds to
match the currency of their financing with their foreign operations. Emerging market sovereign governments often issue
foreign bonds in major currencies to attract a broader investor base and diversify beyond domestic markets.

4.1.3. Eurobond Market

The Eurobond market was created to escape the US regulation. Eurobonds are issued outside any single jurisdiction, are
usually unsecured, and can be denominated in various currencies. They are usually named for the currency in which they
are denominated, such as Eurodollar and Euroyen bonds. They are usually underwritten by a group of financial
intermediaries from different jurisdictions They are primarily sold in Europe, the Middle East, and Asia. For eg : A Chinese
firm requiring US dollars would have to deal with US regulations while trying to issue foreign bonds in the US market. To
bypass, Eurodollar bonds can be issued outside the US market to raise US dollars without dealing with the regulations

4.1.4. Global Bonds

Bonds which are issued in both the Eurobond and at least one domestic bond market, ensuring broader access to fixed-
income investors worldwide.
Many market participants refer to foreign bonds, Eurobonds & global bonds as International bonds. So on a broader level, we get
two divisions: Domestic bonds vs International Bonds.

Note : The currency in which a bond is denominated has a stronger impact on its price than the market where it is issued or traded.
This is because the market interest rates most affecting the bond prices are closely related to the underlying currency.

4.2. Tax Considerations

The following point highlight how tax treatment of fixed-income securities is crucial for both issuers and investors :

o Corporate issuers consider the tax deductibility of interest expense when deciding between debt and equity capital.
o For investors, bond interest income is typically taxed at the ordinary income rate, often similar to the tax rate on wage or
salary income.
o Taxation for government bonds can vary by jurisdiction. For example, UK citizens pay tax on accrued as well as paid interest
but are exempt from capital gains tax on bonds sold above the original purchase price. In the US, investors in Treasury bonds
pay federal income tax on interest but are exempt from state and local tax. Investors in municipal bonds are often exempt
from federal as well as their state's income tax, encouraging local investment.
o Taxation can also depend on where the bond is issued and traded. Some bonds pay interest after deducting income tax at
source, while others, like certain Eurobonds, pay gross interest, thereby allowing the investor with greater control.
o Bonds generating capital gains or losses if sold before maturity maybe subject to different tax treatment, depending on the
holding period for eg : investments sold within 1 year might be taxed higher than those sold after a year.
o Bonds like zero-coupon bonds issued at a discount have tax considerations, like the original issue discount (OID), which differs
by country. For example, the US includes a portion of the discount in interest income yearly, while Japan does not. Similarly,
some jurisdictions also have provisions for bonds purchased at a premium, allowing investors to deduct a portion of the
excess paid over par value from taxable income each year until maturity, though this may be optional. The following example
illustrates the difference in tax treatment using a zero-coupon bond.

Example
Zero-Coupon Bond Tax Treatment

Assume both a US-based investor and an investor based in a tax jurisdiction without an original discount tax provision purchase an identical
zero-coupon US Treasury security based on the following terms:

o Principal amount: USD25,000,000

o Time to maturity: 5 years

11
o Issuance price: USD92.83 (per USD100 par value)

The original issue discount may be calculated as follows:

Original issue discount = Bond par value − Issuance price.

USD1,792,500 = USD25,000,000 − (0.9283 × USD25,000,000).

The USD1,792,500 original issue discount represents the interest that will accrue to both investors over five years. Under the original issue
discount tax provision in the United States, the US-based investor will recognize a prorated portion of the USD1,792,500 OID as taxable income
each year and pay no capital gains tax upon maturity. The non-US investor without an OID tax provision will recognize no taxable income until
maturity, upon which it will face capital gains tax on the OID (provided there is capital gains tax in their jurisdiction).

12
Fixed Income - Learning Module 3
for the CFAâ exam

Fixed-Income Issuance and Trading

Learning Outcomes :

The candidate should be able to:

a) Describe fixed-income market segments and their issuer and investor participants
b) Describe types of fixed-income indexes
c) Compare primary and secondary fixed-income markets to equity markets

1. Introduction

Fixed-income instruments and markets are divided based on factors such as the type of issuer, credit quality, time to maturity,
and additional features like currency and ESG characteristics. Fixed-income indexes play a similar role as equity market indexes in
stock markets. Fixed-income markets consist of both primary markets, where issuers raise funds through new issues, and
secondary markets, where investors trade existing instruments. Due to the finite maturities and unique features of bonds, there
are important differences between fixed-income markets and equity markets.

2. Fixed-Income Segments, Issuers, And Investors

LOS (a) : Describe fixed-income market segments and their issuer and investor participants

Fixed-income instruments and markets are classified based on issuer type, credit quality, and time to maturity, with additional
classifications for geography, currency, and ESG characteristics.

In equities, issuers typically issue one or two instruments (common, preferred etc.) whereas in fixed-income, issuers often have
multiple instruments outstanding which can include various types of loans, bonds either to finance short term working capital
needs or a long-term capital investment. Additionally, these debt instruments may be issued in different currencies to mitigate
risks and attract a wider range of investors. This combination of domestic and cross-border operating, financing, and leasing
activities often lead corporation to have hundreds of unique debt instruments outstanding. For instance, Apple Inc. had over 80
fixed-income instruments but only one equity instrument (common stock) outstanding at the end of 2021.

Fixed-income investors have different positions along the credit and maturity spectrums based on their risk preferences and cash
flow needs. They use money market securities for short-term obligations and to have liquid cash alternatives. For long-term
obligations or higher expected returns, they take on more interest rate risk with long-term bonds. Pension funds and insurance
companies, with long investment time horizons, prefer fixed-income instruments with regular coupon payments and a maturity
profile that aligns with their long-term liabilities. Investors can also take exposure to credit risk at any point on the maturity
spectrum to increase their returns.

Credit ratings are letter-grade measures of credit quality i.e. an issuer's ability to repay debt. They are given by credit rating
agencies like S&P (discussed below) and Moody's for both short-term & long-term debt as well as for issuers and their specific
debt issues. Some investors are often restricted to instruments with credit ratings and often have limits on investing in unrated
instruments

S&P Credit Ratings

S&P ratings range from AAA for the highest credit quality to D for default, with ratings in descending order of credit quality as follows:

AAA Extremely strong capacity to meet financial commitments; highest rating

AA Very strong capacity to meet financial commitments
A Strong capacity to meet financial commitments but somewhat susceptible to adverse economic
Investment Grade conditions and changes in circumstances
BBB Adequate capacity to meet financial commitments but more subject to adverse economic
conditions
BBB- Considered lowest investment grade by market participants

13
 BB+ Considered highest speculative grade by market participants
BB Less vulnerable in the near term but faces major ongoing uncertainties to adverse business,
financial, and economic conditions
B More vulnerable to adverse business, financial, and economic conditions but currently has the
capacity to meet financial commitments
Speculative Grade or CCC Currently vulnerable and dependent on favourable business, financial, and economic conditions
High Yield to meet financial commitments
CC Highly vulnerable; default has not yet occurred but is expected to be a virtual certainty
C Currently highly vulnerable to non-payment, and ultimate recovery is expected to be lower than
that of higher-rated obligations
D Payment default on a financial commitment or breach of an imputed promise; also used when a
bankruptcy petition has been filed or similar action taken

Developed market (DM) sovereign issuers usually represent the most creditworthy borrowers within a market and often carry a AAA
rating. Because investors often assume they will receive all promised interest and principal payments on DM sovereign bonds, they
comprise the “default risk free” category

BBB- (Baa3 on Moody’s scale) or higher ratings are considered investment grade, while BB+ (Ba1 on Moody’s scale) or lower are
referred to as high yield or junk. High-yield issuers are often new issuers with uncertain cash flows or previously investment-grade
issuers with deteriorated credit quality (a.k.a. fallen angels)

Some important points to note are:

o Sovereign government issuers have the lowest credit risk because they have the authority to tax economic activity. Developed
market sovereign bonds are popular among foreign investors and central banks to hold reserves in a stable currency. These
bonds also play a crucial role in the domestic financial system, with central banks using them for monetary policy purposes.
o Investment-grade bond investors prioritize stable cash flows and have low default expectations. Returns are lower compared
to high-yield bonds and modestly higher to sovereign bonds. High-yield investors seek higher returns but accept a higher
default risk, often comparing returns to equity investments.

3. Fixed Income Indexes

LOS (b) : Describe types of fixed-income indexes

Market indexes help track the broad risk and return of different security markets. They are used for benchmarking investments
and investment managers, and forming indexed investment strategies.

Functionally, fixed-income indexes are similar to equity indexes, but they do differ in the following three ways:

o A single issuer can have multiple fixed-income securities some/all of which can be included in the index if they are eligible. As
a result, fixed-income indexes typically have a larger number of constituent securities compared to equity indexes with some
having over 10,000 constituents.
o Bond indexes have more changes in constituents (turnover) than equity indexes due to the limited lifespan of bonds and
frequent new issuances. They are rebalanced monthly to include new issues and remove those maturing soon
o Bond indexes are typically weighted by the market value of debt outstanding, similar to how equity indexes are weighted by
market capitalization. Broad bond indexes will reflect changes in the composition of the bond market over time, including
increases in public versus private issuer debt, longer maturities, and changes in credit quality. Government issuers have a
significant presence in bond markets, resulting in high weights of government debt in many broad bond indexes.

Bond funds that aim to match the returns of an index hold a representative sample of constituent securities due to the complexity
of bond indexes.

Fixed-income indexes can be categorized as either aggregate indexes or narrower indexes based on specific criteria like sector,
credit quality, maturity etc. The choice of index for evaluating an investment manager or fund should align with their investment
strategy. For example, a Short-Term Bond Fund invests in short-term, investment-grade bonds. To evaluate the fund, its returns
should be compared to an index of instruments with similar maturity and credit quality.

4. Primary And Secondary Fixed-Income Markets

LOS (b) : Compare primary and secondary fixed-income markets to equity markets
14
4.1. Primary Fixed-Income Markets

Primary bond markets are where new bonds are sold by an issuer to investors to raise capital, while secondary bond markets
involve the trading of existing bonds between investors. When a company approaches the bond market for the first time (known
as Debut Issuer), it gives fixed-income investors the first opportunity to purchase its bonds. Bonds can be sold via a public offering
or through private placements. Debut issuers often replace private debt, such as bank loans, with bonds, similar to how primary
equity issuance involves transferring ownership from private to public. Some examples of debut issuers are:

o New corporate legal entities that are created after a merger, acquisition, or divestiture. These entities typically refinance all
existing debt that is outstanding.
o Companies entering a mature stage of the life cycle issue debt as they have predictable cash flows and
o sovereign governments that raise external foreign currency debt for the first time.

Underwriters organize roadshows and information sessions before a debut bond issuance to introduce the new entity and its
repayment plans to potential investors.

Repeat issuers of fixed-income securities usually issue new securities priced at or close to par, (contrary to equity issuers who
typically use an identical instrument for additional offerings). Occasionally, fixed-income issuers may increase the size of an
existing bond with a significantly different price, known as reopening an existing bond.

4.2. Secondary Fixed-Income Markets

Fixed-income markets are primarily quote-driven or over-the-counter (OTC), with institutional investors, financial intermediaries,
and central banks as major participants.

The secondary bond market liquidity is not consistent and differs among different segments and even within bonds of the same
issuer. The bid-offer spread, which is the difference in price between what a dealer will buy and sell a bond for, is an important
measure of liquidity. It is often expressed in basis points in fixed-income markets.

On-the-run (or most recently issued) developed market sovereign bonds are highly liquid and actively traded, with primary dealers
making active markets with narrow bid-offer spreads. In certain markets like Australia, government bonds are traded on
exchanges.

Among corporate issuers, recently issued corporate bonds from frequent issuers of higher credit quality usually exhibit the
greatest liquidity and tightest bid–offer spreads. Underwriters and other dealers are more likely to hold trading inventory in recent
issues and may therefore quote bid-offer spreads of a few basis points. Bonds of less frequent corporate issuers or more seasoned
bonds of frequent issuers are rarely traded, leading dealers to quote bid–offer spreads of at least 10–20 basis points or more for
small sizes. One exception that can increase trading frequency of a seasoned issue is a significant deterioration in a bond’s credit
quality.

Distressed debt is bonds of issuers that are close to or in bankruptcy, trading below par in the secondary market. Investors
with rating’s restrictive bond policies may sell distressed debt, while hedge funds and opportunistic investors often buy them.
Distressed debt is traded until the issuer liquidates assets or the bonds are restructured unlike equity securities which are delisted
if the issuer fails to meet exchange requirements (usually under such conditions, by the time issuer’s debt becomes a distressed
security, its equity securities would have already been delisted)

Many bond issues do not trade regularly and therefore price quotes for illiquid bonds often rely on estimates derived from more
liquid bonds of similar credit quality and maturity. This process will be discussed in a later module.

15
Fixed Income - Learning Module 4
for the CFAâ exam

Fixed-Income Markets for Corporate Issuers

Learning Outcomes :

The candidate should be able to:

a) Compare short-term funding alternatives available to corporations and financial institutions

b) Describe repurchase agreements (repos), their uses, and their benefits and risks
c) Contrast the long-term funding of investment-grade versus high-yield corporate issuers

1. Introduction

This module focuses on corporate fixed-income sector, which includes instruments issued by financial institutions and non-
financial corporate issuers. These instruments make up a significant portion of global debt issuance and outstanding debt.

2. Short-Term Funding Alternatives

LOS (a) : Compare short-term funding alternatives available to corporations and financial institutions

Both non-financial corporations and financial institutions borrow capital to support short-term activities or to meet cash needs,
preserve liquidity, and/or to benefit from supplier discounts.

For a non-financial corporate, sources and uses of short-term funding are summarized below

2.1. External Loan Financing

Non-financial corporations rely on financial intermediaries for short-term financing (which can be unsecured or secured,
depending on a company’s financial strength, general credit situation, and jurisdiction) using instruments like :

o uncommitted bank lines of credit,

o committed bank lines of credit, and
o revolving credit agreements, or revolvers.

In the United States, uncommitted lines and revolvers are popular, while committed lines are more common elsewhere. Credit
lines are the most flexible and immediate source of short-term funding

2.1.1. Lines of Credit

Uncommitted lines of credit are a flexible but unreliable form of bank borrowing for companies. These credit lines are
offered by banks up to a specified amount with a predetermined maturity date, typically charging an interest rate based on
a market reference rate and an issuer-specific spread on the outstanding principal. They are often suitable for companies
during normal business conditions, especially when they maintain stable cash deposits with the bank, allowing the bank to

16
 closely monitor their financial health. Uncommitted credit lines require minimal capital reserves on the bank’s end until
they are actually used, companies however cannot rely on uncommitted credit lines as a primary source of funding because
banks may decline to lend in adverse economic conditions. When uncommitted funding is unavailable, finding alternative
sources of funding can be difficult or costly.

The main benefit of uncommitted lines is that they only require the payment of interest on outstanding balances, making
them cost-effective for companies. From the bank's perspective, these credit lines help maintain long-term relationships
with borrowers and are often funded using stable deposits that are not regularly withdrawn by depositors.

Committed (regular) lines of credit are a more dependable source of financing compared to uncommitted lines because
they entail a formal written commitment. These lines necessitate more bank capital, though commitments for less than a
year minimize the bank's capital requirement. For large corporate borrowers, banks often reduce the required committed
capital by forming a group of banks or a syndicate that agrees to accept a predetermined percentage of the total credit
commitment. When utilized, regular credit lines are short-term liabilities, typically classified as notes payable.

Regular lines are unsecured and can be prepaid without penalties. However, they face the risk of renewal at maturity,
especially when used heavily by borrowers with weakening credit conditions. Unlike uncommitted lines, regular lines usually
involve upfront costs in the form of a commitment fee, typically around 0.50%, applied to either the full amount or the
unused portion of the line for the commitment period.

Revolving credit agreements, often called “revolvers" or "operating lines of credit," are the most dependable source of
short-term bank funding. These are multi-year credit commitments that come with certain lender protections, like
covenants that regulate specific borrower actions, similar to bond indentures. Revolvers share similarities with regular credit
lines in terms of borrowing rates, commitment fees, and may even offer optional medium-term loan features.

2.1.2. Secured Loans and Factoring

Secured loans, also known as asset-based loans, demand collateral from the borrowing company, typically in the form of
assets like owned fixed assets, high-quality receivables, inventory, or marketable securities. These assets serve as security
for the loan, and the lender gains an ownership interest in them until the loan is repaid. This interest is recorded in the
company's financial records and appears on its credit report. Secured loans are often sought by companies that don't meet
the credit requirements for unsecured loans.

Companies can use their accounts receivable to generate cash flow in two ways - One is through the assignment of accounts
receivable, where receivables are used as collateral for a loan. The company is still responsible for collecting the accounts
in this case. Option two is selling accounts receivable to a lender, called a factor, typically at a discount. In this factoring
arrangement, the company transfers the credit-granting and collection process to the lender/ factor. The cost, or discount,
for this credit depends on the quality of the accounts and collection costs. Similarly, inventory can also be utilized as
collateral for loans in various ways.

2.2. External, Security-Based Financing

Some companies may find loans more costly than debt issued in financial markets. Large, highly rated firms can issue short-term,
unsecured notes called commercial paper (CP) in the public market or through private placement. CP typically matures in less
than three months and can be used for various purposes like working capital, meeting seasonal cash needs, or bridge financing
(temporary financing till the time a more permanent financing source is arranged !)

Usually, maturing commercial paper is paid with the proceeds from newly issued paper, which can create rollover risk (i.e. the
risk of not being able to issue new paper at the time of maturity). To mitigate this risk, investors often require a backup line of
credit from banks, ensuring the issuer can repay the paper if rollover is not possible. Commercial paper markets react quickly to
adverse credit events due to their short-term nature , and typically defaults are infrequent since the companies going for it are
the highly rated ones.

Besides non-financial corporations, major commercial paper issuers include financial institutions, governments, and supranational
agencies. When issued in the international market, it's known as Euro commercial paper (ECP), similar to United States commercial
paper (USCP) but with smaller transaction sizes and lower liquidity.

2.3. Short-Term Funding Alternatives for Financial Institutions

Financial institutions, like banks, have short-term funding needs stemming from their role as intermediaries between borrowers
and depositors. Their assets primarily consist of loans and securities, while liabilities include deposits, securities sold, and short-
term borrowing. Common bank sources and uses of funding are shown in the image below :
17
2.3.1. Deposits
Household and commercial deposits serve as a primary source of short-term funding for most banks, particularly checking
accounts that pay little to no interest and are available for everyday transactions. Commercial customers benefit from fee
rebates, uncommitted credit lines, and other services, making these demand deposit balances a stable source of funding.
For larger depositors, Operational deposits from clearing, custody, and cash management activities are also relatively stable
source of funding

Savings deposits are often held for non-transactional purposes and often have stated terms, such as certificates of deposit
(CDs) which are specific amounts with pre-determined maturities (typically shorter than a year) and a known interest, which
is paid at maturity. CDs can be non-negotiable, with penalties for early withdrawal, or negotiable, allowing depositors to
sell them before maturity. Small-denomination CDs are for retail customers, while large-denomination CDs provide
wholesale funding from institutional investors, and they are traded similarly to commercial paper in the Eurobond market.

2.3.2. Interbank Market

The interbank market is where financial institutions engage in short-term borrowing and lending, either with or without
collateral. Transactions in this market typically involve unsecured loans and deposits with maturities ranging from overnight
to one year, and their interest rates are closely linked to market reference rates. Banks account for credit risk by
incorporating it into the interest rates and setting counterparty limits as part of their credit risk management in these
transactions.

Banks and financial institutions must maintain reserves at the central bank in most countries. Some banks have more
reserves than required, while others fall short. The central bank funds market helps balance this by allowing banks with
extra funds to lend to those in need. The interest rate for these central bank funds transactions is called the central bank
funds rate. Central banks aim for a specific rate or range of rates, using open market operations or interest paid on reserves
to achieve it.

If a bank can't borrow in the interbank market, they may seek funds directly from the central bank as a last resort through
discount window lending. However, this typically requires collateral and can result in increased central bank oversight and
restrictions on the bank's activities. The interest rate for such lending is higher than the central bank funds rate. Most
commonly, secured interbank borrowing and lending often involve repurchase agreements which are discussed further in
this module.

2.3.3. Commercial Paper

Large financial institutions are the primary issuers of commercial paper, using these unsecured notes for short-term
borrowing and sometimes to fund longer-term assets like loans. About 60% of the total annual issuance of commercial
paper comes from financial institutions, while the rest comes from non-financial corporations. Banks, like non-financial
corporations, also confront rollover risk if their funding requirements extend beyond the maturity of their outstanding
commercial paper.

Banks and other financial institutions often utilize a secured form of commercial paper called asset-backed commercial
paper (ABCP). As shown below, in this 2 step process short-term loans are transferred to a special purpose entity (SPE) in
exchange for cash, and the SPE issues ABCP to investors, backed by a credit liquidity line provided by the bank.

18
 This financing doesn't appear on the issuer's balance sheet and benefits both the bank (SPE sponsor and backup credit
provider) and investors. The bank receives cash up front and reduces capital costs, while investors gain access to a liquid,

short-term note with payments sourced from a loan portfolio.

The ABCP market expanded significantly before the Global Financial Crisis, primarily due to long-term assets being funded
with short-term notes. However, the crisis led to difficulties in rolling over ABCP, causing several SPEs to fail. Post-crisis, the
ABCP market mainly focuses on funding short-term, high-quality loans and receivables

3. Repurchase Agreements

LOS () : Describe repurchase agreements (repos), their uses, and their benefits and risks

The repo market is a key source of secured short-term lending and borrowing. In a repurchase agreement (repo), a security is sold
with a commitment to repurchase it at an agreed-upon price and date in the future. This allows for short-term loans with the
security serving as collateral.

The image below describes a repurchase agreement (repo) involving a US five-year Treasury note. The security buyer acquires the
Treasury note at its face value of USD100,000,000 and pays this amount to the security seller. Assuming a repo term of 30 days
and an annual interest rate (repo rate) of 0.25%, the buyer agrees to repurchase the Treasury note in 30 days at a price of
USD100,020,833. This means the seller effectively borrows USD100,000,000 for a short period, incurring interest of USD20,833,
due at maturity, with the Treasury note serving as collateral.

In a repo transaction, the security seller (cash borrower) keeps ownership of the security throughout the repo term and retains
the interest and coupon payments received from that security. On the other side, the security buyer (cash lender) earns the repo
rate as compensation for lending their cash

19
Cash lenders in the repo market prioritize liquidity and safety. Most repo transactions are short-term, with high-quality securities
like sovereign bonds used as collateral. Repo periods can be as brief as overnight or extend to term repos, which cover maturities
longer than one day. The securities involved are typically highly liquid and have low credit risk, often sovereign bonds of varying
maturities. Some repo transactions reference a group of eligible securities, something known as general collateral repo
transactions, which occur at the general collateral repo rate.

Repos incorporate safety measures to minimize the risk of collateral shortage during the contract. One such safeguard is initial
margin, expressed as:

!"#$%&'( *%&#"!
è Initial Margin =
*$%#+,-" *%&#"!

A 100% initial margin means the loan is fully collateralized, and a higher margin enhances the collateral protection. This margin is
also referred to as a haircut, indicating the reduction in the loan value concerning the initial collateral value and is given by :

!"#$%&'( *%&#"! . *$%#+,-" *%&#"!

è Haircut =
!"#$%&'( *%&#"!

For example, if a Haircut of 1.96% is applied, then for a security with price of USD100,000,000, the cash lender only gives
USD98,039,216 to the borrower.

Repos account for changes in collateral value by allowing participants to request more collateral or release existing collateral to
ensure the security value aligns with the initial margin terms. This is managed through a variable margin payment called the
variation margin, calculated as:

è Variation margin = (Initial margin × Purchase pricet) − Security Pricet.

Repo contract participants establish agreements on margining, collateral substitution, and events of default. These terms are
typically outlined in a master repurchase agreement or a similar legal document that governs all transactions between the
involved parties.

3.1. Repurchase Agreement Applications and Benefits

Financial market participants use the repo market for three specific purposes:

o Finance the ownership of a security

o Earn short-term income by lending funds on a secured basis
o Borrow a security in order to sell it short

Financial institutions engaged in securities trading and holding often take part in the repo market as either security sellers or cash
borrowers. For instance, if an investor sells a bond to a bank's trading desk in exchange for cash, the bank must pay the investor
immediately, even if it plans to sell the security later. To manage this, the bank can borrow the purchase price from another bank
or asset manager, using the bond as collateral. This repo transaction reduces the bank's funding requirement for the security to a
fraction equivalent to the initial margin of the bond's purchase price

From the viewpoint of a security buyer, a repo provides a short-term cash investment backed by collateral, offering low liquidity
and default risk. The returns on overnight cash repos with high-quality collateral are the lowest. Investors, like banks, mutual
funds, and pension funds, can earn higher returns by opting for longer repo terms or by accepting less liquid or lower-quality
collateral. On a bank's balance sheet, these short-term assets are categorized as "Securities Purchased under Agreements to Resell
or Borrowed."

Central banks utilize the repo market as a tool for conducting monetary policy. While methods like reserve requirements and
outright securities transactions have a more lasting impact on the money supply, repo contracts are often employed for short-
term and temporary policy actions. For instance, central banks may temporarily boost cash reserves in the banking system by
borrowing securities and lending cash.

In a repo, a security buyer lends cash for interest and can also uses the security for other purposes. For instance, a hedge fund
anticipating a price decline might provide cash in place of a security to a counterparty and then sell that security to another market
participant. At the repo maturity, it can repurchase the security at the lower price from the market participant and fulfil its repo
commitment, thus profiting from the price decline as well.

20
From the security buyer's perspective, a repo transaction is sometimes called a reverse repurchase agreement or "reverse repo."

The factors influencing repo rates are:

o Money Market Interest Rates: Repo rates are linked to other short-term interest rates, and central banks use secured repo
markets to impact unsecured central bank funds rates.
o Collateral Quality: Higher collateral risk leads to higher repo rates. Equity securities or emerging market bonds typically have
higher repo rates than developed market government bonds.
o Repo Term: Repo rates tend to increase with longer maturities because long-term rates generally exceed short-term rates,
raising credit risk.
o Collateral Uniqueness: Demand for a specific security affects the repo rate. Recently issued or "on-the-run" developed market
sovereign bonds often have the lowest repo rates in a market.
o Collateral Delivery: Repo rates are usually higher when the cash lent is undercollateralized or when no collateral is provided
to the funds lender.

3.2. Risks Associated with Repurchase Agreements

Repo markets are commonly used for short-term funding at low borrowing costs for banks and financial institutions. However,
they come with structural risks, and excessive reliance on repos during challenging market conditions can result in financial distress
or insolvency. Some key risks in repo contracts are:

o Default Risk: The primary risk in a repo transaction, even with collateral. Collateral from less creditworthy parties may face
illiquidity, price changes, and legal challenges in case of default.
o Collateral Risk: Collateral should be chosen to minimize liquidity and credit risks and should have little to no correlation with
the counterparty's credit risk, diversifying credit exposure.
o Margining Risk: Proper and timely collateral valuation and variation margin transfer are crucial to minimize collateral
shortfalls in the event of liquidation following a default. Adverse market conditions can lead to significant changes in collateral
value, increasing margin calls.
o Legal Risk: Concerns the ability to enforce legal rights under a repurchase agreement.
o Netting and Settlement Risk: Involves the ability of repo contract participants to offset or net obligations of a non-defaulting
party and take possession of collateral or cash for trade settlement.

These direct agreements between two parties, where both the lender and borrower engage directly are called bilateral Repos.
Repo market participants often manage risks by involving a third party. Known as triparty Repos, both parties agree to use a third-
party agent, such as a custodian or clearinghouse, for the transaction. Triparty agents don't change the credit risk dynamics
between participants but offer cost efficiencies, access to a broader collateral pool, multiple counterparties, and specialized asset
valuation and safekeeping. The agent administers the transaction and is responsible for cash, securities, collateral valuation, and
custody.

The repo market offers more stable funding compared to short-term unsecured financing. However, it carries rollover and liquidity
risks due to its uncommitted nature and very short maturities, often overnight. Financial institutions need to balance the low cost
of repo funding with the financial flexibility of longer-term alternatives like debt and equity. While collateralized, in practice, firms
that lose market confidence have faced significant losses and even bankruptcy during financial crises, partly because of heavy
reliance on repo financing.

4. Long-Term Corporate Debt

LOS (b) : Contrast the long-term funding of investment-grade versus high-yield corporate issuers

Corporate issuers use long-term debt for stable funding of both short-term and long-term needs. Credit quality becomes more
crucial for longer maturities as the risk of financial distress grows over time which is why it plays a significant role in the features
and availability of long-term corporate funding.

4.1. Similarities between Long-Term Investment-Grade (IG) and High-Yield (HY) Issuance

Both issuers and investors evaluating non-callable long-term debt of varying maturities must balance the risk and yield-to-
maturity. Longer maturities generally come with higher interest rates and credit spreads. If an investor holds a bond beyond their
planned horizon, they face price risk when selling it later. They also face reinvestment risk if market interest rates are lower than
the bond's original coupon rate. On the issuer side, choosing a shorter maturity may offer a lower yield for funding a longer-term
21
project, but it comes with rollover risk if they need to refinance at higher rates when the bonds mature. These considerations
apply to both investment-grade and high-yield issuers.

The relationship between bond price changes, yield changes, and investor returns will be discussed in more detail in a later lesson.

4.2. Differences between IG and HY Issuance

The differences between investment-grade and high-yield corporate bonds go beyond credit spreads.

Key points related to IG issuers are :

o Investment-grade bonds have a significant portion of their yield attributed to government benchmark rates because they are
seen as having a strong ability to meet their obligations from operating cash flows.
o Investors are confident in their ability to make payments, allowing issuers to issue debt with minimal monitoring, few or no
restrictive covenants and flexible maturity choices, often up to 30 years.
o Investment-grade bonds are standardized, and issuers often have various bonds with similar terms but different maturities.
o They reduce refinancing risk by staggering debt maturities, lowering rollover risk while maintaining the flexibility to raise more
debt when market conditions are favorable

Key point related to HY issuers are:

o HY issuers are more likely to experience financial distress, and a larger portion of a bond's yield is due to an issuer-specific
spread over benchmark rates compared to investment-grade debt.
o These bonds have characteristics similar to equities, with uncertain cash flows, and analysts focus on potential losses in case
of default and available protections and secondary repayment sources.
o Investors impose more restrictions on high-yield issuers. Debt covenants in bond indentures or loan agreements allow lenders
to monitor issuer performance and take actions to restructure debt. These constraints limit the flexibility and market
availability for high-yield issuers compared to investment-grade ones.
o HY issuers also have limitations on debt maturities, shorter in duration, and face greater fluctuations in credit spreads and
market availability. They often need to restructure debt and renegotiate covenants to benefit from lower borrowing costs
instead of financing opportunistically as market conditions change.
o These issuers often aim to maintain financial flexibility by using leveraged loans with prepayment options or issuing bonds
with contingency features. In the case of callable debt, issuers have the right to redeem the bond before maturity at a fixed
price. This can be advantageous for borrowers with improving creditworthiness because the value of this feature increases
as their borrowing costs decrease.
o High-yield investors also benefit from lower yields as credit spreads narrow, but with callable debt, these gains are limited to
the call price. If the issuer can refinance at a lower cost within the call period, it makes sense to call the bonds and issue new
debt.

The specifics of how callable bonds' prices and yields relate to high-yield issuers and investors are discussed in greater detail later
in the curriculum.

In the high-yield bond market, there's an exception known as fallen angels, which are formerly investment-grade issuers. These
issuers face a similar risk of financial distress as other high-yield issuers, but their outstanding debt retains investment-grade
features. This means it's typically non-callable, has few restrictions and covenants, and longer maturities. This decline in the
issuer's credit quality results in losses to the original investors, many of whom are forced to sell these bonds because the bonds
no longer meet the minimum rating requirements for their portfolios. Coupled with smaller high-yield bond market, this forced
selloff leads to significant price declines.

22
Fixed Income - Learning Module 5
for the CFAâ exam

Fixed-Income Market for Government Issuers

Learning Outcomes :

The candidate should be able to:

a) Describe funding choices by sovereign and non-sovereign governments, quasi-government entities, and supranational
agencies
b) Contrast the issuance and trading of government and corporate fixed-income instruments

1. Introduction

This module focus on public sector fixed income issuers like sovereign and non-sovereign governments, and it explains how they
differ from private sector issuers. Sovereign governments have the authority to levy taxes within their jurisdiction, whereas non-
sovereign, quasi-government, and supranational issuers rely on various sources like local taxes or fees for repayment. Sovereign
debt is typically issued through scheduled public auctions, involving financial intermediaries in a different capacity than in private
sector issuance. Sovereign debt securities are the most commonly used benchmark securities for pricing and valuation in fixed-
income analyses.

2. Sovereign Debt

LOS (a) : Describe funding choices by sovereign and non-sovereign governments, quasi-government entities, and supranational
agencies

National or sovereign government issuers are defined by their legal authority to establish and manage a country's public services
and their power to collect taxes from economic activities within their jurisdiction. They can also generate revenue through tariffs,
usage fees, and profits from government-owned businesses. The extent and variety of public services offered by national
governments differ across regions and can range from minimal involvement in the economy to substantial engagement. Like
private sector entities, governments can utilize an "economic balance sheet" to depict their sources and uses of funding, as shown
in the image below, which encompasses activities of the central bank as well

23
Private issuers adhere to GAAP for their financial statements, but public sector financial accounting standards differ significantly.
Public sector standards frequently rely on cash-based accounting, omitting factors like asset depreciation and unfunded liabilities.
However, notice that the economic balance sheet above incorporates expected future claims and obligations, making it more
relevant for public sector issuers compared to private ones.

The size of the government sector in relation to a country's economy varies greatly between nations, and how government
activities are distributed between the national government, quasi-government agencies, and local governments also differs from
one country to another. Consequently, this diversity leads to the existence of non-sovereign issuers (discussed in a later section)
operating within the same jurisdiction as the sovereign issuer.

National government issuers can be categorized into two groups:

o Developed Market (DM) Sovereign Issuers: DMs have stable, well-diversified domestic economies. Their national
government budgets mainly consist of predictable and recurrent expenditures funded by broad-based individual and business
taxes. This results in a stable and transparent fiscal policy. DM fixed-income securities are denominated in major currencies
widely held in foreign reserve, allowing them to issue debt often considered default-risk-free with unrestricted market access
across various maturity periods.
o Emerging Market (EM) Sovereign Issuers: EMs experience higher economic growth but face challenges in terms of stability
and diversification. They heavily rely on specific industries, have more state-owned enterprises, and require external funding
for infrastructure investments. EM sovereign debt securities are often denominated in restricted currencies, limiting foreign
investment and access to longer-term maturities.

In the case of emerging market sovereign issuers, it's crucial to differentiate between domestic debt in the local currency and
external debt, which is debt owed to foreign creditors. Domestic currency sovereign bonds are typically held by domestic financial
institutions and local investors. On the other hand, external debt for emerging and frontier market sovereign issuers includes debt
from supranational financial organizations and bonds denominated in a foreign currency, held by foreign private investors.
Investors from developed markets who invest in these bonds don't face the same direct currency risk as they do with domestic
currency emerging market sovereign debt. However, they still have indirect exposure to currency fluctuations because their
returns depend on the issuer's ability to generate foreign currency revenue through international trade and financial transactions,
enough to cover foreign currency interest and principal payments.

A nation's fiscal policy is the government's strategy for managing its finances, and it directly impacts a nation's debt levels. This
policy is determined by government spending, including both budgetary needs and debt servicing costs, and is balanced against
tax revenues and other sources of income. Deficits lead to borrowing, while surpluses reduce the need for borrowing. Projections
of sovereign debt levels must consider changes in fiscal policy, as well as how economic growth and inflation affect expenditures
and revenues.

Government debt management policies encompass decisions regarding the mix of sovereign debt, such as its short-term and
long-term components, among other characteristics. Sovereign debt issues can include:

o Short-term securities: These have maturities ranging from 1 to 12 months and are often referred to as Treasury bills. They
are typically zero-coupon instruments sold at a discount to their face value.
o Medium- and long-term securities: These are commonly known as Treasury notes and bonds. They are usually fixed-rate
coupon instruments denominated in the domestic currency. Sovereigns may also issue floating-rate, inflation-linked, and
foreign currency instruments.
o Government guarantees: Some governments guarantee certain instruments, effectively making them a form of sovereign
debt. An example is mortgage-backed securities, particularly in the United States, that adhere to specific criteria.

National governments, due to their authority to levy taxes on economic activity, generally present the lowest default risk among
domestic currency issuers and are typically the primary bond issuers in their domestic markets

Similar to the Modigliani-Miller theorem for corporate issuers, the Ricardian equivalence theorem suggests that for sovereign
government debt, the choice of debt maturity is irrelevant in determining the present value of future tax cash flows. This is based
on the following assumptions:

o Taxpayers spread their consumption over time and save expected future taxes today for future payments.
o Taxpayers anticipate that tax cuts today will lead to higher taxes in the future.
o Capital markets are perfect, with no transaction costs, allowing taxpayers to borrow and lend freely.
o Taxpayers are altruistic on an intergenerational basis, passing on tax savings to their descendants.

24
Under these conditions, the government's decision to collect taxes immediately or raise debt with any maturity doesn't affect the
present value of future tax revenues, as taxpayers adjust their behaviour to account for the government's financial choices.

Relaxing the assumptions of Ricardian equivalence, which allows for imperfect capital markets and transaction costs, leads to debt
management policies that provide liquidity benefits to investors and issuers across different maturity periods. For instance, short-
term government issuance offers investors high liquidity and safety, often serving as substitutes for bank deposits. These very
short-term government securities tend to have lower yields due to a liquidity benefit under normal market conditions.

While adhering strictly to Ricardian equivalence implies funding with the shortest maturity to minimize borrowing costs and avoid
term premiums, heavy reliance on short-term funding, like corporate bonds discussed earlier, introduces rollover risk which
converts into uncertain refinancing costs. This increases budget cost variability and, consequently, tax rates. As taxpayers don't
perfectly smooth consumption over time and don't form rational expectations about taxes across generations, fiscal instability
creates uncertainty in future tax rates, potentially jeopardizing economic stability. Hence, in practice, governments aim to mitigate
interest rate and rollover risks by diversifying debt across maturities while maintaining a regular and predictable issuance
schedule.

Thus, medium- and long-term sovereign funding issuance involves balancing higher borrowing costs with greater fiscal stability
while considering liquidity and other benefits associated with bonds offering the lowest default risk across various maturity
periods. The advantages of issuing enough longer-term government securities to ensure liquidity across maturities include:

o Establishing a risk-free benchmark: Regular issuance of sovereign bonds across maturities serves as a risk-free benchmark
for calculating credit risk premiums, enhancing capital market efficiency and transparency for private issuers.
o Managing and hedging interest rate risk: Market participants use medium- to long-term government securities and related
derivatives to manage interest rate risk independently of credit risk.
o Preferred collateral in financial transactions: Longer-term government securities are commonly used as collateral in
repurchase agreements and derivative transactions due to their high liquidity and safety.
o Utilized in monetary policy and foreign exchange reserves: Central banks use government securities in executing monetary
policy, and foreign market participants often hold foreign currency reserves in the form of liquid foreign government bonds
due to their liquidity and safety.

While governments aim to ensure regular and predictable access to bond markets across different maturities, changes in debt
amounts, deficits, and differences between short- and long-term interest rates lead to adjustments in debt management policies.

3. Sovereign Debt Issuance And Trading

LOS (b) : Contrast the issuance and trading of government and corporate fixed-income instruments

Corporate debt issuance is typically opportunistic and facilitated by investment banks, while sovereign debt issuance is usually
conducted through a public auction led by the national Treasury or finance ministry. In a government debt auction, potential
investors submit either competitive or non-competitive bids. Competitive bidders specify a price and quantity of securities they
are willing to buy. If the auction price exceeds their bid, they won't receive any securities. Non-competitive bidders agree to accept
the auction price and always receive the securities they bid for.

In a competitive bid process for bond issuance, there are two types of auctions: single-price and multiple-price. In a single-price
auction, all winning bidders pay the same price and receive the same coupon rate, while in a multiple-price auction, different
bidders may pay different prices for the same bonds. Single-price auctions can lead to lower costs and broader investor
participation, while multiple-price auctions may limit large bids as investors must accept bonds at their bid price.

A single-price auction process involves four phases:

o The government announces the bond auction, providing details like the bond type, issue amount, dates, and maturity.
o Bidders, including dealers, institutions, and individuals, submit competitive and non-competitive bids.
o Non-competitive bids are accepted, while competitive bids are ranked from lowest yield (highest bond price) to highest yield.
Counting form the bottom, the highest yield that fills the offering amount is the "cut off," determining the single price for all
securities. Competitive bidders who bid higher do not get any securities.
o Securities are delivered to non-competitive and winning competitive bidders in exchange for payment.

Government of India switches from multiple-price to single-price debt auctions

25
In July 2021, the central bank of India (Reserve Bank of India) moved from multiple- to single-price auctions for its 2-year, 3-year, 5-year,
10-year, 14-year, and floating-rate bonds. The 30-year and 40-year bonds continued to be auctioned via the multiple-price method. The
Reserve Bank of India changed the method- ology it uses for government bond issuance after it faced several partially failed auctions.
Under the single-price auction, volatility in yields is reduced because all successful bidders receive the same rate.

Sovereign governments work with financial intermediaries known as primary dealers, who participate in auctions and play a role
in open market operations. They also facilitate the trading of government debt for foreign central banks and other indirect bidders.
Investors can also directly participate in auctions through platforms like the UK Debt Management Office or TreasuryDirect in the
US.

After issuance, sovereign debt is typically traded similarly to private sector debt, primarily on over-the-counter (OTC) markets by
broker/dealers. Some markets, like Australia, trade them on an exchange. Sovereign issuers are usually the largest borrowers, and
their securities are the most liquid in fixed-income instruments. Recently issued sovereign debt, known as on-the-run securities,
is used for benchmark yield analyses due to their higher liquidity compared to less actively traded off-the-run securities. Some
trading of on-the-run securities occurs electronically on centralized marketplaces run by private companies.

Sovereign debt trading differs from corporate debt due to the presence of investors with non-economic objectives. For instance,
major investors in US Treasuries include the Federal Reserve for monetary policy, foreign governments for holding US dollar
reserves, state and local governments facing restrictions on other securities, and banks/insurance companies complying with
regulatory requirements. These factors lower sovereign borrowing costs compared to the private sector, especially for issuers
with a reserve currency widely used in global trade and finance.

4. Non-Sovereign, Quasi-Government, And Supranational Agency Debt

LOS (a) : Describe funding choices by sovereign and non-sovereign governments, quasi-government entities, and supranational
agencies

Non-sovereign government funding varies by country, depending on the level at which public goods and services are provided.
Some non-sovereign issuers can tax for funding, similar to sovereigns, while others depend on government budgets, user fees, or
even national or local government support. The ability of non-sovereign issuers to access funding across different timeframes
depends on the predictability and stability of these repayment sources, which are crucial factors influencing their credit quality.

4.1. Government Agencies

Government agencies, often quasi-government entities, issue debt to fund government-sponsored provision of specific public
goods or services based on local or sovereign law. They finance activities or infrastructure mandated by law. For example, the
Airport Authority of Hong Kong (AAHK) issues debt for the Hong Kong International Airport, primarily repaid from airport cash
flows, with government backing as a secondary source.

These agencies tailor their debt to match their activities but do not enjoy the full liquidity premium (i.e. lower yield due to liquidity
benefit) associated with sovereign debt.

4.2. Local and Regional Government Authorities

Non-sovereign government authorities can issue debt for general purposes, repaid from local tax revenue, called general
obligation bonds (GO bonds). Alternatively, they issue revenue bonds to fund specific projects like infrastructure, with repayment
linked to project revenue sources (tolls, fees). Revenue bonds typically have longer maturities matching the expected life of the
project's expected cash flows.

4.3. Supranational Organizations

Supranational organizations like the World Bank, International Monetary Fund (IMF), and Asian Development Bank (ADB) are
established by sovereign governments to work toward common objectives, such as economic cooperation, development, and
trade promotion. These organizations have strong credit quality, can access capital markets across various maturities due to
support from member states and try to target bond investors in major currencies using global bond markets. Sometimes,
supranational and sovereign entities collaborate to create quasi-government agencies that can issue debt at a lower cost. For
instance, PT Indonesia Infrastructure Finance (IIF) can access markets due to Indonesian government ownership and financial
support from public entities like the Asian Development Bank and the World Bank.

26
Fixed Income - Learning Module 6
for the CFAâ exam

Fixed-Income Bond Valuation - Price and Yield

Learning Outcomes :

The candidate should be able to:

a) Calculate a bond’s price given a yield-to-maturity on or between coupon dates

b) Identify the relationships among a bond’s price, coupon rate, maturity, and yield-to-maturity
c) Describe matrix pricing

1. Introduction

This module discusses the use of discounted cash flow analysis to calculate bond prices, emphasizing the impact of factors like the
discount rate, coupon rate, and time-to-maturity on pricing. It also explores the concept of yield-to-maturity as a key metric for
fixed-income investors, assuming all cash flows are received as promised. The module delves into how various bond features
influence pricing, including pricing on and between coupon dates. Additionally, it introduces matrix pricing, a method to estimate
a bond's price and yield-to-maturity using comparable bonds when this information is not readily available.

2. Bond Pricing and the Time Value of Money

LOS (a) : Calculate a bond’s price given a yield-to-maturity on or between coupon dates

2.1. Bond Pricing with a Market Discount Rate

Bond pricing is the process of determining the value of a bond by calculating the present value of its future cash flows. The market
discount rate, also known as the required yield or rate of return, is used to discount these cash flows. The market discount rate
represents the return that investors expect from the bond, taking into account its risk.

The present value (PV) calculation for each bond coupon cash flow (PMT) that occurs in t periods with a market discount rate of r
per period can be taken from an earlier time-value-of-money lesson:

!"#/
è PV(Bond coupon) =
(%&')/

This calculation can be extended to a general formula for calculating a bond price (PV) given the market discount rate on a coupon
date:

!"#0 !"#1 !"#2 & *+2

è PV=
(%&')0
+
(%&')1
+ ….. + (%&')2

Where
FV is equal to the bond’s face value and
N is the number of periods to maturity.

In a previous lesson, we learned about the Bright Wheels Automotive (BRWA) bond, which was priced at 100% of its face value
because the market discount rate and the bond's fixed coupon rate were the same. However, we will now explore scenarios where
the bond's coupon rate and the market discount rate are different.

Case 1: Market Discount rate rises to 2%. The PV of cash flows are shown below. Bond price is the sum of these cash flows.

Period: 1 2 3 4 5 6 7 8 9 10
Cash Flow 1.6 1.6 1.6 1.6 1.6 1.6 1.6 1.6 1.6 101.6
PV of Cash Flow at 2.0% 1.6 1.5 1.5 1.5 1.4 1.4 1.4 1.4 1.3 83.3
periodic YTM:
Bond Price 96.41

27
The market discount rate has increased to 2% semiannually. As a result, new bonds must have a coupon rate of 2% as well. The
previously issued BRWA bond has a coupon rate of 1.6%, which is lower than the market discount rate or we can say that the bond
is deficient relative to the required rate. Therefore, the price of the BRWA bond will be lower than its par value of 100% to
compensate for this difference and the bond is said to be trading at a discount. The image below illustrates this case :

Case 2 : Market Discount rate falls to 1.2%. The PV of cash flows are shown below. Bond price is the sum of these cash flows.

Period: 1 2 3 4 5 6 7 8 9 10
Cash Flow 1.6 1.6 1.6 1.6 1.6 1.6 1.6 1.6 1.6 101.6
PV of Cash Flow at 1.2% 1.6 1.6 1.5 1.5 1.5 1.5 1.5 1.5 1.4 90.2
periodic YTM:
Bond Price 103.75

In this case, we can say that the current bond at 1.6% pays more than what the market expects at 1.2%, its price rises and the
bond is said to trade at a premium. The image below illustrates this case :

The following table summarises these cases :

Bond Price Price vs. Future Value Coupon vs. Market Discount Rate
Par PV = FV PMT = Market discount rate
Discount PV < FV PMT < Market discount rate
Premium PV > FV PMT > Market discount rate

Note : Here, we have referred to semi-annual interest rates for comparison since the bond pays semi-annual coupons. Unless
stated otherwise, interest rates are typically quoted as annual rates.
28
2.2. Yield-to-Maturity

The yield-to-maturity of a bond can be calculated using the equation above if the market price of the bond is known. This yield-
to-maturity represents the internal rate of return on the bond's future cash flows. It is the interest rate at which, when the future
cash flows are discounted at that rate, the sum of their present values equals the bond's price. The yield-to-maturity is considered
an implied or observed market discount rate.

For a bond investor to earn a rate of return equal to its Yield to Maturity (YTM), they must

o hold the bond until it matures,

o receive full coupon and principal payments on time assuming no issuer default, and
o reinvest all coupon payments at the same YTM.

Let’s say that a five-year 3.2% fixed-rate BRWA bond is priced at 108.15. The solution for the rate, r is the yield-to-maturity : in

%.- %.- %.%.-

è 108.15 = 0
+ 1
+ ... +
(%&') (%&') (%&')03

This gives us an annual yield-to maturity of 1.50%.

Yield-to-maturity, also known as yield, is a term used to describe the market discount rate or required yield. It is often used instead
of discussing bond prices. For instance, instead of saying bond prices are falling, people may say "yields are rising."

Note : The yield-to-maturity on a bond can be positive, zero, or negative. Negative yields have been seen on sovereign bonds due
to central banks implementing accommodative monetary policies to combat low inflation rates. Bonds with negative yields include
those that were issued at higher yields in the past and have seen price appreciation, as well as newly issued premium-priced zero-
coupon government bonds. It is uncommon for bonds to have negative coupons.

2.3. Flat Price, Accrued Interest, and the Full Price

When a bond is priced between coupon payment dates, its price is made up of two parts: the flat price (PVFlat) and the accrued
interest (AI). The total price, also known as the invoice or "dirty" price, is the sum of these two components.

è PVFull = PVFlat + AI

The flat price of a bond is the full price without the accrued interest and is commonly quoted by bond dealers. When a trade
occurs, the accrued interest is added to the flat price to determine the total price paid by the buyer and received by the seller on
the settlement date. The trade is considered settled once the buyer pays for the bond and the seller delivers it.

The use of flat prices in bond quotations helps prevent investors from being misled by daily price fluctuations caused by the accrual
of interest. If full prices were quoted, investors may mistakenly believe that the bond's market price is constantly rising. However,
once a coupon payment is made, the quoted price would decrease significantly as shown in the image below

To calculate accrued interest, we divide the number of days since the last coupon payment by the total number of days in the
coupon period. This gives us a fractional amount that represents the portion of the coupon payment owed to the seller.

/
è AI = x PMT
0
29
Where
t = number of days from the prior coupon payment to the settlement date
T = number of days in the coupon period
t/T = fraction of coupon period that has passed since the prior payment
PMT = coupon payment per period

Note : The accrued interest portion of the full price does not depend on the yield-to-maturity. Therefore, it is only the flat price
that is affected by a change in interest rates.

The full price of a fixed-rate bond between coupon payments is given the market discount rate per period (r) is the present value
of future cash flows as of the trade settlement date, given by :

!"# !"# !"#& *+

è PVFull = 04//6
+ + ….. + (%&')24//6
(%&') (%&')14//6

This can be simplified by multiplying both numerator and denominator by (1 + r)t/T :

!"# !"# !"#& *+
è PVFull = [ (%&') +
0 (%&')1
+ ….. +
(%&')2
] x (1 + r) t/T

t/T
è PVFull = PV × (1 + r)

3. Relationships between Bond Prices and Bond Features

LOS (b) : Identify the relationships among a bond’s price, coupon rate, maturity, and yield-to-maturity

3.1. Inverse Relationship

The price of a fixed-rate bond will change depending on the interest rate used to calculate its present value. A higher interest rate
will result in a lower present value and a lower interest rate will result in a higher present value. This means that bond yields-to-
maturity and prices move in opposite directions.

3.2. Coupon Effect

The size of a bond's coupon cash flows determines how much its price will change given a change in yield. Bonds with lower
coupons have a higher proportion of their cash flows occurring at maturity. When discounting the final cash flow by the factor of
(1 + r)N, a change in yield has a greater impact on the bond's price compared to bonds with a smaller proportion of their cash flows
occurring at maturity. This can be easily seen by comparing a zero-coupon bond, which has all cash flows including cumulative
interest paid at maturity, with an otherwise identical fixed-coupon bond.

Example
Yield Change Effect for Zero-Coupon vs. Coupon Bond

Assume an investor has the choice between the 4.625% fixed-coupon 30-year Romania Eurobond priced at par and an otherwise
identical zero-coupon bond from the same issuer at the same yield-to-maturity of 4.625%. Calculate the percentage change in price for
both bond alternatives if YTM rises or falls by 100 bps upon issuance. The calculations are shown below :

Face Value 100

Periods / year 1
Number of 30
periods
Coupon payment 4.625
Change YTM Prices Price Changes Percentage Price Changes
Coupon Zero Coupon Zero Coupon Zero
-- 0.04625 100.000 25.759 -- -- -- --
0.01 0.05625 85.665 19.364 –14.335 –6.395 –14.34% –24.83%
–0.01 0.03625 118.107 34.361 18.107 8.601 18.11% 33.39%

30
For the same time-to-maturity, a lower-coupon (or zero-coupon) bond has a greater percentage price change than a higher-coupon
bond when market discount rates change by the same amount.

3.3. Maturity Effect

The time-to-maturity of a bond affects its price and yield relationship. A longer-term bond will experience a greater percentage
price change compared to a shorter-term bond when market discount rates change by the same amount. This is because the
longer-maturity bond has a higher value of N in the equation that determines price change.

Exceptions to the maturity effect are very uncommon in real-world scenarios. They are only observed in the case of long-term
bonds with low coupons ( but not zero-coupon) that are trading at a discount. However, the maturity effect is always present for
zero-coupon bonds and for bonds trading at or above their face value.

3.4. Constant-Yield Price Trajectory

The passage of time affects bond prices regardless of the market

discount rate. As time goes on, the bondholder gets closer to
receiving the par value at maturity, as long as the issuer doesn't
default. The constant yield price trajectory in the adjoining image,
shows the price change of two 10-year bonds over time: a 2%
coupon bond issued at a discount and an 8% coupon bond issued at
a premium. The bond prices are recalculated at each time using a
market discount rate of 5%. The 2% coupon bond starts at a price of
$76.835 per $100 of its par value. Its price increases over time and
gets closer to its par value as it approaches maturity. On the other
hand, the 8% coupon bond starts at a price of $123.165 and
decreases each year, also approaching par value as it nears
maturity. Both bond prices are “pulled to par”

3.5. Convexity Effect

The bond's price will change differently depending on how the yield changes. The increase in price is greater than the decrease in
price, implying that the relationship between bond prices and yields is not linear but curved and convex. This relationship is
discussed in the example below :

Example
BRWA Bond: Convex Relationship

Take the BRWA case discussed before. Despite a uniform increase and decrease in the BRWA bond’s annual yield-to-maturity, notice how the
resulting changes in price are different.

Face Value 100

Coupon payment 1.6
Number of periods 10
YTM YTM Price %Price
Change Change
-- 0.016 100.00 --
0.004 0.020 96.41 –3.59%
–0.004 0.012 103.75 3.75%

A decrease in the yield-to-maturity from 160 bps to 120 bps results in a bond price increase of 3.75%, but an increase in the YTM from 160 bps
to 200 bps results in a smaller bond price decrease. Based on this, we can say that the BRWA bond has positive convexity. Convexity will be
discussed in greater detail in a later lesson.

4. Matrix Pricing

LOS (c) : Describe matrix pricing

31
4.1. Matrix Pricing Process

Matrix pricing is used to estimate the price of bonds that are not actively traded or not yet issued. It involves using the prices of
comparable bonds that have similar characteristics such as maturity, coupon rates, and credit quality. This estimation process
helps determine the bond's price when there is no current market price available and is shown in the image below :

Suppose, an analyst is trying to determine the value of Bond X, a corporate bond with a 4% semiannual coupon payment, which
has limited trading activity and no recent transactions reported. They have gathered data from four other corporate bonds with
similar credit quality, including quoted prices and yields-to-maturity. The first image presents the data gathered while the second
image shows the matrix created:

Next, the analyst calculates the average yield for each year: 3.8035% for the two-year bonds ( (3.786% + 3.821%) / 2) and 4.1885%
for the five-year bonds ( ( 4.181% + 4.196%) / 2 )

The estimated three-year yield for bonds of similar credit quality can be obtained with linear interpolation :

!"#
è 0.038035 + ( × (0.041885 − 0.038035) = 0.03932 = 3.932%
$"# )

Using 3.9318% as the estimated yield, the 3-year 4% semi-annual corporate bond has an estimated price of 100.191 per 100 of
par value

Matrix pricing is a method used to determine the required yield spread for new bonds. It involves comparing the yield-to-maturity
of a bond with a government benchmark bond of similar maturity. This helps underwriters estimate the difference in yields
between the two bonds and determine the appropriate spread.

32
Fixed Income - Learning Module 7
for the CFAâ exam

Yield and Yield Spread Measures for Fixed-Rate Bonds

Learning Outcomes :

The candidate should be able to:

a) Calculate annual yield on a bond for varying compounding periods in a year

b) Compare, calculate, and interpret yield and yield spread measures for fixed-rate bonds

1. Introduction

Previous lessons explored the relationship between bond prices and yields-to-maturity, as well as other factors like coupon rate
and time-to-maturity. This module builds upon them and discusses the importance of considering the frequency of compounding
interest and the presence of embedded options when determining yield measures. Additionally, the module introduces spread
measures, which compare yields to benchmark rates to assess the level of compensation investors receive for taking certain risks.

2. Periodicity and Annualized Yields

LOS (a) : Calculate annual yield on a bond for varying compounding periods in a year

Investors analysing bonds with different cash flow and maturity patterns require a standardized yield measure to compare their
options. This yield measure is usually annualized to facilitate direct comparisons. For securities that mature in more than one year,
investors look for an annualized and compounded yield-to-maturity.

Conventions for securities maturing in one year or less will be discussed in a later lesson.

The annualized and compounded yield of a fixed-rate bond is influenced by the number of interest periods in a year, known as
the periodicity. The periodicity usually aligns with the frequency of coupon payments. For instance, if a bond pays semiannual
coupons, the periodicity is 2 (as there are two semiannual periods in a year). The annual yield-to-maturity is calculated by
multiplying the rate per semiannual period by 2. Similarly, a bond with quarterly coupon payments has a periodicity of 4, where
the annual yield is determined by multiplying the rate per quarter by 4.

The folowing image shows how a 5% stated annual yield-to-maturity generates different amounts in one year with annual,
semiannual, quarterly, monthly compounding based on a fixed-rate par bond priced at 100.

If the bond interest amounts on the right side are expressed as percentages, they are known as effective annual rates. These rates
have a periodicity of 1, meaning there is only one compounding period in a year. For example, a quarterly coupon bond with a
1.25% rate per period, or a 5% annual coupon rate, assumes that each coupon received is reinvested at the 1.25% rate for the rest

33
of the year. In this case, a quarterly coupon bond with an annual stated rate of 5% generates the same interest as an annual
coupon bond with a stated rate of 5.0945%. (Although not shown here, spreadsheets can be utilised for these calculations)
In many fixed income markets, the most common periodicity for bond payments is semiannual, meaning bonds make coupon
payments twice a year. This is why an annual rate with a periodicity of two is called a semiannual bond basis or semiannual bond
equivalent yield. The semiannual bond basis yield is calculated by multiplying the yield per semiannual period by 2. It is important
to note that the terms "semiannual bond basis yield" and "yield per semiannual period" have different meanings. For example, if
a bond yield is 2% per semiannual period, its annual yield would be 4% when expressed on a semiannual bond basis.

The conversion of an annualized yield using one periodicity to another periodicity, called periodicity or compounding conversions,
is a useful tool in fixed income and is as follows :

Where, APR is the annual percentage rate and the m, n represents the periodicity

For example, a 3-year, 5% semiannual coupon payment corporate bond, priced at 104 per 100 of par value. Its yield-to-maturity
is 3.582%, quoted on a semiannual bond basis for a periodicity of 2: 0.01791 × 2 = 0.03582. The 6 semiannual coupon payments
can be represented as follows

è 104 = [2.5 / (1+r)1 ]+ [2.5 / (1+r)2] + [2.5/ (1+r)3] + [2.5 / (1+r)4] + [2.5/ (1+r)5] + [102.5/ (1+r)6]; r = 0.01791.

If we want to convert this rate into a quarterly one, we can do as follows :

An annual yield-to-maturity of 3.582% for semiannual compounding provides the same rate of return as annual yields of 3.566%
for quarterly compounding. A general rule for periodicity conversions – “compounding more frequently at a lower annual rate
corresponds to compounding less frequently at a higher annual rate”. This can be used to check periodicity conversion calculations.

Examples
Periodicity of Zero-Coupon Bonds

The periodicity of the annual market discount rate for a zero-coupon bond is arbitrary because there are no coupon payments. Consider a five-
year, zero-coupon bond priced at 80 per 100 of par value. Assuming annual compounding, or a periodicity of one, the yield-to-maturity is 4.564%.

è 80 = 100 /(1 + r)5; r = 0.045640; 4.564%

Assuming semiannual compounding, or a periodicity of 2, the annual yield-to-maturity for this same five-year, zero-coupon bond is 4.51%.

è 80 = 100 /(1 + r)10; r = 0.022565; x 2 = 0.045130

Assuming quarterly compounding, or a periodicity of 4, the annual yield-to-maturity for this same five-year, zero-coupon bond is 4.488%.

è 80 = 100/ (1 + r)20; r = 0.011220; × 4 = 0.044880

The compounded total return is the same for each expression for the annual rate. They differ in terms of the number of compounding periods
per year—that is, in terms of the periodicity of the annual rate. For a given pair of cash flows, the stated annual rate and the periodicity are
inversely related.

Comparing Strip Bonds to Coupon Bonds

Financial intermediaries can own coupon bonds and then issue individual zero-coupon bonds composed of coupon or principal payments from
the coupon bonds. These zero-coupon bonds are known as strip bonds. Strip bonds are attractive to investors seeking to match known cash
flows on a specific future date. A 20-year government of Canada strip (zero-coupon) bond is priced at 69.4300 per 100. An analyst wants to
compare the yield of the strip bond with that of a newly issued 20-year coupon bond. Both the strip bond and the coupon bond are non-callable.
The 20-year coupon bond pays semiannual coupons of 2%, and its current price is 101.99 per 100, which corresponds to a semiannual bond

34
equivalent yield of 1.880%. The analyst will compute a semiannual bond equivalent yield for the strip bond and compare it to the semiannual
bond equivalent yield of 1.880% of the 20-year coupon bond.

There are two approaches.

Approach 1

The 20-year strip bond does not pay any coupons, so as the first step, we assume annual compounding (periodicity of 1) to calculate an effective
annual rate based on the current price and remaining years to maturity.

è 69.43 = 100/(1+r)20;r = 0.01840997 = 1.841%.

The next step is to convert the effective annual rate to semiannual bond equivalent yield. This is done through the conversion equation to
convert from a periodicity of 1 to a periodicity of 2.

è = APR2 = 0.01832 = 1.833 %

Approach 2

Alternatively, we can assume that compounding happens semiannually (periodicity of two) and the effective rate calculated would be
semiannual

è 69.43 = (1 + r)40;r = 0.009163 = 0.916%.

To annualize this, we multiply it by 2 and obtain the same result as the first approach: 1.833%

Note : Negative yields do not call for any difference in the calculation method. For example an effective annual rate (assuming a
periodicity of 1) of -0.7278% , to convert it into a periodicity of 2, all we do is :

è = APR2 = − 0.007291 = − 0.7291 %

3. Other Yield Measures, Conventions, and Accounting for Embedded Options

LOS (b) : Compare, calculate, and interpret yield and yield spread measures for fixed-rate bonds

3.1. Other Yield Measures and Conventions

The current yield, given by CY = Annual Coupon / Bond price, was introduced earlier and is a simple measure. However, it does
not take into account factors such as the frequency of coupon payments, the time value of money, or accrued interest. It is only
focused on the interest income. Additionally, investors can gain or lose if they buy a bond at a discount or premium and it is
redeemed at par value.

In bond yield calculations, the actual timing of cash flows is important. However, for convenience and simplicity, bond yields are
often quoted and calculated based on the assumption that payments are made on scheduled dates, without considering weekends
and holidays. This is known as the "street convention" yield. In reality however, if the payment date falls on a non-business day,
investors would receive the payment on the next business day. A true yield can then be calculated, taking into account the actual
payment dates that consider weekends and holidays. However, the true yield is not used in practice as the difference between
the street convention yield and the true yield is usually small, no more than a basis point or two with the true yield never being
larger than street convention one.

Corporate bond yields are commonly calculated using the 30/360 day count convention. However, they can also be restated using
the actual/actual day count convention, known as a government equivalent yield. This allows for comparison with government
bond yields and helps determine the spread between the two.

35
Example
Government Equivalent Yield for BRWA Five-Year Bond

BRWA issued a 3.2% semiannual fixed-coupon five-year bond at par. As is standard for corporate bonds, the BRWA bond yield is calculated on
a 30/360 day count basis. The comparable five-year US Treasury bond yields 2.3%, but as a government bond, the yield is calculated using the
actual/ actual day count basis. While the yield difference appears to be 90 bps (= 3.2% – 2.3%), the day count bases differ. Calculate the
government equivalent yield for the BRWA bond and show the yield difference between the BRWA and government bonds based on the same
day count basis.

Solution: A simple approximation for restating a corporate bond yield from the 30/360 day count basis to the actual/actual day count basis is
to multiply the BRWA bond yield by 365/360.

Yield ACT/ACT = 365/360 × Yield30/360

Yield ACT/ACT = 365/360 x 0.032 = 3.244%

The bond equivalent yield for the BRWA bond is 3.2444%; hence, the yield-to-maturity difference between two bonds is 94.4 bps (= 3.2444% –
2.3%).

The simple yield on a bond is the total return on the bond, including coupon payments and any gain or loss, divided by the bond's
price. This measure is commonly used for Japanese government bonds (JGBs).

The following table presents a summary of all the yield conventions :

Convention Meaning
Actual/Actual Actual number of days from prior coupon payment to settlement date/number of days in a coupon period, assuming the
(Act/Act) actual number of days in a year. Typically used with government bonds.
Number of days from prior coupon payment to settlement date, assuming 30 days in a month/number of days in a coupon
30/360
period, assuming 360 days in a year. Typically used with corporate bonds.
Street Yield measure that does not account for weekends and bank holidays and thus assumes cash flows are paid on their
Convention scheduled dates.
Yield measure that accounts for weekends and bank holidays and thus assumes cash flows are paid after their scheduled
True Yield
dates. True yield is never higher than street convention yield due to the delay in time to payment.
Government
Yield measure that restates a yield-to-maturity based on a 30/360 day count to one based on an actual/actual day count. It
Equivalent
is used to restate the YTM on a corporate bond to obtain the spread over the government YTM.
Yield
Yield measure that is the sum of coupon payments plus the straight-line amortized share of the gain or loss, divided by the
Simple Yield
flat price. It is used mostly to quote Japanese government bonds (JGBs).

3.2. Bonds with Embedded Options

When a fixed-rate bond has an embedded option, different yield measures need to be used. These provisions, such as the ability
for the issuer to buy back the bond from the investor, cannot be separated from the bond and traded independently. The call
option can only be exercised by the issuer after a certain period of time, known as the call protection period and at specific prices
on pre-determined dates.

For example, consider the following callable bond prospectus:

Prospectus Summary
Issuer: Vivivyu Incorporated
Settlement Date: [T + 3 Business Days]
Maturity Date: [Seven Years from Settlement Date]
Principal Amount: US$ 400 million
Interest: 6.5% fixed coupon
Interest Payment: Starting six months from [Settlement] to be paid semiannually with final payment on [Maturity]
The Notes are secured and unsubordinated obligations of VIVU and rank pari passu with all other secured and
Seniority:
unsubordinated debt
The Issuer may redeem some or all of the Notes on any Business Day before [Maturity] starting three years after
Call Provision:
[Settlement] based upon the Call Price Schedule as a percent- age of the Principal Amount plus accrued interest
103.25% [Three to Four Years after Settlement]
Call Price Schedule:
102.50% [Four to Five Years after Settlement]

36
 101.75% [Five to Six Years after Settlement]
101.00% [Six to Seven Years after Settlement]

Issuer has the right to call the bond for the final four years based on a fixed price schedule. Investors who are concerned about
call risk often calculate the lowest possible yield by considering the sequence of yields corresponding to the bond's call dates.
Traditional yield-to-maturity measures assume that all cash flows occur as promised, but this assumption needs to be adjusted
for callable bonds. Analysts need to use alternative return measures that consider the bond's call feature, such as the yield to the
first call date, second call date, and so on. The yield-to-call is calculated by modifying the general formula as :

è PV = [PMT / (1 + r)1] + [PMT / (1+r)2] + . . . + [ (PMT + Call price)/ (1+r)N ]

Where,
PV = the price of the bond
PMT = coupon payment per period
Call price = price at which a bond can be called on a given date r = yield per period or market discount rate
N = number of evenly spaced periods to the date when a bond can be called at the call price

For the bond given above, if we use the above equation keeping in mind the periodicity, we get the following values :

o Yield-to-first call = 5.149%

o Yield-to-second call = 5.247%
o Yield-to-third call = 5.313%
o Yield-to-fourth call = 5.362%
o Yield-to-maturity = 5.374%

The yield-to-worst is the lowest yield in a sequence of yields for a bond (5.15% in this case), including yields to call and yield to
maturity. It is used to provide investors with a conservative estimate of the rate of return. This measure is commonly used by
bond dealers and investors to assess fixed-rate callable bonds.

Valuing a callable bond more accurately involves using an option pricing model to determine the value of the embedded call
option, which reduces the bond's price from the investor's perspective. The option-adjusted price is calculated by adding the
value of the call option to the flat price of the bond. This price is used to calculate the option-adjusted yield, which is the required
market discount rate adjusted for the value of the embedded option. The value of the call option is determined by subtracting the
price of the callable bond from the price of the option-free bond.

4. Yield Spread Measures for Fixed-Rate Bonds and Matrix Pricing

LOS (b) : Compare, calculate, and interpret yield and yield spread measures for fixed-rate bonds

4.1. Yield Spreads over Benchmark Rates

Understanding changes in bond prices and yields-to-maturity is important in fixed-income security analysis. Decomposing the
yield-to-maturity into a benchmark rate and an issuer-specific spread helps differentiate between macroeconomic and
microeconomic factors that affect bond prices. The benchmark rate captures top-down factors, while the spread captures bottom-
up factors as shown in the image below :

37
The most commonly used benchmark rate is the most recently issued government bond, also called on-the-run security, which is
actively traded and has a coupon rate close to the current market discount rate. It is priced close to par value and typically trades
at slightly lower yields than seasoned, off-the-run government bonds with similar time-to maturity. This is mainly due to
differences in demand and sometimes due to different financing costs in the repo market

The benchmark spread is the yield difference between a specific bond and a benchmark government yield curve, indicating the
risk premium and potential tax impact of holding the bond. The following image helps visualize this relationship:

Spreads help analysts control for macroeconomic factors and thus enable better assessment of bond relative value on a historical
and comparative basis.

The G-spread is the yield spread over a government bond yield and represents the return for bearing risks relative to sovereign
bond. If there is no matching sovereign benchmark bond, an approximation process is used to find the G-spread, discussed in the
example below :

Example
Calculating G-Spread without a Comparable Benchmark Bond

Assume that the Russian Federation has issued a 30-year US dollar–denominated sovereign bond based on the following terms:

5.25% Russian Federation Bonds : Brief Summary of Terms

Issuer: Russian Federation
Settlement Date: [T + 5 Business Days]
Maturity Date: [30 Years from Settlement Date]
Principal Amount: USD 750 million
Interest: 5.25% fixed semiannual 30/360 basis
Issuance Price: 99.625

38
 Issuance Spread: 200 bp versus current US 30y Treasury
Issuance and Trading: US Private Placement under Rule 144A DTC / Euroclear / Clearstream
Seniority: Senior Unsecured
Exchanges: Luxembourg

Six years after the original issuance date, on 15 March 2026, the bond is trading at a price of 123.5 per 100 face value, and an analyst observes
that 20-year and 30-year US Treasury yields are currently 2.00% and 2.25%, respectively. Calculate the current G-spread of the Russian
Federation bond.

Step 1 Calculate the current yield-to-maturity of the Russian Federation bond. We may solve for r using the general formula for bond price and
yield: PV=PMT1/(1+r)1 +PMT2/(1+r)2 +...+(PMTN +FVN)/(1+r)N = 3.756%

Step 2 Linearly interpolate the current 20-year (r20y) and 30-year (r30y) US Treasury yields to solve for an approximate 24-year (r24y) US
Treasury benchmark:

1. Solve for the weights of the 20-year and the 30-year bonds in the interpolation calculation:

20-year bond weight = w20 = 60% [= (30 – 24)/(30 – 20)] and 30-year bond weight = w30 = 40%, or (1 – w20).

Note that(w20 ×20)+(w30 ×30)=24.

2. The 24-year government rate is a weighted average of the 20-year bond rate and the 30-year US Treasury rate using the weights above.

è r24y =w20 ×r20y +w30 ×r30y = (60% × 2.00%) + (40% × 2.25%) = 2.10%.

Step 3 The G-spread is the difference between the current Russian Federation bond yield-to-maturity and the 24-year US government rate:

1.656% = 3.756% – 2.10%, so the G-spread is 166 bps.

The I-spread, also known as the interpolated spread, is the difference between the yield of a bond and the standard swap rate in
the same currency and tenor. It is commonly used to price and quote euro-denominated corporate bonds, with a euro interest
rate swap serving as the benchmark. The I-spread is used by issuers to compare the cost of fixed-rate bonds with floating-rate
alternatives, and by investors to assess a bond's credit risk. An asset swap converts a bond's fixed coupon to a market reference
rate plus or minus a spread, and if the bond is priced at par, then this provides an estimate of the bond's credit risk over the
market reference rate.

4.2. Yield Spreads over the Benchmark Yield Curve

Whereas the G-spread and I-spread are the difference between two single numbers and use the same discount rate (yield-to-
maturity) for each cash flow, a different approach is to calculate a constant yield spread over a government (or interest rate swap)
spot curve, or series of yields. This spread is known as the zero-volatility spread (Z-spread) of a bond over the benchmark rate. In
other words, the Z-spread is what must be added to each benchmark spot rate to make the present value of a bond’s cash flows
equal its price.
The G-spread and I-spread are calculated by subtracting two numbers and use the same discount rate (yield to maturity) for all
cash flows. On the other hand, the Z-spread is calculated by adding a constant spread to each benchmark spot rate to match the
present value of a bond's cash flows with its price i.e. :

Where,
z1, z2, . . . , zN—are the benchmark spot or zero rates, derived from the government yield curve (or from fixed rates on
interest rate swaps),
Z is the Z-spread per period and is the same for all time periods.
N is an integer, so the calculation is on a coupon date when the accrued interest is zero.

Z-spread is called the “static spread” because it is constant (and has zero volatility)

39
The Z-spread is a measure used to calculate the option-adjusted spread (OAS) on a callable bond. The OAS takes into account an
option-pricing model and an assumption about future interest rate volatility. It involves subtracting the value of the embedded
call option, stated in basis points per year, from the yield spread.

è OAS = Z-spread – Option value in basis points per year.

This important measure is covered in detail later

The table below provides a summary of the yield spread measures :

Type Description
G-spread Government spread, the yield spread in basis points over an actual or interpolated government bond. Used in the US, the
UK, Japan, and other jurisdictions.
I-spread Interpolated spread, the yield spread of a bond over the standard swap rate in the same currency and with the same
tenor. Euro-denominated corporate bonds are typically priced vs. a euro interest rate swap benchmark.
Z-spread Zero-volatility spread, a constant yield spread over a government (or interest rate swap) spot curve used to derive the
term structure of credit spreads for an issuer.
Option-adjusted The Z-spread adjusted for the value of an embedded call option.
spread

40
Fixed Income - Learning Module 8
for the CFAâ exam

Yield and Yield Spread Measures for Floating Rate

Instruments
Learning Outcomes :

The candidate should be able to:

a) Calculate and interpret yield spread measures for floating-rate instruments

b) Calculate and interpret yield measures for money market instruments

1. Introduction

The previous lessons discussed bond pricing, yields, and spreads for fixed-rate bonds with maturities of one year or longer. Now
we will cover variable-rate instruments (floating-rate) and money market instruments (i.e. those with maturities of one year or
less). Both types are important for investors and issuers. Floating-rate instruments adjust to interest rate changes, reducing price
risk and serving as hedges. Money market instruments provide short-term financing, allowing quick reinvestment for investors
and refinancing for issuers, lowering interest rate risk.

2. Yield And Yield Spread Measures For Floating-Rate Notes

LOS (a) : Calculate and interpret yield spread measures for floating-rate instruments

2.1. Yield and Yield Spread Measures for Floating-Rate Instruments

Floating-rate instruments, such as floating-rate notes (FRNs) and loans, differ from fixed-rate bonds. They have variable coupon
payments that change based on a reference interest rate, which helps borrowers adapt to market conditions and reduces price
risk for investors or lenders during interest rate fluctuations. Unlike fixed-income securities, floaters tend to maintain a stable
price because their cash flows adjust with changing interest rates, making them less sensitive to interest rate volatility.

A sample term-sheet of a 4-year FRN of a German design firm is shown below:

Antelas AG Four-Year Floating-Rate Notes (the “Notes”) Prospectus Summary

Issuer: Antelas AG
Settlement Date: [T + 5 Business Days]
Maturity Date: [Four Years from Settlement Date]
Principal Amount: EUR250 million
Interest: MRR plus 250 bps p.a.
MRR is reset quarterly and interest is paid quarterly Commencing three months from [Settlement Date] to be
Interest Payment:
paid quarterly with final payment on [Maturity Date]
The Notes are secured and unsubordinated obligations of Antelas AG and will rank pari passu with all other
Seniority:
secured and unsubordinated indebtedness
Business Days: Frankfurt

Floating-rate instruments like FRNs or loans often use a short-term money market rate as their market reference rate (MRR).
Normally, this reference rate is established at the start of a period, and interest payments are made at the end of that period, a
method known as "in arrears." In the case of the Antelas FRN, the MRR is reset every quarter, and interest payments are also
made quarterly.

In the case of most FRNs and loans, a specified spread is applied to the market reference rate. For the Antelas FRN, the spread
over the MRR is 250 basis points (bps), known as the quoted margin which compensates the investor for the difference in credit
risk between the issuer and the reference rate. Highly creditworthy firms may even have a negative quoted margin.

The required margin for a floating-rate note (FRN) is the yield spread that makes the FRN's price equal to its par value on a rate
reset date, and it's determined by the market. Changes in the required margin for floating-rate notes (FRNs) are typically driven
by shifts in the issuer's credit risk, but alterations in liquidity or tax status can also play a role, mirroring the factors influencing

41
yield spreads for fixed-rate bonds. For instance, if the required margin increases to 75 basis points (bps) on a reset date due to an
issuer's credit rating downgrade (while the quoted margin which is decided at issuance remains 50 bps), the FRN will yield a lower
interest payment than expected, leading to a discount below par value. The size of this discount represents the present value of
the lower future cash flows and equals 25 bps per period for the remaining life of the bond, which is the difference between the
required and quoted margins. Conversely, if the required margin falls to 40 bps, possibly due to an improvement in the issuer's
creditworthiness, the FRN will be priced at a premium. The premium reflects the present value of the 10 bps excess interest
payment per period.

Fixed-rate and floating-rate bonds both respond to changes in credit risk in a similar way. For fixed-rate bonds, the premium or
discount is based on the gap between the fixed coupon rate and the required yield-to-maturity. In contrast, for floating-rate bonds,
the premium or discount depends on the difference between the fixed quoted margin and the required margin. However, when
it comes to changes in benchmark interest rates, fixed-rate and floating-rate bonds behave quite differently.

Recall that the price for a fixed-rate bond given a market discount rate r and a coupon per period PMT is :

For a FRN, the PMT is a function of the MRR and the quoted margin while the discount rate is the function of MRR and the required
margin and thus FRN’s valuation is given by :

Where,
PV = present value, or the price of the floating-rate note
MRR = the market reference rate, stated as an annual percentage rate (it is some- times known generically as Index)
QM = the quoted margin, stated as an annual percentage rate
FV = the future value paid at maturity, or the par value of the bond
m = the periodicity of the floating-rate note, the number of payment periods per year
DM = the discount margin = required margin stated as an annual percentage rate
N = the number of evenly spaced periods to maturity

Note : Since, all rates are mentioned in annual percentages, periodicity needs to be kept in mind through “m”.

This pricing model simplifies calculations due to the following reasons.

o It considers the present value (PV) at a rate reset date, with N evenly spaced periods to maturity and no accrued interest.
o It assumes a 30/360 day-count convention to ensure an integer periodicity (m). In practice though, most floating-rate
instruments use actual/360 day counts.
o The model employs the same Market Reference Rate (MRR) for all cash flows. More complex pricing models for floating-rate
notes incorporate projected future rates in the numerators and spot rates in the denominators, making the calculation of the
discount margin (DM) dependent on the assumptions used in the model.

Example
Calculating the Discount Margin for a Floating-Rate Note

Suppose that a two-year FRN pays MRR plus 0.75% on a semi-annual basis. Currently, MRR is 1.10% and the price of the floater is 95.50
per 100 of par value, a discount to par, because of worsening credit risk. We have the following inputs:

PV = 95.50,
MRR = 0.0110,
QM = 0.0075,
FV = 100,
m = 2, and
N=4

On solving the equation, we get DM = 3.12% or 312bps. If this FRN was issued at par value initially, investors required at that time a
spread of only 75 bps over MRR. Now, after the credit downgrade, investors require an estimated discount margin of 312 bps. The floater

42
trades at a discount to par because the quoted margin remains fixed at 75 bps, so is “deficient” by 237 bps (312-75) per period. The
discount margin is an estimate because it is based on a simplified FRN pricing model.

3. Yield Measures For Money Market Instruments

LOS (b) : Calculate and interpret yield measures for money market instruments

Money market instruments are short-term debt securities with maturities of one year or less. They encompass various types, such
as overnight repos, bank certificates of deposit, commercial paper, Treasury bills, bankers' acceptances, and time deposits tied to
market reference rates. Money market mutual funds, which exclusively invest in these instruments, serve as alternatives to
traditional bank deposits

Yield measures for money market instruments and bonds differ in several key ways:
1. Bond yields-to-maturity are annualized and compounded, whereas money market yields are annualized but not
compounded, calculated on a simple interest basis.
2. Bonds have a common periodicity for all times-to-maturity, while money market instruments with different maturities
may have varying periodicities for the annual rate.
3. Calculating bond yields-to-maturity uses standard time-value-of-money analysis. Money market instruments are often
quoted using non-standard interest rates, necessitating different pricing equations than those used for bonds.

Money market rates are typically quoted as either discount rates or add-on rates. Commercial paper, Treasury bills, and bankers'
acceptances are often quoted using discount rates, while bank certificates of deposit, repos, and market reference rate indexes
use add-on rates. In this context, a discount rate includes the interest in the face value of the instrument, while an add-on rate
involves adding interest to the principal or investment amount.

The pricing formula for money market instruments quoted on a discount rate basis is given by :

where
PV = present value, or the price of the money market instrument
FV = the future value paid at maturity, or the face value of the money market instrument
Days = the number of days between settlement and maturity
Year = the number of days in the year
DR = the discount rate, stated as an annual percentage rate

For example, a 91-day T-bill from India with face value of INR10million, quoted at a discount rate of 3.45%, assuming 360 day year
will be priced at :

è PV = 10,000,000 x [ 1 – (91/360) x 0.0345 ] = INR 9.912 million

From the above equation, we can isolate the DR term as :

First term is the periodicity of the annual rate. The second term is interesting : The numerator represents the interest earned but
the denominator is FV. Normally, interest is the amount earned on the investment amount i.e. PV and not the maturity amount
FV which includes the interest. Therefore, by design, a money market discount rate understates the rate of return to the investor,
and it understates the cost of borrowed funds to the issuer. That is because PV is less than FV if DR is greater than zero.

The pricing formula for money market instruments quoted on an add-on rate basis is given by :

Where,
PV = present value, the principal amount, or the price of the money market instrument
FV = the future value, or the redemption amount paid at maturity including interest
Days = the number of days between settlement and maturity
43
 Year = the number of days in the year
AOR = the add-on rate, stated as an annual percentage rate

From the above equation, we can isolate the AOR term as :

è

Notice, how the second term differs in this add-on case by using the initial investment amount PV as the base value v/s FV for the
discount rate case.

Analysing money market securities is more complex due to differences in quoting methods (discount rate vs. add-on rate), varying
day-count conventions (360-day vs. 365-day year), and variations in what the "amount" represents. For discount rate-based
quotes, the "amount" is typically the face value paid at maturity, while for add-on rate quotes, the "amount" usually represents
the price at issuance. These differences add to the challenge of evaluating money market instruments.

To make money market investment decisions, it is essential to compare instruments on a common basis

Example
Yield Measures on Bank Certificates of Deposit

Suppose that an investor is comparing the following two money market instruments. Which offers the higher expected rate of
return, assuming that credit risks are the same?

o A 90-day commercial paper (CP) issued by Bright Wheel Automotive Corporation (BRWA), quoted at a discount rate of 0.100%
for a 360- day year
o A 90-day certificate of deposit issued by CFP Bank, quoted at an add-on rate of 0.120% for a 365-day year

The price of the commercial paper is 98.560 per 100 of face value, calculated using discount rate equation and entering FV = 100,
Days = 90, Year = 360, and DR = 0.0012.

è PV = FV × [ 1− ( Days/ Year) × DR ] = 99.970.

Next, use add-on equation to solve for AOR for a 365-day year, where Year = 365, Days = 90, FV = 100, and PV = 99.970

è AOR = ( Year / Days) x ( FV – PV ) / PV = 0.00122

The 90-day commercial paper discount rate of 0.120% converts to an add-on rate for a 365-day year of 0.122%. This converted
rate is called a bond equivalent yield, or sometimes just an “investment yield.” A bond equivalent yield is a money market rate
stated on a 365-day add-on rate basis. If the risks are the same, BRWA’s CP offers 0.2 bps more in annual return than CFP Bank’s
CD.

As discussed, a key distinction between yield measures in the money market and the bond market is the periodicity of the annual
rate. Bond yields-to-maturity involve interest rate compounding, leading to a well-defined periodicity, often semiannual (two
periods per year). In contrast, money market rates use simple interest without compounding, and their periodicity is calculated
as the number of days in the year divided by the number of days to maturity. As a result, money market rates for different
maturities have varying periodicities.

Suppose an analyst wants to convert money market rates to a semiannual bond basis for direct comparison with bonds having
semiannual coupon payments. So if a 91-day Indian rupee T-bill is quoted at bond equivalent yield of 3.50%, then its periodicity is
365/91, and we can use the conversion formula discussed earlier to convert this rate from a periodicity of m (365/91) to n (2),
allowing for meaningful comparisons with semiannual bond yields

44
 è APR2 = 0.03515 = 3.515 %

Therefore, 3.50% for a periodicity of 365/91 corresponds to 3.515% for a periodicity of 2. The difference is –1.5 bps

45
Fixed Income - Learning Module 9
for the CFAâ exam

The Term Structure of Interest Rates: Spot, Par, and Forward

Curves
Learning Outcomes :

The candidate should be able to:

a) Define spot rates and the spot curve, and calculate the price of a bond using spot rates
b) Define par and forward rates, and calculate par rates, forward rates from spot rates, spot rates from forward rates, and the
price of a bond using forward rates
c) Compare the spot curve, par curve, and forward curve

1. Introduction

In prior lessons, fixed-income instruments were priced by discounting future cash flows at a single interest rate. However, the
next three lessons introduce the concept of the term structure of interest rates, which recognizes that interest rates vary with
time-to-maturity. The ideal data for analysing the term structure are default-risk-free zero-coupon bonds, also known as spot
rates or the spot curve. Since these bonds are not directly observable, various estimation techniques are used. The spot curve is
used to derive two other important yield curves: the par curve, which involves bond yields for benchmark securities priced at par,
and the forward curve, which involves rates for future interest periods. These three curves are crucial for fixed-income analysis
and other applications as they represent default-risk-free rates of return for different time periods. The pricing of bonds using
these rates is explained, and their relationships are established.

2. Maturity Structure Of Interest Rates And Spot Rates

LOS (a) : Define spot rates and the spot curve, and calculate the price of a bond using spot rates

2.1. Maturity Structure of Interest Rates

The yield-to-maturity between two bonds can vary for several reasons, such as credit risk, currency differences, liquidity, tax
variations, and the frequency of yield calculation. Another factor that can affect bond yields is the time remaining until maturity,
known as the maturity structure or term structure of interest rates. The term structure effect, is best analyzed using bonds that
have the same properties except for their time-to-maturity. These bonds should

o denominated in the same currency

o have the same credit risk
o liquidity
o tax status
o periodicity assumption
o and coupon rate.

46
The ideal dataset for analyzing the term structure would be
yields-to-maturity on a series of default-risk-free zero-
coupon bonds, known as spot rates. Developed market
sovereign bonds are commonly used for this purpose
because they have the lowest default risk. This dataset is
called the government bond spot curve or the zero or
"strip" curve. It is ideal for analyzing maturity structure
because it meets the assumption of "other things being
equal" and eliminates coupon reinvestment risk and it is
illustrated in the adjoining image, for maturities ranging
from 1 to 30 years. The annual yields are stated on semi-
annual bond basis to allow for easier comparison to
coupon-bearing bonds that also make semiannual
payments.
The upward sloping spot curve in the previous image
shows that longer-term government bonds have higher yields than shorter-term bonds, which is typical in normal market
conditions. Occasionally, the spot curve can be downward sloping, indicating inverted yield curves. Theories explaining the yield
curve's shape and implications for future financial
market conditions will be discussed later.

While a spot curve derived from zero-coupon

government bonds is the preferred choice for
analysis, practical challenges exist. Many actively
traded government bonds come with coupon
payments, which can affect liquidity and tax
treatment. Seasoned bonds are less liquid than
newly issued ones, and older bonds can be priced
differently due to interest rate fluctuations,
leading to tax variations. As a result, only recently
issued and actively traded government bonds,
with similar liquidity fewer tax implications (due
to their prices being closer to par value), are
typically used to construct a yield curve.
Interpolation is employed to fill in the gaps in the
curve due to limited data for various maturities.

The adjoining image shows a yield curve for a

government that issues bonds with different
maturities – 2, 3, 5, 7, 10 and 30 years. The yield
curve is created by using straight-line
interpolation between the points on the curve. It
also includes yields for short-term money market
government securities with different maturities –
1, 3, 6, 12 months. These yields are converted to
bond equivalent yields to facilitate comparisons.
All bonds on the yield curve are also converted to
the same periodicity for easier comparison. The
process of converting discount rates to bond
equivalent yields and across different periodicities
has been explained in previous lessons.

2.2. Bond Pricing Using Spot Rates

The term structure of interest rates allows us to determine the price of bonds by using discount rates that correspond to the dates
of cash flows. The spot curve, which represents default-risk-free rates, is one way to calculate these discount rates. By using spot
rates, we can establish "no-arbitrage" prices for bonds. If a bond's price is different from its no-arbitrage value, there is an
opportunity for arbitrage, assuming there are no transaction costs involved. Assume that one-year spot rate is 2%, the two-year
spot rate is 3%, and the three-year spot rate is 4%. The price of a 3- year bond that makes a 5% annual coupon payment is

è [ 5/(1.02)1] + [5 / (1.03)2] + [ 105/ (1.04)3] = 4.902 + 4.713 + 93.345 = 102.960

47
Bond is priced at a premium, so its YTM must be < its 5% coupon rate. Using the basic formula, the YTM is:

è 102.960 = [ 5/ (1+r)1] + [5 / (1+r)2] + [ 5/ (1+r)3] ;r = 0.03935 = 3.935%:

If the cash flows are discounted using the yield-to-maturity, the same price is obtained :

è [5 / (1.03935)1] + [ 5 / (1.03935)2] + [5 / (1.03935)3] = 4.811 + 4.629 + 93.520 = 102.960.

Notice that the present values of the individual cash flows discounted using spot rates differ.
The general formula for calculating a bond price given the sequence of spot rates is :

è PV = [PMT / (1+Z1)1] + [ PMT / (1+Z2)2] + . . . . + [ PMT / (1+ZN)N ]

where
Z1 is the spot rate, or zero-coupon yield or zero rate, for period 1
Z2 is the spot rate, or zero-coupon yield or zero rate, for period 2
ZN is the spot rate, or zero-coupon yield or zero rate, for period N

Important Note : For pricing a bond with a different risk profile than the spot curve (such as credit risk, as for corporate bonds ) a
spread would be added to the spot rates

3. Par And Forward Rates

LOS (b) : Define par and forward rates, and calculate par rates, forward rates from spot rates, spot rates from forward rates, and
the price of a bond using forward rates

3.1. Par Rates from Spot Rates

Spot rates are used to determine par rates, which are yields-to-maturity that make the present value of a bond's cash flows equal
to par (100% of face value). Par rates are commonly used in term structure analysis as they account for potential distortions
associated with actual bonds priced at a discount or premium. The widely used US Treasury yield curve is composed of par rates
and is published daily by the US Department of the Treasury. The most recently issued, on-the-run government securities
introduced earlier, are actual bonds that have yields-to-maturity that are close to but not equal to par rates.

On a coupon payment date, solving for PMT in the following equation with give us the par rate given a sequence of spot rates.

è 100 = [ PMT / (1+z1)1] + [ PMT / (1+z2)2] + . . . . + [ (PMT + 100) / (1+zN)N]

Between coupon dates, we set the flat price (rather than the full price) equal to 100.

For a bond trading at par, coupon rate = yield-to-maturity. By solving for PMT, we also solve for YTM for the bond to trade at par.
This rate divided by 100 is the par rate.

For example, in effective annual rate term, the current 1, 2, 3, and 4-year spot rates on government bonds are 5.263%, 5.616%,
6.359%, and 7.008%, respectively. The par rates are :

è For 1 year : 100 = (PMT + 100) / (1.05263)1 implies PMT = 5.263 and par rate = 5.263%

è For 2 year : 100 = [ PMT / (1.05263)1] + [ (PMT + 100) / (1.05616)2] implies PMT = 5.606 and par rate = 5.606%

è For 3 year : 100 = [ PMT / (1.05263)1] + [ PMT / (1.05616)2] + [ (PMT + 100) / (1.06359)3] implies PMT = 6.306 and par
rate = 6.306 %

è Similarly, 4 year par rate = 6.899%

To confirm these rates, we can use these as the coupon and yield-to-maturity. For example for a 2 year bond, if coupon and yield
is 5.606%, its price is

è 5.606/(1.05606)1 + (100 + 5.606) /(1.05606)2 = 100.

48
Likewise, the price of the four-year bond is :

è 6.899/(1.06899)1 + 6.899/(1.06899)2 + 6.899/(1.06899)3 + (100 + 6.899) /(1.06899)4 = 100.

3.2. Forward Rates from Spot Rates

Forward rates are breakeven reinvestment rates that link the return on an investment in a shorter-term zero-coupon bond to the
return on an investment in a longer-term zero-coupon bond. Say an analyst wants to determine the additional return that can be
earned by investing for four years instead of three years. They are specifically interested in the implied one-year forward yield
three years into the future. To calculate this, they need to compare the yields-to-maturity on the three-year and four-year zero-
coupon bonds, which are 3.65% and 4.18%, respectively. An illustration is shown below :

The standard practice in the market is to refer to the forward rate as "3y1y" or "3's, 1's", which means a three-year forward period
and a one-year tenor. In the money market, the forward rate is typically expressed in months.

An investor's decision to invest in a four-year zero-coupon bond or a three-year bond depends on their view of future bond yields.

o If they believe that 3 years from now, the 1-year yield will be lower than the 3y1y yield, they should choose the four-year
bond.
o If they expect the 1-year yield to be higher than the implied forward rate, it is better to invest in the 3 year bond and reinvest
at the expected higher rate for the additional one year.

Thus, implied forward rate is considered the breakeven reinvestment rate in this scenario. The formula for the implied forward
rate is :

è (1 + ZA)A × (1+IFRA,B–A)B–A = ( 1 + ZB )B

Where,
Implied forward rate, IFRA,B–A, for a security begins at t = A and matures at t = B (tenor B – A).
ZA and ZB are the short and long-term spot rate respectively.

3.3. Spot Rates from Forward Rates and Bond Pricing with Forward Rates

Forward rates and spot rates are interconnected and can be calculated from each other, making them both useful for pricing.

Example
Deriving Spot Rates from Forward Rates and Pricing Bonds Using Forward Rates

Forward tenor Rates

0y1y 0.3117%
1y1y 0.8250%

49
Suppose we have the following forward rates for 2y1y 1.2587% Canadian government bonds:
1y2y 1.0416%

1. Calculate a three-year spot rate on Canadian government bonds using the forward rate information.

Solution: The three-year spot rate is calculated using three of the one-year forward rates above: the 0y1y, 1y1y, and 2y1y.

è (1.003117 × 1.008250 × 1.012587) = (1 + z3)3. z3 = 0.7977%.

2. Calculate the value of a three-year Canadian government bond paying a 0.50% coupon using forward rates.

Solution: PV = 0.5 / (1.003117) + (0.5) / (1.003117 × 1.008250) + (100 + 0.5) / (1.003117 × 1.008250 × 1.0012587) = 99.126

4. Spot, Par, And Forward Yield Curves And Interpreting Their Relationship

LOS (c) : Compare the spot curve, par curve, and forward curve

Spot, par, and forward rates are interconnected, due to which their curves are also inter-connected. This is illustrated using an
example of Canadian and Australian government bond yield curves across various maturities. The spot curve along with the data
is presented below :

Maturity (Years) 1 2 3 4 5 7 10 20 30
Canada 0.31% 0.57% 0.80% 0.96% 1.11% 1.30% 1.58% 1.98% 2.06%
Australia 0.03% 0.07% 0.30% 0.59% 0.81% 1.17% 1.52% 2.35% 2.47%

The derived forward and par curves are shown below :

50
Some key observations are :
1. Spot rates are positive and upward sloping.
2. Par rates are slightly lower than spot rates, with a greater difference at longer maturities. ( notice this trend in the example
discussed while converting spot rates into par rates)
3. Forward rates are higher than spot and par rates.

These trends will be discussed in more detail in future modules.

If the spot curve is assumed to be flat, i.e. constant yield across maturities, par and forward rates will equate to the spot rate
across all maturities. A flat spot rate curve reflects no expectations of changes in future interest rates; thus forward rates equal
spot rates.

51
The adjoining image shows a downward-sloping spot curve,
indicating falling spot rates as time goes on. The spot rates start at
4% for a 1-year maturity and decrease to 1.90% for a 10-year
maturity. The par rates are similar to the spot rates. The forward
curve shows expectations of significantly lower one-year rates in
future years. In this example, the forward rate term structure
suggests a one-year rate of 0.1175% expected in nine years.

The table below summarizes the general relationship between the spot, par, and forward curves for different spot curve shapes

Spot Curve Shape Par Curve Forward Curve

Upward Sloping Below spot curve Above spot curve
Flat Equal to spot curve Equal to spot curve
Downward Sloping (Inverted) Above spot curve Below spot curve

52
Fixed Income - Learning Module 10
for the CFAâ exam

Interest Rate Risk and Return

Learning Outcomes :

The candidate should be able to:

a) Calculate and interpret the sources of return from investing in a fixed-rate bond;
b) Describe the relationships among a bond’s holding period return, its Macaulay duration, and the investment horizon;
c) Define, calculate, and interpret Macaulay duration

1. Introduction

In this lesson, we will explore the sources of return for fixed-income investments and how they relate to yield-to-maturity
calculations. We will also discuss interest rate risk and how it is affected by investment horizon and bond characteristics.
Additionally, we will introduce the concept of Macaulay duration and its role in balancing reinvestment and price risks.

2. Sources Of Return From Investing In A Fixed-Rate Bond

LOS (a) : Calculate and interpret the sources of return from investing in a fixed-rate bond

Fixed-rate bond investors receive returns from three sources: coupon and principal payments, reinvestment of coupon payments,
and potential capital gains or losses from selling the bond before maturity. Now, we focus on how changes in interest rates impact
the reinvestment of coupon payments and the market price of bonds sold before maturity.

To illustrate, we consider two investors who purchase a 10-year, 6.2% annual coupon eurobond from issuer “BRWA”. They have
different time horizons for holding the bond. Initially, interest rates remain the same. Then, the impact of higher interest rates on
the investors' total return is demonstrated. Finally, the effect of lower interest rates is shown

2.1. Case 1

The first investor, VFO, purchases BRWA’s new 10-year, 6.2% (annual) coupon eurobond priced at par (settlement: 15 October
2025; maturity: 15 October 2035) and holds it to maturity. If the coupon payments are reinvested at 6.2%, the yield-to-maturity,
the future value of the coupons on the bond’s maturity date, is 82.493 per 100 of par value. This implies that difference between
82.293 and the actual coupon payments of 62 ( = 6.2 x 10) is the “interest on interest” from re-investment and compounding and
is equal to 20.293 (82.293 – 62)

The investor’s rate of return, expressed as a compound annual growth rate, is 6.20% given by:

è r = (FV / PV) 1/T − 1

= [ (82.493 + 100) / 100 ] 1/10 - 1 = 6.20%

The above calculations imply that yield-to-maturity at the time of purchasing a bond will be the investor's rate of return only if

o the bond is held until maturity,

o there is no default by the issuer, and
o the coupon interest payments are reinvested at the same rate of interest.

2.2. Case 2

The second investor Baywhite buys the 10-year, 6.2% annual coupon payment bond and pays the same par value as price but has
a 4 year investment horizon. So coupons are re-investment only 4 years after which the bond is sold. The future value of the 4
coupons after 4 years is 27.20321 per 100 of par value. Actual coupon payment is of 24.8 ( = 6.2 x 4) and the difference between
the two ( = 2.403) is the “interest on interest”. Assume YTM is still 6.2% so sale price is still 100

In this case, the investors return is :

53
 è r = (FV / PV) 1/T − 1 = [ (27.203 + 100) / 100) 1/4 - 1 = 6.20%

The horizon yield is the annualized holding period rate of return on a bond investment, taking into account both the reinvested
coupon payments and the sale price or redemption amount of the bond. The horizon yield for Baywhite is 6.2%, which is the same
as the original yield-to-maturity, even though they did not hold the bond until maturity. This demonstrates that the realized
horizon yield will match the original yield-to-maturity if the coupon payments are reinvested at the same interest rate and the
bond is sold at a price on the constant-yield price trajectory, indicating no capital gain or loss. It is important to note that capital
gains or losses can arise if a bond is sold above or below its constant-yield price trajectory.

The trajectory of a bond represents its carrying value at different points in time. The carrying value is calculated by adding or
subtracting the amortized amount of the discount or premium, depending on whether the bond was purchased below or above
its par value. In the cases discussed, the constant-yield price trajectory for the investors is a flat curve at a price of 100, as the
bonds were bought and sold at their par value.

2.3. Case 3

If interest rates increase by 100 basis points (bps) immediately after investment. The yield on the bond increases from 6.20% to
7.20%, and coupon reinvestment rates go up by 100 bps as well

o For VFO (buy and hold), future value of 6.2 coupons re-invested at the higher 7.2% rate is 86.475 and the return is :

è r = (FV / PV) 1/T − 1 = [ (86.475 + 100) / 100 ] 1/10 – 1 = 6.43%

VFO benefits from a higher coupon reinvestment rate, resulting in a realized horizon yield of 6.43%, which is 23 basis points
higher than where interest rates were constant. VFO does not experience any capital gain or loss as it holds the bond till
maturity.

o For Baywhite, the future value of the reinvested coupons at 7.2% is 27.609. After 4 years, we calculate the price of a bond
which pays 6.2% coupon for 6 more years when the current yield is 7.2%. This price is 95.263. The investor return then is :

è r = (FV / PV) 1/T − 1 = [ (27.609 + 95.263) / 100 ] 1/4 – 1 = 5.28%

Baywhite also benefits from the higher coupon reinvestment rate, which is offset by the capital loss from the sale of the bonds
at the higher yield (lower price).

Similarly, if we now take the case where the interest rates decline by 100bps, performing similar calculations as above, we will
find that
o VFO’s horizon yield will be 5.98% ( lower due to lower reinvestment returns )
o Baywhite’s horizon yield will be 7.16% ( due to increase in the bond’s resale value which more that offsets the lower coupon
re-investment return)

Some key observations to draw from this discussion :

o Interest income refers to the income earned from the passage of time, which includes receiving coupon interest, reinvesting
those coupons, and amortization of the discount (or premium) from purchase at a price below (or above) par value to align
the return with the market discount rate
o Capital gain or loss, on the other hand, is the return an investor earns from the change in the value of a security, particularly
a fixed-rate bond, which occurs due to a change in the yield-to-maturity.
o An investor's investment horizon is crucial in understanding interest rate risk and return in the context of bonds. Interest rate
risk for bond investors involves two contrasting elements: reinvestment risk and price risk. When interest rates increase,
reinvestment risk leads to higher future values of reinvested coupon payments, while it results in lower values when rates
decrease. Conversely, price risk impacts the sale price of a bond that matures after the investor's horizon date, causing it to
decrease with rising interest rates and increase with falling rates. Reinvestment risk is more significant for long-term investors,
like buy-and-hold investors, while price risk is more pertinent for short-term investors who sell before receiving the first
coupon payment. Consequently, two investors holding the same bond can have differing levels of exposure to interest rate
risk based on their unique investment horizons.

3. Investment Horizon And Interest Rate Risk

54
LOS (b) : Describe the relationships among a bond’s holding period return, its Macaulay duration, and the investment horizon;
LOS (c) : Define, calculate, and interpret Macaulay duration

Let us extend our discussion by introducing a third investor in BRWA’s 10-year, 6.2% annual eurobonds: Hightest Capital, which
has an 8-year time horizon. All the possible cases are summarise below :

Rate = 6.20% Rate= 7.20% Change Rate = 5.20% Change

Future Value of Re-invested coupon 61.807 64.071 2.264 59.630 -2.177
Selling Price after 8 years 100 98.197 -1.803 101.854 1.854
Horizon yield : r = (FV / PV) 1/T − 1 6.20% 6.24% 0.04% 6.17% -0.03%

The combined results for all 3 investors is illustrated in the image below :

From the tabular data presented above, notice that in both

100bps increase and decrease case, the changes in the
coupon FV and the final selling price are close to each other,
resulting in minimal changes in the horizon yield for the
investor. This Hightest’s case was take to demonstrate
Macaulay duration, a holding period for a bond that
balances coupon reinvestment gain (loss) and price loss
(gain) for a one-time instantaneous “parallel” shift in the
yield curve once the bond purchase is settled. Given the
result for Hightest, we know that the Macaulay duration of
this BRWA bond is close to eight years.

The adjoining image illustrates this effect :

o In part A, when interest rates increase, bond prices
initially decrease. Over time, however, the bond price
tends to return to its original value. This is because the
future value of reinvested coupons gradually increases,
compensating for the initial drop in price caused by
higher interest rates. At the Macaulay duration, these
two effects balance each other out, resulting in the gain
on reinvested coupons being equal to the loss from the
increase in interest rates.
o In part B, the same pattern is observed when interest
rates decrease. Initially, there is a rise in price, but as
time goes on, the "pull-to-par" effect brings the price back down. The impact of reinvesting at a lower rate starts off small but
becomes significant over time. The Macaulay duration indicates the point where the effects of the decrease in interest rates
balance out the loss from coupon reinvestment at lower rates.
55
This analysis allows for statements to be made about the relationship between interest rate risk, Macaulay duration, and the
investment horizon as shown in the table below :

Investment Horizon Dominant Risk Source of Interest Rate Risk

> Macaulay Duration Reinvestment Risk Falling Interest Rates
= Macaulay Duration Price Risk = Reinvestment Risk —
< Macaulay Duration Price Risk Rising Interest Rates

The Macaulay duration of the BRWA bond is 7.7429 years (calculation in the next lesson). From the table above, case 1 reflects
VFO’s situation with its 10-year horizon; case 2, Hightest, the investor with the 8-year horizon; and case 3, Baywhite, the investor
with the 4-year horizon.

Duration gap for a bond is given by :

è Duration gap = Macaulay duration – Investment horizon

VFO has negative duration gap lower interest rates is the primary risk. Hightest, has a duration gap of approximately zero, so it is
nearly hedged against interest rate risk. Baywhite has a positive duration gap and is at risk of higher rates.

4. Macaulay Duration

LOS (c) : Define, calculate, and interpret Macaulay duration

Macaulay duration of a traditional fixed-rate bond is the weighted average of the time to receipt of the bond’s cash flows, where
the weights of each cash flow in the calculation are each cash flow’s share of the bond’s full price (i.e., present value).

Let’s take a sample calculation for better understanding : Bond under question is BRWA’s 10-year, 6.2% (annual) coupon eurobond
used previously. The details are :

Coupon 6.20%
Coupon frequency per year 1
Price per 100 par value 100
Yield-to-maturity 6.20%
Settlement date 15 October 2025
Maturity 15 October 2035
Years to maturity 10
Day Count Basis 30/360

The Macaulay duration calculation is shown below.

o Columns 1 and 2 show the number of periods and the time to receipt of the cash flow, respectively. If the calculation is done
at issuance or on a coupon date, they are equal
o Column 3 is the cash flow per 100 of par value
o Column 4 is the present value of that cash flow.
o Column 5 is weight or each cashflow’s share of total PV
o Column 6 is the (weight) x (time to receipt of that cash flow). Sum of column 6 is the Macaulay duration value

(1) (2) (3) (4) (5) (6)

(4) ÷ Sum of present values (2) × (5)
Period Time to receipt Cash flow Present value Weight Time to receipt × weight
1 1 6.2 5.8380 0.0584 0.0584
2 2 6.2 5.4972 0.0550 0.1099
3 3 6.2 5.1763 0.0518 0.1553
4 4 6.2 4.8741 0.0487 0.1950
5 5 6.2 4.5895 0.0459 0.2295
6 6 6.2 4.3216 0.0432 0.2593
7 7 6.2 4.0693 0.0407 0.2849
8 8 6.2 3.8317 0.0383 0.3065
56
 9 9 6.2 3.6080 0.0361 0.3247
10 10 106.2 58.1942 0.5819 5.8194
100.0000 1.0000 7.7429

It is typically quoted as an annualized statistic, and if the bond pays coupons annually, no adjustment is needed. However, if the
bond pays coupons semiannually, the Macaulay duration is divided by 2 to obtain an annualized Macaulay duration. The units for
Macaulay duration are in years.

The general calculation of Macaulay duration, MacDur, that also accounts for partial coupon periods if the calculation is done
between coupon dates is as :

Where,
t is the number of days from the last coupon payment to the settlement date;
T is the number of days in the coupon period;
t/T is the fraction of the coupon period that has passed since the last payment; PMT is the coupon payment per period;
FV is the future value paid at maturity, or the par value of the bond;
r is the yield-to-maturity per period; and
N is the number of evenly spaced periods to maturity as of the beginning of the current period

Another approach to calculating Macaulay duration is to use a closed-form equation derived using calculus and algebra, as shown
below :

Where,
r is the yield-to-maturity per period;
N is the number of evenly spaced periods to maturity as of the beginning of the current period;
c is the coupon rate per period;
t is the number of days from the last coupon payment to the settlement date; and
T is the number of days in the coupon period

57
Fixed Income - Learning Module 11
for the CFAâ exam

Yield-Based Bond Duration Measures and Properties

Learning Outcomes :

The candidate should be able to:

a) Define, calculate, and interpret modified duration, money duration, and the price value of a basis point (PVBP)
b) Explain how a bond’s maturity, coupon, and yield level affect its interest rate risk

1. Introduction

This lesson builds upon previous lessons on interest rate risk by introducing measures of price risk. There are two categories of
price risk measures: those that assume certain bond cash flows and measure price sensitivity to changes in a bond's own yield,
and those that consider the possibility of bond default and measure price sensitivity to changes in a benchmark yield curve. This
lesson focuses on the former category and explains how the interest rate risk of a bond is influenced by its time-to-maturity,
coupon rate, and yield.

2. Modified Duration

LOS (a) : Define, calculate, and interpret modified duration, money duration, and the price value of a basis point (PVBP)

We know that price of a bond moves inversely with its yield. Let us take 3 bonds which were introduced in earlier fixed income
modules, assume all are denominated in the same currency.

o 1-year, zero-coupon Australian government bond,

o 5-year, 3.2% semiannual coupon Bright Wheels Automotive Corporation (BRWA) bond, and
o 30-year, 4.625% annual coupon Romanian government bond.

If we map out the prices of these bonds when yields vary from 0 to 10%, we get the following image :

Notice how the 1-year and 5-year bond lines are relatively flat compared to the steep 30 year bond line. If an investor held these
bonds and each bond’s yield increased from 2% to 3%, the changes in price, as shown in the table below would be very different:

YTM Price of 1-Year Australian Bond Price of 5-Year BRWA Bond Price of 30-Year Romanian Bond
2% 98.039 105.683 158.791
3% 97.087 100.922 131.851
Change in Price as YTM 2% → 3% −1% −5% −17%
This implies that the 30 year bond’s price is more sensitive to yield changes. We will try to find a measure for this sensitivity. Recall
the general option-free bond pricing equation:
58
 è PV = PMT/(1+r)1 + PMT / (1+r)2 + . . . + PMT / (1+r)N + FV / (1+r)N.

If we apply some calculus and take the first derivative with respect to r, we get the following which is essentially the change in
price for a small change in the interest rate:

If we re-arrange it algebraically, we get :

Each [PMT/(1+r)] / PV term is the cash flow present value as a percentage of the bond price which is then multiplied time to
receipt of that cash flow. In essence, this can be re-written as :

Without the sign, this is known as the Modified duration :

è ModDur = MacDur / (1 + r)

The ModDur, or modified duration, of a bond can be annualized by dividing it by the number of coupon periods per year. This
allows us to estimate the percentage price change for a bond when its yield-to-maturity changes. By substituting –AnnModDur in
the above equations and multiplying both sides by the change in annualized yield-to-maturity (dr), we can calculate the
approximate percentage change in bond price

è %ΔPV Full ≈ − AnnModDur × ΔAnnYield

So if bond’s modified duration is 5, its price will decrease by an estimated 5% for a 100 bp increase in yield: –5 × 0.01 = –5%. Thus,
higher a bond’s modified duration, the steeper its price–yield line and more sensitive its price is to yield changes.

Key points to note :

o Percentage price change refers to the full price, which includes accrued interest.
o The ≈ sign indicates this is an estimation since it is a linear approximation of the nonlinear relationship of price and yield.
o The negative sign indicates that bond prices and yields-to-maturity move inversely with one another.

2.1. Approximate Modified Duration

If the Macaulay duration is unknown due to default risk or contingency provision with the bond, an alternative approach is to
approximate modified duration by estimating the slope of the line tangent to the price–yield curve of a bond as shown below :

59
To estimate the slope of the price-yield curve, the yield-to-maturity of a bond is changed by a fixed amount in both directions. The
resulting bond prices are used to calculate the slope, which is the difference between the two prices divided by twice the change
in yield. To express the slope as a percentage change in the bond price, it is divided by the initial bond price. This is shown below
:

Where,
PV0 = quoted full price of the bond
ΔYield = Amount by which yield is changed in either directions
PV- and PV+ = Prices corresponding to new yields

The equation provides an estimate of the annualized modified duration of a bond: the frequency of coupon payments and the
periodicity of the yield-to-maturity is accounted within the bond price calculations. The Macaulay duration also can be
approximated by multiplying the approximate modified duration by 1 plus the yield per period.

è AnnMacDur ≈ AnnModDur × (1 + r)

3. Money Duration And Price Value Of A Basis Point

LOS (a) : Define, calculate, and interpret modified duration, money duration, and the price value of a basis point (PVBP)

Modified duration is a measure of the sensitivity of a bond's price to changes in its yield-to-maturity. It helps investors understand
how much the price of a bond will change when interest rates fluctuate. Money duration, also known as “dollar duration” in the
US, is a similar measure but expressed in currency units rather than percentage terms. It provides an estimate of the actual change
in the bond's price in terms of the currency value.

Money duration (MoneyDur) is product of annualized modified duration and the full price (PVFull) i.e. :

è MoneyDur = AnnModDur × PVFull

This can be expressed in either percent of par or the currency value of the position.

The estimated change in the bond price in currency units is very similar to an earlier equation and is given as :

è %ΔPVFull ≈ −MoneyDur × ΔYield

Price value of a basis point (PVBP), also called “PV01,” is a similar measure which estimates the change in the full price of a bond
given a 1 bp change in its yield-to-maturity and is calculated as :

è PVBP = [(PV- ) - (PV+ )] / 2

Where, PV– and PV+ are the full prices calculated by decreasing and increasing the yield-to-maturity by 1 bp.

The PVBP is particularly useful for bonds for which future cash flows are uncertain, such as callable bonds. A related statistic called
a “basis point value” (BPV) is simply the money duration times 0.0001 (1 bp)

The table below provides a summary of the various yield duration statistics :

Measure Calculation Use

Macaulay Average time to receipt of promised cash flows, weighted by shares Holding period that would balance
duration of the full price corresponding to each promised future cash flow reinvestment and price risks for an investor
Modified First derivative of price with respect to yield; Macaulay duration Estimate the percentage price change for a
duration divided by 1 + yield per period bond given a change in its yield-to-maturity
Estimate price change in bond investment for
Money duration Modified duration multiplied by full price of bond or bond position
a given yield change
Price value of a Difference in price of a 1 bp yield decrease and a 1 bp yield increase, Estimate of the change in the bond price given
basis point divided by 2 a 1 bp change in the yield-to-maturity

3.1. Yield Duration of Zero-Coupon and Perpetual Bonds

60
The Macaulay duration of a zero-coupon bond are equal to its time-to-maturity. This is because the bond only has one cash flow
at maturity, which has a present value weight of 1.0. Modified duration is calculated by dividing the time-to-maturity by 1 plus
the yield of the bond.

A perpetuity or perpetual bond is a type of bond that has no maturity date, meaning it does not have a set time at which the
investor receives the face value of the bond. Instead, the investor receives a fixed coupon payment indefinitely, unless the bond
is called or redeemed early. Non-callable perpetuities are rare, but they have a unique measure of duration called Macaulay
duration, which is calculated as [(1 + r) / r ]

3.2. Duration of Floating-Rate Notes and Loans

The Macaulay duration for a floating-rate note or bond is the amount of time remaining until the next reset date. This is because
the interest on these instruments is adjusted at predetermined dates to reflect changes in the market reference rate. Therefore,
the interest rate risk only occurs between reset dates, as the coupon payments will be adjusted to the new market reference rate
at the next reset date.

è MacDurFloating = (T − t) / T

Where,
T = Number of days in the coupon period
t = Number of days that have passed

Floating-rate instruments, have short coupon periods of less than six months, resulting in low duration. This characteristic makes
them attractive to investors looking to decrease the duration of their fixed-income portfolios.

4. Properties Of Duration

LOS (c) : Explain how a bond’s maturity, coupon, and yield level affect its interest rate risk

As discussed in the previous module, the macaulay duration formula is :

Where,
r is the yield-to-maturity per period;
N is the number of evenly spaced periods to maturity as of the beginning of the current period;
c is the coupon rate per period;
t is the number of days from the last coupon payment to the settlement date; and
T is the number of days in the coupon period

The relationship between a bond’s duration and its features (r, c, N, and t/T) are shown below :

Effect on duration (interest rate risk) from an increase in feature

Coupon rate, c ↓ (Inverse relationship)
Yield to maturity, r ↓ (Inverse relationship)
Time-to-maturity, T ↑ (Direct relationship)
Fraction of current coupon period that has elapsed, t/T ↓ (Inverse relationship)

The following image shows how the Macaulay duration is related to time-to-maturity for different types of bonds, including
premium, discount, zero-coupon, and perpetual bonds. This relationship also holds for modified duration, money duration, and
price value of basis point.

61
All else equal, lower coupons and lower yields increase the weight of the final cash flow and reduce the weight of nearer-term
cash flows in the bond price, resulting in a higher duration. Longer times-to-maturity also correspond to higher duration. This
pattern holds for bonds trading at par or at a premium. The Macaulay duration is always less than (1 + r)/r and approaches that
threshold from below as the time-to-maturity increases.

If we look at the above image, we notice a curious case for discount bonds. When the time-to-maturity of a bond is high enough,
the Macaulay duration eventually exceeds the (1+r)/r threshold, reaches a maximum and then starts decreasing. This occurs when
the number of periods is large and the coupon rate is lower than the yield-to-maturity ( i.e. c-r < 0). In this case, the second term
within brackets in the calculation of Macaulay duration become negative. This suggests that long-dated bonds, which are trading
below their face value, may have lower interest rate risk compared to shorter-term bonds.

The Macaulay duration of a bond with a constant yield-to-maturity decreases steadily over time, but increases slightly on coupon
payment dates. This creates a saw-tooth pattern in the Macaulay duration. This pattern is illustrated in the image below for the
BRWA bond discussed earlier with a constant yield-to-maturity.

62
63
Fixed Income - Learning Module 12
for the CFAâ exam

Yield-Based Bond Convexity and Portfolio Properties

Learning Outcomes :

The candidate should be able to:

a) Calculate and interpret convexity and describe the convexity adjustment

b) Calculate the percentage price change of a bond for a specified change in yield, given the bond’s duration and convexity
c) Calculate portfolio duration and convexity and explain the limitations of these measures

1. Introduction

The relationship between a bond's price and its yield-to-maturity is not linear, but rather curved. This non-linear relationship is
captured by the concept of convexity. Convexity is introduced as a risk measure to complement duration and improve estimates
of bond price changes. It becomes particularly important when there are larger changes in yield-to-maturity and for longer-
maturity bonds. These lessons also cover how to estimate duration and convexity for a portfolio of bonds, while also highlighting
the limitations due to certain assumptions.

2. Bond Convexity And Convexity Adjustment

LOS (a) : Calculate and interpret convexity and describe the convexity adjustment

Interest rate risk is the risk that a bond's price will change in response to changes in interest rates. Modified duration measures
the linear effect of a change in yield on a bond's price, while convexity is a complementary risk measure that takes into account
the non-linear effect of yield changes on the price of an option-free bond. This is illustrated in the image below :

The above image shows that the relationship between a bond's price and its yield-to-maturity is not straight but rather is a curved
line. Duration measures the change in bond price along a straight line tangent to the curved line. For small changes in yield, this
is sufficient as a risk measure, but for larger changes, the non-linear price effect of convexity must be considered. By combining
duration and convexity metrics, estimated bond prices are closer to actual bond prices, as including convexity accounts for the
non-linear price changes. Combining the two effects, the percentage (full) price change equation introduced earlier now becomes
as :

è %ΔPVFull ≈ (− AnnModDur × ΔYield)+ [(1/2) × AnnConvexity × (ΔYield)2]

64
The first expression represents the effect of modified duration, while the second expression in brackets represents the convexity
adjustment. The convexity adjustment is always positive for a fixed-rate bond without options, meaning that whether the yield
goes up or down, the bond price is higher than the value which was computed only using duration statistic.

AnnConvexity can be calculated in several ways, we will discuss the first 2:

o using a Microsoft Excel spreadsheet,

o using an approximation method, and
o using a closed-form equation derived from calculus.

2.1. Spreadsheet

Take BRWA’s five-year, 3.2% (semiannual) coupon bond priced at par for settlement on 15 October 2025 and maturity on 15
October 2030. The following table shows the AnnConvexity calculation. Till Column 6, it is similar to duration calculations
introduced earlier. The difference is the inclusion of a new column (Col. 7) for the following operation (where CF means cash flow)
to calculate convexity:

è (Time to receipt of CF) × (Time to receipt of CF + 1) × (Weight of CF) × (1 + Periodic YTM)(–Periods per year)

Multiplying the first two terms introduces non-linearity (Time to receipt of CF2). Column 7 sum of (96.95578) is divided by period
per year squared to get the annualised convexity statistic of 24.2389

Col. 1 Col. 2 Col. 3 Col. 4 Col. 5 Col. 6 = Col. 2 × Col. 5 Col. 7 = Col. 2 × (Col. 2 + 1) × Col. 5 × (1 +YTM/2)-2
Time to Present Time to Receipt ×
Period Cash Flow Weight Convexity of Cash Flows
Receipt Value Weight
1 1.0 1.6 1.5748 0.0157 0.0157 0.0305
2 2.0 1.6 1.5500 0.0155 0.0310 0.0901
3 3.0 1.6 1.5256 0.0153 0.0458 0.1774
4 4.0 1.6 1.5016 0.0150 0.0601 0.2909
5 5.0 1.6 1.4779 0.0148 0.0739 0.4295
6 6.0 1.6 1.4546 0.0145 0.0873 0.5919
7 7.0 1.6 1.4317 0.0143 0.1002 0.7767
8 8.0 1.6 1.4092 0.0141 0.1127 0.9829
9 9.0 1.6 1.3870 0.0139 0.1248 1.2093
10 10.0 101.6 86.6875 0.8669 8.6688 92.3766
100.0000 1.0000 9.3203 96.9558
Annualized Macaulay Duration and Convexity 4.6601 24.2389

2.2. Approximation Method

The following equation uses the same inputs as the approximate modified duration, and can be used to approximate annualized
convexity (ApproxCon) for bonds with uncertain cash flows, such as those with contingency features and default risk :

The features of a bond that contribute to greater convexity are similar to those that contribute to greater duration. These features
include a longer time-to-maturity, a lower coupon rate, and a lower yield-to-maturity.

65
One factor that affects convexity is the dispersion of cash
flows, which refers to how payments are spread out over
time. Bonds with greater dispersion of cash flows have
higher convexity. This benefits investors when yields
change significantly. For example, the two bonds shown in
the adjoining image have the same price, maturity, YTM
and modified duration (due to which they share the same
tangent line). When

o yields decrease, a bond with more convexity will

increase in price more than a bond with less convexity.
o bond yields increase, a bond with more convexity will
decrease in price less than a bond with less convexity.

Thus, a bond with more convexity is considered less risky for investors compared to a bond with less convexity in both falling and
rising yield environments. However, this conclusion assumes that the price of the more convex bond does not reflect its higher
convexity. If it does, the more convex bond would have a higher price and lower yield-to-maturity. The main takeaway is that
convexity is valuable to investors in reducing risk, but they must be willing to pay a higher price for it.

3. Bond Risk And Return Using Duration And Convexity

LOS (b) : Calculate the percentage price change of a bond for a specified change in yield, given the bond’s duration and convexity

To estimate the percentage price change of a bond for a given yield change, it is important to consider the bond's duration and
convexity. By taking these factors into account, the estimate becomes much more accurate compared to using duration alone.
This allows for more effective risk management in bond investments.

Take the previous BRWA’s 5-year, 3.2% (semiannual) coupon bond priced at par for settlement on 15 October 2025 and maturity
on 15 October 2030. Using the simple bond pricing equation, we can calculate the prices for new YTM values:

o 100 bp increase in yield (4.20%): Price = 95.53212; %∆PVFull = –4.46788% ( using [95.53212 – 100] /100 )
o 100 bp decrease in yield (2.20%): Price = 104.71035; %∆PVFull = 4.71035% ( using [104.71035 – 100]/ 100)

Modified duration calculated earlier was 4.58676 so a 100 bp increase (decrease) in yield-to-maturity results in

è %∆PVFull ≈ –4.58676% (4.58676%) ( i.e. − AnnModDur × ΔYield)

If we include the convexity adjustment, for YTM changes, we get more precise values :

è %∆PVFull ≈ (–4.58676 × 0.0100) + [1⁄2 × 24.23895 × (0.0100)2] = –4.46556% for a 100bps increase

è %∆PVFull ≈ (–4.58676 × –0.0100) + [1⁄2 × 24.23895 × (–0.0100)2] = 4.70795% for a 100bps decrease

Money duration measures the impact of a change in yield-to-maturity on the price of a bond in currency units. Money convexity,
on the other hand, measures the second-order effect on the price of a bond in currency terms and is calculated by

è MoneyCon = AnnConvexity × PVFull

The combination of MoneyDur and MoneyCon is used to estimate the change in a bond's full price more accurately and is given
by :

è ΔPVFull ≈ − (MoneyDur × ΔYield) + [1/2 × MoneyCon × (ΔYield)2]

If an investor has a position in the BRWA bond with a par value of USD100 million and the yield-to-maturity increases by 100 basis
points (bps), the bond's price will decrease to 95.53212. As a result, the market value of the investor's position will decrease to
$95,532,116, reflecting a decline of $4,467,884. Now take the following cases :

o Using MoneyDur alone results in a decline which is $118,875 larger and is equal to $4,586,759 (= (−MoneyDur × ΔYield) =
$458,675,875 × 0.0100)

66
o If we use the MoneyCon for this position, which is $2,423,894,503 (= AnnConvexity × PVFull = 24.23895 × $100,000,000), and
account for this convexity in the full price, the result is a decline of –$4,465,564 ≈ − ($458,675,875 × 0.01) + [1/2 × 2,423,894,
503 × (0.01)2] = [− (MoneyDur × ΔYield) + [1/2 × MoneyCon × (ΔYield)2]

By using both MoneyDur and MoneyCon, the difference in the estimated versus the actual changes in bond position value is only
$2,320 compared to $118,875 when using only the duration statistic.

4. Portfolio Duration And Convexity

LOS (c) : Calculate portfolio duration and convexity and explain the limitations of these measures

The interest rate risk of a bond portfolio can be measured using duration and convexity, just as it is done for individual bonds.
There are two methods to calculate the duration and convexity of a bond portfolio:

o By calculating the weighted average of the time it takes to receive the total cash flows of the portfolio. This approach is
theoretically correct but difficult in practise
o By calculating the weighted averages of the durations and convexities of the individual bonds that make up the portfolio. Its
application and limitation will be our focus.

Take an institutional investor holding a two-bond portfolio, denomination in US dollar : $50 million par value each of the BRWA
5-year bond and a government of Romania 30-year bond, details are shown in the table below.

Maturity
Bond Par Value Market Value Portfolio Weight Coupon (%) Price Yield (%) Duration Convexity
(Years)
BRWA 50,000,000 50,000,000 0.5050 5 3.200 100.0 3.200 4.586 24.238
Romania 50,000,000 49,011,224 0.4950 30 4.625 98.02 4.750 15.906 369.642

The portfolio's total market value is $99,011,224 and is almost evenly split between two bonds. The duration and convexity of the
portfolio are calculated as the weighted average of the individual bonds' statistics, with the market value shares of each bond as
the weight. This method provides an approximation of the portfolio's duration and convexity, which becomes more accurate when
the yield differences between the bonds are smaller and the yield curve is flat.

The portfolio duration and convexity are calculated as follows:

è Weighted-average modified duration = (4.58676 × 0.5050) + (15.90637 × 0.4950) = 10.19004

è Weighted-average convexity = (24.23896 × 0.5050) + (369.64203 × 0.4950) = 195.21581.

The weighted-average approach is a useful tool for easily measuring interest rate risk. If for example, the yields-to-maturity of the
bonds in this portfolio increase by 100 basis points, the estimated decline in portfolio value would be 9.214% given by:

è %∆PVFull ≈ (–10.19004 × 0.0100) + [1⁄2 × 195.21581 × (0.0100)2] = –9.21396%.

The limitation of measuring portfolio duration and convexity is that it assumes all maturities experience the same change in yields
in the same direction i.e. a parallel shift, which rarely happens. In reality, we often see variations in the shape of the yield curve,
such as steepening, flattening, or twisting. These will be discussed in later modules.

67
68
Fixed Income - Learning Module 13
for the CFAâ exam

Curve-Based and Empirical Fixed-Income Risk Measures

Learning Outcomes :

The candidate should be able to:

a) Explain why effective duration and effective convexity are the most appropriate measures of interest rate risk for bonds with
embedded options
b) Calculate the percentage price change of a bond for a specified change in benchmark yield, given the bond’s effective duration
and convexity
c) Define key rate duration and describe its use to measure price sensitivity of fixed-income instruments to benchmark yield
curve changes
d) Describe the difference between empirical duration and analytical duration

1. Introduction

We now introduce curve-based measures of a bond's price sensitivity to changes in a benchmark yield curve, particularly when
cash flows are uncertain. We discuss how the change in a bond's full price is estimated by combining these curve-based duration
and convexity sensitivity measures, how issuers and investors can use these approximate measures, highlighting their advantages
and limitations. Key rate duration, a measure of interest rate risk across the term structure, is introduced as well. Additionally, it
notes that benchmark yield changes and credit spreads for lower credit quality issuers tend to be negatively correlated, especially
during market distress, emphasizing the benefits of empirical analysis over analytical approaches.

2. Curve-Based Interest Rate Risk Measures

LOS (a) : Explain why effective duration and effective convexity are the most appropriate measures of interest rate risk for bonds
with embedded options

Yield duration and convexity calculations for bonds assume that the cash flows are certain. However, if a bond has contingency
features like embedded options, the future cash flows become uncertain as they depend on market interest rates. This means
that the duration of a callable bond, for instance, does not accurately show the bond price's sensitivity to changes in yield-to-
worst, as it represents just one of several potential outcomes based on future interest rates. In simple terms, since bonds with
embedded options do not have clear-cut measures of their yields-to-maturity, traditional measures like Macaulay and modified
durations are not suitable for assessing the interest rate risk of these bonds. Instead, the appropriate measure is the bond's price
sensitivity to changes in a benchmark yield curve (like the government par curve) which is known as effective duration. This is a
curve duration rather than a yield duration statistic.

The image below compares the impact of a change in the benchmark yield curve ((ΔCurve) on the prices of callable bond and a
non-callable bond. The bonds have the same features such as coupon rate, payment frequency, time-to-maturity, and credit risk.
The horizontal axis represents the benchmark yield, i.e. a point on the par curve for government bonds.

69
The price of a non-callable bond is always higher than that of a comparable callable bond because of the embedded call option
held by the issuer. The value of the call option is low when interest rates are high relative to the coupon rate and high when rates
are low because when the rates are low, the issuer is more likely to exercise the call option and refinance the debt at lower rates.
The investor bears the risk of the bond being called, as they would have to reinvest the proceeds at a lower interest rate.

The image above also demonstrates that when there are parallel shifts in the benchmark yield curve, the effective durations of
callable and non-callable bonds are similar when benchmark yields go higher. However, when benchmark yields decrease, the
effective duration of a callable bond is lower than that of a non-callable bond. This is because the price of a callable bond does
not increase as much when benchmark yields fall, due to the presence of the call option. Therefore, the embedded call option
reduces the effective duration of the bond, particularly when interest rates are falling and the bond is more likely to be called.
The lower effective duration can be understood as a shorter expected life for the bond, as it reduces the average time to receive
cash flow.

Effective convexity is a measure of the second-order effect of a parallel shift in the benchmark yield curve. In the image above,
the non-callable bond shows positive convexity as the benchmark yield declines, indicated by a steeper slope of the tangent line
to the curve. However, the callable bond shows a flattening slope of the tangent line as the benchmark yield declines, reaching a
point where the effective convexity becomes negative. So, when benchmark yields are high and the value of the embedded call
option is low, callable and non-callable bonds are affected similarly by changes in interest rates and both have positive convexity.
However, as benchmark yields decrease, the two types of bonds start to differ. The callable bond enters a range of negative
convexity because the issuer sees more value in the embedded call option and is more likely to exercise it. This limits the potential
price increase of the bond due to lower benchmark yields.

The following image shows the characteristics of a bond with an embedded put option.

A putable bond gives the investor the option to sell the bond back to the issuer before it reaches maturity. This protects the
investor from potential losses due to rising benchmark yields that may cause the bond's price to drop. As a result, the price of a
putable bond is typically higher than that of a similar non-putable bond, with the difference in price representing the value of the
put option.

An embedded put option in a bond reduces the bond's effective duration, especially when interest rates are increasing. If interest
rates are low compared to the bond's coupon rate, the put option has a low value and the bond's price changes similarly to a non-
putable bond when there is a parallel shift in the benchmark yield curve. However, when benchmark interest rates rise, the put
option becomes more valuable as it allows the investor to sell the bond back to the issuer at par, limiting price depreciation. It is
important to note that putable bonds always have positive effective convexity.

Effective duration and effective convexity are important measures for mortgage-backed securities (MBSs) (which are created from
a pool of residential or commercial loans) because the cash flows of MBSs depend on homeowners' ability to refinance or pay off
their existing mortgage with the funds from a new mortgage.

Calculating effective duration (EffDur) is very similar to calculating approximate modified duration, as shown below :

70
The formula for calculating effective convexity (EffCon) is also very similar to the formula for approximate convexity, as shown:

The key differences in the calculation involve ΔCurve, in the denominator, signifying that effective duration measures interest rate
risk concerning a parallel shift in the benchmark yield curve. Additionally, PV- and PV+ are determined using option pricing models,
with inputs like - the call protection period, call prices and dates, credit spreads, interest rate volatility, and market interest rates.
The analyst keeps the first four inputs constant and adjusts the fifth input (parallel shifts) to calculate PV+ and PV-. More detailed
explanations of these models are covered in later modules.

Effective duration and effective convexity are commonly used to measure interest rate risk for bonds with embedded options.
However, they can also be applied to option-free bonds to complement yield duration. It is worth noting that there may be slight
discrepancies between a bond's effective duration and its modified duration because when the government par curve is shifted
in the model, the government spot (i.e., zero) curve is also shifted, but not in the same parallel manner. As a result, the change in
the bond's price may not be equivalent to the change that would occur if its yield-to-maturity changed by the same amount as
the par curve.

In general, modified duration and effective duration on an option-free bond are not identical. However, the difference narrows
when the yield curve is flatter, the time-to-maturity is shorter, and the bond is priced closer to par value; the difference disappears
only in the rare circumstance of a flat yield curve.

Example
Effective Duration and Convexity

The portfolio manager asks you, the analyst on a fixed-income team, to determine the interest rate sensitivity of a callable bond she is considering.
The portfolio manager is seeking to invest in a bond with a duration between 7.0 and 8.0 and positive convexity.
Suppose the full price of the callable bond is 101.060 per 100 of par value. When the government par curve is raised and lowered by 25 bps, the
new full prices for this callable bond from your option valuation model are 99.050 and 102.891, respectively. Therefore,

o PV0 = 101.060,
o PV+ = 99.050,
o PV– = 102.891, and
o ΔCurve = 0.0025.

Effective duration and effective convexity for this callable bond are :

è EffDur = [(PV- ) − (PV+ )]/ [2 × (ΔCurve) × (PV0)]

è EffDur = ( 102.891 – 99.050) / [2 × (0.00025) × (101.060)] = 7.601

è EffCon= [(PV-)+(PV+)−2×PV0]/ [(ΔCurve)2 × (PV0)]

è EffCon = [(102.891) + (99.050)] − 2 × (101.060)] / [(0.00025)2 × (101.060)] = -283

You recommend that the portfolio manager not buy this callable bond. While its effective duration meets her criteria, the bond has negative
effective convexity.

3. Bond Risk And Return Using Curve-Based Duration And Convexity

LOS (b): Calculate the percentage price change of a bond for a specified change in benchmark yield, given the bond’s effective
duration and convexity

Effective duration and effective convexity are metrics used to measure the interest rate risk of complex instruments with uncertain
future cash flows. They are calculated based on bond prices derived from an option valuation model and changes in the underlying
benchmark government yield curve. These metrics can be used to estimate the percentage change in a bond's price for a given
shift in the yield curve as shown below :

71
Take the BRWA’s five-year, 3.2% (semiannual) coupon bond priced at par, settlement on 15 October 2025, maturity on 15 October
2030. Effective duration and effective convexity were derived before as EffDur = 4.816 and EffCon = 26.723, and the percentage
changes in the bond’s full price for ±100 bp shifts in the benchmark government par curve are estimated as follows:

è %∆PVFull ≈ (–4.816 × 0.01) + [1⁄2 × 26.723 × (0.01)2] = –4.68%

è %∆PVFull ≈ (–4.816 × –0.01) + [1⁄2 × 26.723 × (–0.01)2] = 4.95%.

The previously estimated bond price changes for this BRWA bond were -4.47% using ApproxModDur alone and 4.71% using both
ApproxModDur and ApproxCon, with yield-to-maturity changes of ±100 bps. These differences in results between curve-based
measures and yield-based interest rate risk measures are because of slight variations in bond prices and metrics like Effective
Duration (EffDur) and Effective Convexity (EffCon) compared to Approximate Modified Duration (ApproxModDur) and
Approximate Convexity (ApproxCon). This is because a parallel shift in the government par curve leads to a non-parallel shift in
spot rates.

4. Key Rate Duration As A Measure Of Yield Curve Risk

LOS (c) : Define key rate duration and describe its use to measure price sensitivity of fixed-income instruments to benchmark yield
curve changes

Effective duration measures a bond's sensitivity to changes in the overall yield curve, i.e. if all yields change by the same amount,
while key rate duration focuses on a bond's sensitivity to changes in specific maturities on the yield curve. Key rate duration helps
isolate the price responses of bonds to changes in rates for specific time periods.

Key rate durations define a security’s price sensitivity over a set of maturities along the yield curve. Sum of key rate durations
equals effective duration as shown below :

Where
rk represents the kth key rate.

Key rate durations help identify “shaping risk” for a bond—that is, its sensitivity to changes in the shape of the benchmark yield
curve (e.g., the yield curve becoming steeper or flatter or twisting).

The process for calculating key rate durations is similar to calculating effective duration. However, instead of shifting the entire
benchmark yield curve, only specific points on the curve are shifted one at a time as shown. This is done for different key rates
such as 0.5-, 2-, 5-, 10-, 20-, or 30-year rates. The rate is shifted up and down by 1 basis point, and new bond prices are generated.
The key rate duration at that specific maturity is then calculated using the above equation. This allows for the calculation of
effective duration for each individual maturity point shift.

72
In terms of usage of this measure, say an analyst wants to understand how the price of a callable bond will change if short-term
benchmark rates increase but longer-term rates remain the same. This scenario is called a flattening of the yield curve. They can
use the key rate duration, specifically the duration of the two-year Treasury note, to estimate the price change by using the
equation below ( which is just a re-arrangement of a previous equation) :
è ΔPV/ PV = − KeyRateDurK x ΔrK

Example
Using Key Rate Duration Estimate Interest Rate Risk for Bonds in a Portfolio

A portfolio manager asks you to determine if the following bond portfolio needs rebalancing to improve overall return, given the tenor of the
portfolio’s bonds, key rate duration information, and forecasted benchmark government par curve shifts at the various maturities. All four bonds
have the same benchmark government par curve. Current information for the bonds are as follows:

Bond Tenor Position Size Key Rate Duration

A 1 year $200,565,245 0.645
B 5 years $201,042,132 1.483
C 10 years $202,673,298 2.158
D 20 years $202,588,801 2.982

Information on the forecasted benchmark government par curve changes at the various maturities are as follows:

Maturity 1 year 5 years 10 years 20 years

Expected change –23 bps –25 bps –18 bps –10 bps

If we take the product of the key rate duration and curve shift at a certain maturity, we can forecast the change in the price of the bond. For
example, for the one-year maturity, this would be –0.645 × –0.0023 = 0.148%. The calculation for all the bonds is shown below:

Maturities 1 year (Bond A) 5 years (Bond B) 10 years (Bond C) 20 years (Bond D)

% change in bond price 0.148% 0.371% 0.388% 0.298%

Therefore, since the forecasted price change in the bonds favour Bonds B and C, it would be advisable to increase the weightings for these bonds,
taking more from the Bond A position than the Bond D position, since Bond A is forecasted to give the least gain of all the bonds.

5. Empirical Duration

LOS (d) : Describe the difference between empirical duration and analytical duration

The current methods used to calculate duration and convexity statistics using mathematical formulas are called analytical
duration. These measures are summarized in the table below. It is important to note that these estimates assume that
government bond yields and spreads are independent and uncorrelated variables. Analytical duration provides a good
approximation of the relationship between bond prices and yield changes in many cases.

Measure Definition Interpretation

Approximate Estimates the slope of the line tangent to a bond’s
Yield-based method to estimate modified duration
Modified Duration price–yield curve
Sensitivity of a bond’s price to a change in a benchmark Curve-based method to estimate modified duration for
Effective Duration
yield curve complex bonds with uncertain cash flows
Measures bond sensitivity to a benchmark yield change Partial duration statistic that gauges a bond’s sensitivity to
Key Rate
for a specific maturity non-parallel benchmark yield curve changes
Measure using historical data in statistical models and Statistical estimate that accounts for correlation between
Empirical incorporating factors affecting bond prices to yield spreads and benchmark yield-to-maturity changes
determine the price–yield relationship under different economic scenarios

In addition to the above measures, fixed-income professionals also use empirical duration estimates derived from historical data
and statistical models. These estimates take into account various factors that influence bond prices and are calculated over
different time periods and interest rate environments. This information helps inform the decision-making process for managing
fixed-income portfolios.

73
During times like the covid-19 pandemic, analytical and empirical duration estimates may differ. For low-risk government bonds,
analytical and empirical duration estimates are expected to be similar because changes in benchmark yields drive bond prices.
However, during extreme periods, credit spreads may widen due to increased default risk, while a “flight to quality” can cause
government benchmark yields to fall. Typically, wider credit spreads will partially or fully offset the decline in government
benchmark yields, resulting in lower empirical duration estimates than analytical duration estimates. Analysts need to consider
the correlation between benchmark yields and credit spreads when choosing which duration estimate to use.

74
Fixed Income - Learning Module 14
for the CFAâ exam

Credit Risk
Learning Outcomes :

The candidate should be able to:

a) Describe credit risk and its components, probability of default and loss given default
b) Describe the uses of ratings from credit rating agencies and their limitations
c) Describe macroeconomic, market, and issuer-specific factors that influence the level and volatility of yield spreads

1. Introduction

Credit analysis is crucial in fixed-income markets for efficient capital allocation. It involves evaluating and pricing credit risk, which
is an ongoing process affected by market conditions. This module introduces credit risk concepts, credit ratings, and compares
creditworthiness within and across industries. It also delves into how financial markets assess and price credit risk, focusing on
credit risk analysis, with later lessons covering government and corporate debt analysis.

2. Sources Of Credit Risk

LOS (a) : Describe credit risk and its components, probability of default and loss given default

Fixed-income investors face credit risk, where a borrower's failure to meet interest and principal payment obligations is considered
a default. This risk leads to potential economic loss for investors, known as credit risk. It depends on borrower-specific factors and
general economic conditions, and it can change during the contract's life. Credit risk exposes lenders and investors to potential
losses and underperformance. Traditional credit analysis often relies on the "Cs of credit analysis." As shown below :

In credit analysis, five key criteria, namely capacity, capital, collateral, covenants, and character, are important for assessing
individual borrowers. Capacity evaluates their ability to make debt payments on time, while capital considers the company's
resources that reduce reliance on debt. Collateral assesses the quality and value of assets supporting the issuer's indebtedness,
covenants involve legal terms in debt agreements that must be followed, and character relates to management quality and
willingness to repay debt. Capacity and capital are typically quantitative, based on financial data, while collateral, covenants, and
character are qualitative, relying on historical performance, credit relationships, and management reputation.

75
The last three criteria in credit analysis, which are conditions, country, and currency, focus on overarching factors affecting all
borrowers. Conditions consider the broader economic and business environment's impact on debt servicing. Country evaluates
the geopolitical, legal, and political factors affecting all issuers in a jurisdiction. Currency concerns the impact of exchange rate
fluctuations on cash flows for borrowers dealing with foreign currency debt.

Although a borrower’s inability to make timely payments may be due to several underlying and contributing factors, but it
ultimately results from a lack of sufficient cash available to make a current debt payment

2.1. Sources of Credit Risk

Following image shows the main sources of repayment for corporate and sovereign bonds :

Credit risk arises when borrowers may not generate sufficient cash flow to meet debt obligations on time, increasing the risk of
default for both corporations and sovereign borrowers. Illiquid borrowers lack the means to secure funds for timely payments,
unlike insolvent borrowers whose assets are worth less than liabilities. Credit risk analysis involves understanding a borrower's
cash generation, cash usage, and potential risks that could hinder repayment. Secured debt relies on a company's cash flows and
collateral, while unsecured debt relies solely on cash flows. An example compares an investor's choice between unsecured and
secured bonds.

While the likelihood of default for investment-grade borrowers is typically well below that of a high-yield issuers, the investor’s
loss in the event of a default for HY issuers’ secured debt, is usually lower than investment-grade issuers’ unsecured debt due to
the secondary source of repayment for secured bonds.

The main borrower types and their primary sources of repayment and credit risk are listed below:

Borrower Types, Sources of Repayment, and Sources of Credit Risk

Borrower Primary Source of Cash Flow Secondary Source of Cash Flow
Sources of Credit Risk
Type Generation Generation
o Business operations o Asset sales o Economic contraction
o Investment and financing o Divestitures o Strategic shifts in the business
activities o Additional debt issuance o and market environment
o Equity issuance o Increased competition
Corporate o Reduced pricing power
o Shrinking operating margins, increased
losses
o Excessive debt service needs

o Corporate and personal o Newly issued debt o Economic contraction

income taxes, sales tax and o Sale of public assets, o Political uncertainty
Sovereign or VAT revenue, capital gains and privatization o Excessive debt service needs
public entity wealth-based taxes o Expansionary economic policies
o Tariffs, fees, and other o Budget deficits
government revenue o Tax cuts

76
 o Limited ability to collect taxes

While many factors affect the primary and secondary sources of repayment for different fixed-income issuers, investors seek to
measure and compare credit risk among different borrowers for similar maturities as well as across maturities for the same
borrower.

2.2. Measuring Credit Risk

Fixed-income investors face credit risk, which is the risk of the issuer not making promised interest and principal payments. This
risk is measured as the expected loss (EL) over a given period, consisting of two components, as shown below

The first is the probability of default (POD), representing the likelihood of the issuer failing to make full and timely payments,
typically on an annual basis. The second component is the loss given default (LGD), which is the investor's loss in the event of a
default. LGD combines the severity of loss and the investor's claim at the time of default, where the recovery rate (RR) is the
percentage of the outstanding debt claim recovered, and the loss severity is the unrecovered portion (1 - RR). The investor's claim
at default is the expected exposure (EE) or exposure at default (EAD), representing the potential loss in case of default, usually
calculated as the bond or loan face value plus accrued interest minus the current market value of collateral. Typically, bondholders
recover some portion of their investment in the event of default.

The expected loss (EL) is determined by :

è EL = POD × LGD,

where LGD = EE × (1 – RR). LGD can be expressed either in currency terms or as a percentage of the principal. Comparing the
expected loss to the credit spread is a way to assess whether an investor is adequately compensated for taking on the credit risk.
The credit spread, approximated as - Credit Spread ≈ POD × LGD, should be similar to the expected loss for fair compensation.

Example
Comparing Expected Loss and Credit Spreads

Bright Wheel Automotive (BRWA) issued an unsecured five-year bond with a 3.2% fixed coupon. The yield-to-maturity difference
between BRWA’s five-year bond and the comparable US Treasury bond is 90 bps (= 3.2% – 2.3%), which reflects BRWA’s credit
spread over Treasuries, known as the G-spread. Vivivyu Inc. (VIVU) issued a 6.5% fixed-rate bond, which the issuer has the right to
call at a fixed price any time from three years from the issuance date until final maturity in seven year

1. Assuming the BRWA bond has a probability of default of 1% and a loss given default of 80%, estimate whether BRWA bond
investors are adequately compensated for assuming BRWA credit risk.

Solution: We may solve for BRWA’s expected loss in percentage terms as follows: EL = POD × LGD, or 0.8% = [0.01 × 80%].

77
Given BRWA’s credit spread of 0.9%, we may conclude based upon the approximation (Credit Spread ≈ POD × LGD) that BRWA
investors are fairly compensated for assuming the credit risk since: Credit Spread > POD × LGD. Investors earn a 90 bps spread per
year and have an expected loss of 80 bps per year.

2. If we assume that VIVU has issued a five-year non-callable bond, as in the case of BRWA, with a probability of default of 6% and
a loss given default of 50%, compare investor compensation for assuming the credit risk of the 6.5% VIVU debt coupon to that of
the 3.2% fixed rate of the BRWA bond.

Solution: We may solve for VIVU’s expected loss in percentage terms as follows: EL = POD × LGD, or 3.0% = [0.06 × 50%].

We may calculate VIVU’s five-year credit spread by subtracting its 6.5% coupon from the 2.3% five-year US Treasury to solve for a
G-spread of 4.2%. Based upon the approximation in Equation 2, we may conclude that VIVU investors are fairly compensated for
assuming the credit risk since: Credit Spread > POD × LGD. Investors earn a 420 bps per year spread and have an expected loss of
300 bps per year.

3. How would the determination of the spread as well as investor’s view of the risk versus compensation for the VIVU bond change
from Question 2 if we consider the VIVU bond’s actual maturity and call feature with the original 6.5% coupon?

Solution: VIVU investors face both call risk and greater maturity risk on the original bond terms versus a five-year, non-callable
bond. As described in earlier lessons, bonds callable at a fixed price prior to maturity are advantageous to issuers and
disadvantageous to investors, so investors expect to be compensated via a higher yield versus a similar non-callable bond given the
uncertain maturity and limited price appreciation known as call risk. This option-adjusted yield is the required market discount rate
for which the bond’s price is adjusted for the value of the embedded option. Investors would also expect to be compensated for a
longer time to maturity with a higher credit spread.

The probability of default (POD) is influenced by a borrower's ability to service debt, considering both qualitative and quantitative
factors. Key factors include profitability, with stable and predictable cash flows and profits; coverage, with enough cash
flows/profits to meet debt payments; and leverage, which measures reliance on debt financing. Higher profitability, better
coverage, and lower leverage are associated with lower POD and higher credit quality.

While financial ratios are just one aspect of assessing credit risk and vary across industries, changes in these ratios over time can
lead to rating upgrades or downgrades and affect credit spreads. Loss given default (LGD) depends on the creditor's claim seniority
and nature in a default scenario. For investors in unsecured investment-grade bonds, high LGD poses the greatest risk due to an
increase in POD. Conversely, high-yield investors aim to reduce expected loss by seeking covenant restrictions and security to
lower LGD.

3. Credit Rating Agencies And Credit Ratings

LOS (b): Describe the uses of ratings from credit rating agencies and their limitations

The three main credit rating agencies, Moody's, Standard & Poor's, and Fitch Ratings, are key players in the credit markets. They
evaluate the credit risk of issuers through a combination of quantitative and qualitative analysis. These agencies assign credit
ratings to corporate and sovereign bonds, which indicate the likelihood of default by the bond or issuer. Typically, at least two of
these agencies provide credit ratings for most outstanding bonds, helping investors assess risk.

Credit ratings are commonly used by bond investors for easy comparison of the creditworthiness of different bond issuers, though
their comparability across bond types is debated. Changes in credit ratings offer insights into overall credit market conditions and
can trigger contractual changes in individual bonds. Credit migration risk refers to the possibility of an issuer's creditworthiness
declining, potentially leading to a higher risk of default. Credit ratings are also important for meeting regulatory, statutory, and
contractual obligations

Credit ratings are typically issued by agencies in consultation with bond issuers, often based on non-public information. These
agencies continuously monitor issuer performance and may adjust ratings as credit risk changes. However, their forward-looking
assessments can sometimes underestimate financial risks, as seen in the 2008 financial crisis. In response to this, regulations were
introduced to enhance transparency and reduce conflicts of interest in the industry. New credit rating agencies have emerged
globally and locally, but the market remains dominated by 3 major agencies discussed above, and the "issuer pay" model persists
largely unchanged.
78
3.1. Credit Ratings

The three major global credit rating agencies use similar, symbol-based ratings that assess a bond issue’s risk of default and the
potential loss the investor may suffer. The following table compares their long-term rating scale ranked from highest to lowest.
These are ratings for bonds with a maturity exceeding one year. Ratings on short-term debt follow a similar logic but are not
shown here.

Long-Term Rating Matrix: Investment Grade vs. Non-Investment Grade

Moody’s S&P Fitch Rating Grade Description
High-Quality Aaa AAA AAA Highest credit quality, lowest level of credit risk
Grade Aa1 AA+ AA+ Very high credit quality with very low level of credit risk
Aa2 AA AA
Aa3 AA– AA–
Upper-Medium A1 A+ A+ High credit quality with low level of credit risk
Investment Grade Grade A2 A A
A3 A– A–
Low-Medium Baa1 BBB+ BBB+ Good credit quality with moderate level of credit risk
Grade Baa2 BBB BBB
Baa3 BBB– BBB–

Low Grade or Ba1 BB+ BB+ Speculative with substantial credit risk
Speculative Grade Ba2 BB BB
Ba3 BB– BB–
B1 B+ B+ Highly speculative with high credit risk
B2 B B
B3 B– B–
Caa1 CCC+ Substantial credit risk with default as a real possibility
Non-Investment Grade Caa2 CCC CCC
(“Junk” or “High Yield”) Caa3 CCC–
Ca CC CC Very high levels of credit risk with default either occurring
or about to occur
Ca C C Default or default-like process has begun
Default C D D In default (entered bankruptcy filings, administration,
receivership, liquidation, or other formal winding-up
procedure) with little prospect for recovery of principal
or interest

Issuers of bonds rated investment grade are generally more consistently able to issue debt and can borrow at lower interest rates
than those rated below investment grade. In comparison to high-yield bonds, investment-grade bonds have a lower risk profile,
are less negatively affected by adverse economic and market conditions, and are more appropriate for institutional portfolios that
face quality restrictions.

3.2. Credit Rating Considerations

Credit rating agencies are valuable for assessing bonds' relative credit risk, but most market participants conduct their own analysis
when making investment decisions. Relying solely on credit ratings can be risky, as they may not keep up with market conditions,
miss financial risks, or miscalculate potential changes. It's crucial for investors, especially those dealing with high-yield or
potentially downgraded bonds, to conduct their own research and assessments of credit risk.

3.2.1. Credit ratings tend to be sticky and lag market pricing of credit risk
Credit ratings often change less frequently than bond prices and credit spreads, leading to a lag in reflecting changes in
credit risk. This lag is especially noticeable with speculative-grade bonds. Bonds with similar ratings may have different
credit spreads because ratings primarily assess expected loss, while market pricing considers default timing and expected
recovery rates. Waiting for rating changes before making investment decisions can lead to underperformance compared to
investors who act based on market conditions or rating outlooks.

3.2.2. Some risks are difficult to capture in credit ratings

Certain risks, such as litigation, environmental, and natural disasters, are challenging to assess in credit ratings. Complex
financial transactions, like debt-financed acquisitions, are also difficult to anticipate and incorporate into ratings. This can

79
 lead to divergent ratings from different agencies, as seen in the case of WeWork Inc., which received varying ratings from
Fitch, S&P, and Moody's for its unsecured debt issuance in 2018.

3.2.3. Ratings may involve miscalculations or unforeseen changes not fully captured in a rating agency’s forward-looking
analysis
Credit rating agencies have a history of failing to predict major financial crises and defaults, such as the 2008 housing market
collapse and the subsequent default of highly rated subprime mortgage bonds. Notable examples of companies that
received high credit ratings before experiencing significant financial troubles due to accounting fraud include Enron and
WorldCom in the United States and Wirecard AG in Germany.

4. Factors Impacting Yield Spreads

LOS (c) : Describe macroeconomic, market, and issuer-specific factors that influence the level and volatility of yield spreads

Corporate bonds and other debt instruments with credit risk typically trade at higher yields compared to bonds considered safe
from default, like US Treasury or German government bonds. These yield premiums, known as credit spreads and measured in
basis points, can widen due to issuer-specific issues like reduced creditworthiness (credit migration or downgrade risk) or market-
related factors like increased risk aversion during financial crises. Credit spread risk refers to the increased expected loss resulting
from changes in credit conditions due to macroeconomic, market, or issuer-related factors.

4.1. Macroeconomic Factors

Changes in macroeconomic conditions and the credit cycle often move together. During an improving business cycle, credit
spreads narrow as investors become more comfortable with credit risk. Conversely, a deteriorating credit cycle widens credit
spreads. Spreads are thinnest at the peak of the credit cycle when credit risk is perceived to be lowest and widest at the bottom
when risk is considered highest.

High-yield bonds (HY) offer several reasons for investment:

o Portfolio diversification: HY bonds have a lower correlation with investment-grade (IG) bonds and risk-free interest rates,
making them valuable for diversifying a fixed-income portfolio and improving risk-adjusted returns.
o Capital appreciation: Economic recovery and improved issuer performance can have a more positive impact on HY bond
prices. Factors such as rating upgrades, mergers, acquisitions, or favorable management changes can also drive capital
appreciation.
o Equity-like returns with lower volatility: HY bonds tend to follow similar economic cycle fluctuations as equities but offer
more stability due to their substantial income component. Some studies suggest that HY bonds provide a more attractive risk-
return profile than equities in the long term, making them a preference for yield-seeking investors with limited tolerance for
equity volatility.

Some key points to note are :

o higher the credit rating, the lower the yield for a given maturity. Investors require less compensation for the risk of higher
rated bonds with lower default risk.
o In general, the longer the maturity, the higher the yield, as default risk tends to rise for longer maturities.
o the yield spread difference between IG bond ratings is generally narrower than the difference between IG and HY.
o Over the business cycle, HY bond spreads are more susceptible to widening under adverse market conditions when investors
tend to sell riskier assets and buy default risk-free assets, known as a “flight to quality.” In addition, HY bonds may face
liquidity risk, which also widens bid–offer spreads in times of financial stress.
o Change in spread for IG bonds is narrower than that for HY bonds. HY bonds are more sensitive to changing macroeconomic
and credit conditions.

4.2. Market Factors

The yield for highly liquid, low-default-risk bonds, like developed market sovereign debt, consists of real interest rates and an
expected inflation premium. In the case of corporate bonds, the yield spread over government bonds includes an extra premium
to account for credit and liquidity risks, as well as potential tax implications. Any changes in these factors affect the bond's yield,
price, and returns. The overall yield spread over the government benchmark bond encompasses these risk components.

Market liquidity risk refers to the costs associated with selling a bond, with potential differences between the market price and
the actual transaction price. The willingness of broker-dealers to make markets, reflected in bid-ask spreads, is crucial for liquidity.

80
Two key issuer-specific factors impacting liquidity risk are the size of the issuer and their credit quality. Smaller issuers with
infrequently traded debt and lower credit quality face higher liquidity risk and wider bid-ask spreads. Corporate bond spreads
include both market liquidity and credit risk premiums to compensate for these risks, ensuring investors are adequately
compensated for potential liquidity issues

Bond liquidity is influenced by trading frequency and volume, with more actively traded bonds offering easier buying and selling.
The difference between the buying and selling price (bid-ask spread) depends on bond type, transaction size, timing, and other
factors. Highly liquid government bonds have tiny spreads, while less liquid corporate bonds have wider spreads. During financial
stress or crises, market liquidity can decrease, leading to falling bond prices and wider yield spreads for corporate and similar
spread-based debt. Crises often result in not only wider bid-ask spreads due to credit issues but also contagion effects, where risk
aversion in one bond segment affects others (e.g., high-yield impacting lower-rated investment-grade bonds).

4.3. Issuer-Specific Factors

The financial performance of individual issuers, in addition to macroeconomic and market factors, significantly influences yield
levels and volatility. Common factors for all issuers include debt coverage (sufficiency of cash flows for payments) and leverage
(reliance on debt vs. other financing sources). Different issuer types have unique repayment sources and purposes. Corporations
use operating cash flow to repay debt, while sovereign borrowers rely on tax revenue. Investors typically compare a specific
issuer's yield and spread with bonds in the same credit rating, sector, or companies with similar business characteristics to evaluate
their investment.

4.4. The Price Impact of Spread Changes

Bond duration and convexity are used to estimate a bond's price change when there's a shift in yield-to-maturity, as discussed in
a previous module. Now, we focus on what causes this change in yield. The yield-to-maturity of a corporate bond is comprised of
a government benchmark yield and a spread. Alterations in the bond's yield can arise from either of these components, or a blend
of both. Importantly, for a fixed-rate bond without options, the same duration and convexity measures that apply to a shift in
benchmark yield also apply to a change in spread.

Example
Decomposition of a Romanian Eurobond Yield

In 2019, the Government of Romania issued its first-ever 4.625% 30-year Eurobond, which was priced at a spread of 411.4 bps over
the 1.25% Federal Republic of Germany bond maturing 15 August 2048. The initial yield spread indicated the combined credit and
liquidity risk of the bond. The 4.625% Romania bond subsequently traded in a wide price range, reflecting the prevailing market
assessment of its credit risk and yield spread as well as the benchmark German yield, as shown in the chart below:

81
Suppose that two years after issuance, the bond was traded at 122.25/125.75 (bid/offer). This meant that a buyer would have to
pay the offer price of 125.75 for the bond and a seller would receive the bid price of 122.25. Bond mid-market price = (122.25 +
125.75)/2 = 124.00. With 28 years remaining to maturity, the Romanian bond yield based on its mid-market price is equivalent to
3.2988%:

124.00= 28∑n=1 [4.625/ (1+r)n] + 100/ (1+r)28 => r ≈ 3.2988%.

Assume we observe a Federal Republic of Germany benchmark bund yield of 0.2350% on the same day. The current spread of the
Romania bond may be shown as: = 3.2988% − 0.2350% = 3.0638% or 306.38 bps. To further break down this spread, we can compute
the liquidity spread using the bid/offer prices. At the offer price, the yield is equivalent to 3.2396%:

125.25 = 28∑n=1 [4.625/ (1+r)n] + 100/ (1+r)28 => r ≈ 3.2396%.

At the bid price, the yield is equivalent to 3.3588%:

122.75 = 28∑n=1 [4.625/ (1+r)n] + 100/ (1+r)28 => r ≈ 3.3588%.

Therefore: Liquidity spread = 3.3588% − 3.2396% = 0.1192% or 11.92 bps. Credit spread = 306.38 bps − 11.92 bps = 294.46 bps.
These “building blocks” of the Romania bond yield are summarized below:

While IG debt investors are less likely to be impacted by default, they are more focused on spread risk—that is, the effect on
prices and returns from changes in spreads. For small, instantaneous change in yield spread,

è %∆PVFull = −AnnModDur × ∆Spread,

For larger spread changes, the effect of convexity is to be accounted :

è %∆PVFull = −(AnnModDur × ∆Spread) + 1⁄2 x AnnConvexity × (∆Spread)2,

where Ann Convexity is annualized convexity. Care is required to ensure convexity is properly scaled to be consistent with how
the spread change is expressed. For option-free bonds, convexity should be scaled so it has the same order of magnitude as
duration squared and the spread change is expressed as a decimal. For example, if a bond has duration of 5.0 and reported
convexity of 0.235, then first re-scale convexity to 23.5, and then apply the formula. For a 1% increase in spread, the result would
be :
è %∆PVFull = (−5.0 × 0.01) + 1⁄2 × 23.5 × (0.01)2 = −0.048825 or −4.8825%.

Example
Changes in BRWA Bond Price Following a Credit Downgrade

The 3.2% BRWA senior unsecured five-year note was originally offered with few covenants. Suppose that BRWA is downgraded by
one notch by the rating agencies due to rising technological and environmental risk and BRWA’s focus on the legacy technology of
internal combustion engines. Based on the current market environment, the differences in credit spread in the same industry due
to the one-notch lower rating, applicable to the 2030 and 2035 bond tenors, are observed to be 1.0% and 2.2%, respectively.
Assume that when the rating downgrade happens:

Modified Duration Convexity

3.20% 2030s 3.82250 20.22640

82
 6.20% 2035s 6.57882 58.43082

Using previous equation, the price impact on the 3.20% BRWA 2030 bond can be estimated as:

è %∆PVFull = −(AnnModDur × ∆Spread) + 1⁄2 x AnnConvexity × (∆Spread)2

è −(3.82250 × 0.01) + 1⁄2(20.2264) × (0.01)2 = −0.037214 or −3.7214%.

For the 6.20% BRWA 2035 bond, the price impact is estimated as:

è %∆PVFull = −(6.57882×0.022) + 1⁄2(58.43082) × (0.0220)2 = −0.130594 or −13.0594%.

As in the earlier examples, the negative price impact on the longer-duration bond is expected to be much larger due to credit
migration.

83
Fixed Income - Learning Module 15
for the CFAâ exam

Credit Analysis for Government Issuers

Learning Outcomes :

The candidate should be able to:

a) Explain special considerations when evaluating the credit of sovereign and non-sovereign government debt issuers and issues

1. Introduction

This learning module focuses on the unique considerations involved in assessing the creditworthiness of sovereign and other
public issuers in the fixed-income markets. The key distinction between these entities and corporate issuers lies in the purpose
and means of repaying debt. Sovereign and government issuers use debt to support fiscal policy, provide public services, and
cover government expenses, relying on tax revenues and other sources like tariffs and fees for debt repayment, while corporations
use operating cash flow for this purpose. Evaluating sovereign bonds involves a combination of qualitative and quantitative factors
to gauge their capacity and willingness to meet their obligations. Sovereign defaults, especially in transitioning economies, are not
rare. However, unlike corporate issuers, bondholders of sovereign debt typically cannot compel governments to declare
bankruptcy and liquidate assets. Non-sovereign issuers, such as local governments or quasi-government bodies, also issue debt to
finance various needs, secured by their ability to collect local taxes or generate revenue from specific projects.

2. Sovereign Credit Analysis

LOS (a) : Explain special considerations when evaluating the credit of sovereign and non-sovereign government debt issuers and
issues

Sovereign and non-sovereign governments issue debt to fund various activities, primarily fiscal policy and public services.
Sovereign debt is typically repaid through taxes and government revenue sources. Sovereign bonds have low credit risk due to
the government's ability to tax all economic activity within its jurisdiction. However, emerging market governments may pose
higher default risk. Bond investors assess creditworthiness based on cash flow stability, sufficiency for interest and principal
payments, and reliance on debt. Credit evaluation for government issuers involves unique qualitative and quantitative factors
specific to the public sector.

2.1. Qualitative Factors

Sovereign government policies impact the macroeconomy and financial markets through monetary and fiscal measures aiming
for stable growth and low inflation. Creditworthiness evaluation by investors, both domestic and foreign, centres on a
government's taxation, spending policies, and the overall economy as the primary source of tax revenue for repayment.
Qualitative factors considered in this assessment encompass Government Institutions and Policy, Fiscal Flexibility, Monetary
Effectiveness, Economic Flexibility, and External Status.

Government Institutions & Policy refers to the impact of a sovereign government's institutions and policies on political and
economic stability. This encompasses legal protections like upholding the rule of law and property rights, as well as promoting
transparency, debt repayment culture, and ease of doing business. Political stability and peaceful relations with neighbouring
countries are also crucial. Assessments are often done through rankings or scores. Additionally, considering a government's
willingness to pay is vital due to sovereign immunity, which limits investors' legal recourse in case of default. This can lead to debt
restructuring agreements to recover investments, facilitated by entities like the International Monetary Fund.

Fiscal Flexibility assesses a sovereign government's ability to maintain fiscal discipline in various economic conditions. It includes
aspects like effective tax collection, wise allocation of government budget for public goods, and managing the level of sovereign
debt in relation to economic activity. Evaluation considers past fiscal adjustments during economic cycles and the anticipated
impact of fiscal policy changes.

Monetary Effectiveness evaluates a sovereign government's ability to manage its monetary policy effectively. This involves the
central bank's efforts to control the money supply and credit within the economy by setting interest rates, reserve requirements,
and buying/selling sovereign bonds. The independence of the central bank from government interference is a key factor. Greater

84
independence reduces the risk of a government inflating its domestic debt, which can lead to higher inflation and a weaker
domestic currency.

Economic Flexibility pertains to the capacity of a sovereign government to generate revenue for debt repayment from economic
activity within its jurisdiction. Creditworthiness factors include the size of the economy, per capita income, economic
diversification, and growth potential. Highly-rated sovereigns typically have advanced, diverse, and robust economies with
sustainable growth. In contrast, emerging or frontier market economies may rely heavily on one industry or commodity, making
their revenue more vulnerable to economic shifts, commodity price changes, or trade disruptions. These countries may also face
difficulties in tax collection due to informal economies or other challenges.

External Status examines how a sovereign government's international trade, capital, and foreign exchange policies impact its
ability to manage and service its debt. Credibility of monetary policy and exchange rate regimes significantly influence
international capital flows. An essential aspect is whether the domestic currency is considered a reserve currency (i.e. one that is
fully convertible and frequently held by foreign central banks and other investors as a portion of their foreign exchange reserves)
as this expands the government's ability to attract foreign investors, reducing the risk of default and supporting structural budget
deficits and higher debt levels. Many emerging and frontier market countries have restrictions on exchange rates, capital controls,
or limited currency convertibility, making it challenging to issue foreign currency bonds. In such cases, they may turn to
supranational organizations like the IMF for foreign currency funding.

Additionally, geopolitical risk can also influence a country's creditworthiness, as seen in the deterioration of East European
countries' creditworthiness following Russia's military invasion of Ukraine in February 2022.

In practice, many of these qualitative factors are interrelated; for example, a weak legal system often goes hand in hand with a
limited ability to collect taxes due or enforce debt contracts.

2.2. Quantitative Factors

Quantitative credit analysis assesses the likelihood of an issuer meeting its fixed debt obligations. Unlike corporations with
standardized financial statements, sovereign analysts rely on government economic data that can vary in quality, timing,
comparability, and be influenced by political factors. Consequently, detailed public sector financial balance sheets are less useful
for forecasting creditworthiness. Instead, analysts use a top-down, macroeconomic approach with a focus on quantitative factors
like Fiscal Strength, Economic Growth and Stability, and External Stability. Financial ratios, similar to those used for corporations,
are employed for comparisons across sovereign issuers and over time. These ratios typically involve the government's debt size
or periodic fixed payments as the numerator and government revenue or domestic GDP as the denominator, reflecting the primary
measure of taxable economic activity.

Fiscal Strength of a sovereign issuer considers the current and projected future debt burden, as well as the extent to which it
relies on debt compared to other financial resources. Key ratios employed for this are illustrated below :

Debt burden measures, such as leverage and debt affordability ratios, indicate a government's ability to pay off its debts. A higher
debt burden ratio usually suggests lower credit quality. Fiscal surpluses or deficits as a percentage of GDP are also used to assess

85
a country's fiscal discipline and whether its debt burden is improving or worsening. Rating agencies use these and other financial
metrics, along with other factors, to analyse a country's creditworthiness. These ratios are not considered in isolation but rather
as part of a comprehensive credit analysis.

Economic Growth and Stability assessment considers a country's economic prospects. Factors like GDP size and per capita income
are essential, as larger and wealthier economies are better equipped for sustainable growth and resilience against economic and
political shocks. Historical and projected real economic growth rates, along with their variability, are crucial quantitative measures
in this evaluation. Key financial measures are illustrated alongside:

External Stability is contingent on foreign investors' willingness to hold a country's currency assets. Nations with actively traded
currencies and significant foreign investors holding their currency assets, or those whose currency is held in reserve by other
countries, tend to have better external stability.

The ability of a sovereign government with a non-reserve currency to meet external debt obligations depends on external liquidity
and solvency which in simpler terms, refers to its capacity to generate stable foreign currency cash inflows for interest and
principal payments on external debt and other obligations to foreign investors.

For emerging and frontier market countries, commodity exports are pivotal for foreign currency reserves. Strong and stable
commodity demand can bolster creditworthiness, while adverse commodity price fluctuations can contribute to sovereign
defaults, particularly in nations heavily reliant on commodities like oil.

3. Non-Sovereign Credit Risk

LOS (a) : Explain special considerations when evaluating the credit of sovereign and non-sovereign government debt issuers and
issues

3.1. Non-Sovereign Government Debt

Non-sovereign government issuers, like government agencies and regional governments, issue debt to fund their operations.
Government agencies often have credit risk similar to the sovereign government due to implicit or explicit government support.
Regional governments, with their own economic and political governance, benefit from the sovereign's policies but may have
varying creditworthiness. Non-sovereign government issuers include agencies, public banks, supranationals, and regional
governments.

3.2. Agencies

Agencies are quasi-government organizations with a mission to provide public services, typically empowered by specific laws to
finance their activities with debt. Investors generally expect strong sovereign government support for these entities, and they are
often rated the same as the sovereign government by rating agencies.

3.3. Government Sector Banks and Development Financing Institutions

86
Sovereign governments often create specialized financial intermediaries to serve specific purposes, such as economic or policy
objectives. These institutions, like agencies, are typically established or supported by the government and usually receive a similar
credit rating.

3.4. Supranational Issuers

Supranational entities are organizations owned by multiple sovereign governments working together towards a common goal. For
instance, the World Bank and its affiliates issue debt to support projects in developing countries, while regional-focused
supranational entities like the Asian Development Bank and the Development Bank of Latin America help with regional
development initiatives.

3.5. Regional Government Issuers

Local government bonds, known as municipal bonds in the US, are issued by provincial, state, and local governments within a
sovereign jurisdiction. The financing and credit ratings of local governments vary between countries. For instance, in the
Netherlands, a public financial institution provides financing to municipalities, giving them the same credit rating as the federal
government. In other countries, a tax revenue sharing system helps local authorities meet their obligations. In the US, municipal
issuers like state and local governments receive individual credit ratings and usually issue either general obligation or revenue
bonds.

3.5.1. General Obligation Bonds

General obligation (GO) bonds are unsecured bonds issued by non-sovereign governments, backed by their general
revenues and taxing authority. The credit analysis for GO bonds is similar to sovereign debt analysis but with some
differences. Factors such as the local business environment, diverse corporate tax base, possible national government
support, and responsible budget management determine the issuer's creditworthiness. However, non-sovereign
governments have limited jurisdictional powers and no control over sovereign economic and monetary institutions. They
may face challenges from technological and demographic changes, as exemplified by Detroit's bankruptcy in 2013, driven
by a decline in the automotive industry and population shift to the suburbs, leading to a tax revenue shortfall.

3.5.2. Revenue Bonds

Revenue bonds are issued to fund specific projects like sewer systems, toll roads, hospitals, or sports arenas. They are riskier
than general obligation (GO) bonds because they rely on a single source of revenue. Analysing revenue bonds involves
assessing the project's necessity, projected use, and economic support. This analysis resembles corporate bond analysis,
focusing on operating results, cash flow, liquidity, and the issuer's ability to meet debt payments based on cash flow
projections. The debt service coverage ratio, indicating revenue available for payments after expenses, is a crucial credit
measure, with higher ratios indicating stronger creditworthiness. Minimum coverage ratio requirements are common. In
assessing these bonds, it's vital to consider the reliability of cash flows and repayment sources, especially for non-sovereign
government infrastructure bonds, where the national government may act as a secondary source in case of revenue
shortfalls.

Example
Using Key Rate Duration Estimate Interest Rate Risk for Bonds in a Portfolio

A portfolio manager asks you to determine if the following bond portfolio needs rebalancing to improve overall return, given the tenor of the
portfolio’s bonds, key rate duration information, and forecasted benchmark government par curve shifts at the various maturities. All four bonds
have the same benchmark government par curve. Current information for the bonds are as follows:

Bond Tenor Position Size Key Rate Duration

A 1 year $200,565,245 0.645
B 5 years $201,042,132 1.483
C 10 years $202,673,298 2.158
D 20 years $202,588,801 2.982

Information on the forecasted benchmark government par curve changes at the various maturities are as follows:

Maturity 1 year 5 years 10 years 20 years

Expected change –23 bps –25 bps –18 bps –10 bps

87
If we take the product of the key rate duration and curve shift at a certain maturity, we can forecast the change in the price of the bond. For
example, for the one-year maturity, this would be –0.645 × –0.0023 = 0.148%. The calculation for all the bonds is shown below:

Maturities 1 year (Bond A) 5 years (Bond B) 10 years (Bond C) 20 years (Bond D)

% change in bond price 0.148% 0.371% 0.388% 0.298%

Therefore, since the forecasted price change in the bonds favour Bonds B and C, it would be advisable to increase the weightings for these bonds,
taking more from the Bond A position than the Bond D position, since Bond A is forecasted to give the least gain of all the bonds.

88
Fixed Income - Learning Module 16
for the CFAâ exam

Credit Analysis for Corporate Issuers

Learning Outcomes :

The candidate should be able to:

a) Describe the qualitative and quantitative factors used to evaluate a corporate borrower’s creditworthiness
b) Calculate and interpret financial ratios used in credit analysis
c) Describe the seniority rankings of debt, secured versus unsecured debt and the priority of claims in bankruptcy, and their
impact on credit ratings

1. Introduction

This learning module focuses on assessing the creditworthiness of non-financial corporate borrowers. It discusses the factors that
affect a company's ability to meet its debt obligations, such as its business model and activities. The module also covers qualitative
and quantitative factors that impact the probability of default and loss given default. Financial statement analysis and cash flow
projections are important tools used in corporate credit analysis. The module also discusses the calculation and interpretation of
financial ratios to assess a company's probability of default. Lastly, it addresses the importance of seniority rankings and collateral
in determining credit ratings and assessing loss given default in the event of default.

2. Assessing Corporate Creditworthiness

LOS (a) : Describe the qualitative and quantitative factors used to evaluate a corporate borrower’s creditworthiness

Creditworthiness is determined by a company's ability to generate enough profits and cash flow to make its debt payments.
Analysts use both qualitative and quantitative factors to assess the probability of default and potential loss for investors. Various
models exist to measure credit risk, but our focus will be on general qualitative and quantitative factors.

2.1. Qualitative Factors

In corporate issuers modules, we discussed the important qualitative factors that help determine a company's ability to meet its
debt obligations. These factors include the company's business model, the industry it operates in, the competitive forces it faces,
and the risks it encounters.

From a debtholder’s perspective, financial analysts evaluating a company must not only consider whether a firm generates an
acceptable return over its cost of capital, but also whether the timing and size of cash flows are sufficient to adequately cover
debt obligations. Firms with stable cash flows and low business risk are better positioned to use debt as part of their overall
financial structure. They are less likely to default on their debt obligations compared to firms with less stable cash flows and higher
business risk.

Unsecured claims rely on company cash flows for repayment, while secured debt uses specific company assets as collateral for
interest and principal payments. Secured lenders prefer tangible collateral, like physical assets, over intangible assets. Collateral
becomes crucial for companies with lower credit quality, especially when the borrower's risk of default is high. Tangible assets
include physical items like property and inventory, while intangible assets encompass things like patents and intellectual property.
Using collateral and secured debt can lower borrowing costs and provide access to debt markets that might be otherwise
unavailable.

Corporate governance is a crucial aspect in assessing a company's creditworthiness. While evaluating an individual borrower's
character is straightforward, it's more challenging to evaluate management's character and how they'll treat debtholders in
publicly or privately owned corporations. Unlike equity investors with voting rights, debtholders aim to dictate how debt proceeds
are used and any borrower restrictions at the time of issuance.

Highly rated unsecured debt issuers can raise funds for general corporate purposes with minimal restrictions, usually involving
affirmative covenants such as compliance with laws, asset maintenance, and tax payments. Credit analysts need to assess how
management treats debtholders compared to shareholders and potential dilution risks. On the other hand, high-yield secured

89
debt issuers face stricter restrictions from investors to protect bondholders in case of financial troubles. These include limits on
dividends, additional debt, and financial covenants. Past management behavior, such as causing significant credit rating
downgrades through debt-driven actions, is a crucial factor in credit analysis.

Credit analysts, like equity analysts, should assess a company's accounting policies. Aggressive policies can obscure the true
performance and risk of the business, raising concerns about its integrity and leadership. Examples include extensive off-balance-
sheet financing, capitalizing rather than expensing items, and premature revenue recognition. A major warning sign is frequent
changes in auditors or CFOs. These indicators, along with any signs of fraud or wrongdoing, may suggest behavior that could harm
the company's creditworthiness.

2.2. Quantitative Factors

Financial statement modelling and forecasting involves quantitatively predicting a company's future performance by considering
its fundamental drivers, risks, and opportunities. Analysts use top-down or bottom-up approaches to determine model inputs.
Unlike equity models, which assess a firm's stock value, quantitative credit analysis focuses on estimating a company's ability to
meet its debt obligations. Key quantitative factors used are summarise below :

Top-down analysis starts with a macroeconomic outlook and assesses a company's growth in relation to GDP, market potential,
market share, and potential adverse scenarios. It considers factors like the credit cycle's impact on credit risk at a macro level. In
contrast, bottom-up analysis focuses on predicting revenue drivers and balance sheet items. A hybrid approach blends cyclicality
and bottom-up elements to forecast a company's cash flows.

Quantitative analysis aims to determine the key factors influencing a company's Probability of Default (POD) and how they
change during the credit cycle. These factors include:

o Profitability: Strong and stable earnings are crucial for servicing debt. Analysts focus on recurring revenues and operating
profits, while factors like economic downturns or declining market share can impact profitability.
o Leverage: Leverage measures a company's reliance on debt financing. Lower leverage is preferred by debt investors, while
equity investors often benefit from higher financial leverage.
o Coverage: Lenders assess creditworthiness by comparing income or cash flows to debt service. Better coverage means more
income or cash flows are available to meet debt obligations.
o Liquidity: Evaluating near-term debt obligations involves considering short-term resources to pay interest or principal.
Liquidity measures also include assets that can be quickly converted to cash, such as marketable securities or committed
bank facilities.

3. Financial Ratios In Corporate Credit Analysis

LOS (b) : Calculate and interpret financial ratios used in credit analysis

90
The financial ratios outlined earlier allow credit analysts to assess the financial health of a company, trends over time, and compare
companies within and across industries. Some common ratios used during credit analysis are outlined below :

Credit risk analysis focuses on a company's ability to generate cash from its core operations, rather than asset sales or financing.
Conservative cash flow measures, like free cash flow, funds from operations, and retained cash flow, account for cash used to run
the business and distributed to shareholders. Debt and interest expense measures in credit analysis can be adjusted for items like
operating leases and off-balance-sheet obligations that affect debt servicing.

These financial measures and ratios are non-IFRS, meaning they lack official IFRS definitions and can vary in usage. Credit analysts
commonly use metrics like:

o EBIT Margin: Evaluates a company's operating performance by looking at EBIT (earnings before interest and taxes), excluding
interest and taxes. Higher EBIT margins indicate more profit available for servicing debt.
o EBIT to Interest Expense: Assesses the extent to which operating profit covers interest payments. A higher coverage ratio
suggests lower credit risk. It may include factors like depreciation and amortization or rental expenses in the numerator.
o Debt to EBITDA: Measures leverage, with a higher ratio indicating higher leverage and, therefore, greater credit risk.
Adjustments may be made for operating leases and off-balance-sheet commitments.
o Retained Cash Flow (RCF) to Net Debt: Evaluates leverage using cash flow instead of earnings, with debt reduced by available
cash. A higher RCF to net debt ratio signifies lower leverage.

While financial ratios used in credit analysis vary across industries, the values of financial ratios themselves for a given rating or
level of credit quality may also range widely across industries due to different business models, competitive pressures, and other
factors.

Credit analysts can also use financial modelling to evaluate how these ratios might change over time as revenue drivers change.

4. Seniority Rankings, Recovery Rates, And Credit Ratings

LOS (c) : Describe the seniority rankings of debt, secured versus unsecured debt and the priority of claims in bankruptcy, and their
impact on credit ratings

Corporate borrowers can have varying levels of seniority for their debt obligations. Some companies have simple capital structures
with all debt being equally ranked and issued by a primary operating entity. In contrast, companies in more complex industries,
like media conglomerates or regulated sectors like banks and utilities, may have intricate debt structures. They often consist of
multiple subsidiaries, each with their own debt, and parent holding companies that issue debt with different seniority levels.

4.1. Seniority Rankings

Seniority ranking determines the order in which debt holders are paid, with the most senior debt having the first claim on an
issuer's cash flows and assets. It plays a crucial role in the value of an investor's claim in the event of a default and restructuring.
Secured debt is backed by specific assets and their cash flows, reducing the lender's potential loss in case of default, as the lender
can use the collateral to recover their losses. Rankings involving secured and unsecured debt are shown below :

91
4.2. Secured versus Unsecured Debt

First mortgage and first lien debt have the highest priority among secured creditors for repayment. First mortgage debt is tied to
specific property (e.g., a utility's power plant), while first lien debt is linked to various assets like buildings, equipment, licenses,
patents, or inventory. Second lien secured debt holds a lower priority in both collateral protection and repayment compared to
first lien debt. Most second lien loans are senior secured, surpassing junior secured obligations. Unsecured bondholders lack
specific asset backing and have a general claim on the issuer's assets and cash flows. In case of default, unsecured debtholders
are paid after secured creditors due to the priority of claims.

Among unsecured debts, senior unsecured debt is the highest ranked, sitting between senior secured debt and subordinated
debt. Lower-ranked debts include subordinated debt and junior subordinated debt, with the lowest priority of claims and often
no recovery in case of default. Different seniority levels serve the needs of both issuers and investors. Issuers choose seniority
based on cost optimization, offering secured or subordinated debt as needed. In bankruptcy, senior secured creditors have the
first claim on specific assets, followed by senior unsecured creditors and subordinated creditors, ahead of shareholders.

4.3. Recovery Rates

Understanding recovery rates is crucial in credit analysis and risk assessment. Key points to note are :

o In bankruptcy, creditors at the same seniority level are treated equally, regardless of the maturity date of their debt.
o Defaulted debt often trades near the expected recovery rate for bonds expected to enter bankruptcy or liquidation.
o Recovery rates can vary widely by industry and economic cycle - Companies in declining industries generally have lower
recovery rates than those in cyclical downturns. Recovery rates are also influenced by the strength of the economy; a robust
economy leads to higher recovery rates, while a weak economy results in lower rates.
o The recovery rates also vary significantly across individual companies. The debt composition in a company's capital structure
plays a role, with a higher proportion of secured debt leading to lower recovery rates for lower-ranked debt.

The priority of claims in bankruptcy is a well-established legal standard. However, lower-ranked creditors and even shareholders
may receive some consideration, as the resolution process takes time. Compensating subordinated debt holders can speed up the
process. Bankruptcy proceedings involve significant legal and accounting fees, and the company's value may decline. This can lead
to negotiations and compromises, resulting in lower-ranked creditors receiving more than their legal entitlement.

In the United States, there's a preference for reorganization, while elsewhere, liquidation is more common to maximize value for
bank lenders and senior creditors. Due to the complexity and variation of bankruptcy laws by country, it's hard to predict how
creditors will fare in a default scenario.

4.4. Issuer and Issue Ratings

Rating agencies assign both issuer and issue ratings for corporate debt. They use terms like corporate family rating (CFR) and
corporate credit rating (CCR), or issuer credit rating and individual issue credit rating. An issuer rating evaluates the overall
creditworthiness of the obligor, usually applying to its senior unsecured debt. An individual issue rating pertains to specific
92
financial obligations, considering factors like seniority. While the probability of default may be the same for an issuer and its issues
due to cross-default provisions, issuer ratings can differ due to differences in loss given default (LGD) caused by factors like
seniority, subordination, and repayment sources. This adjustment methodology is known as notching. Higher-rated companies
typically have smaller notching adjustments due to lower perceived default risk, while lower-rated firms face larger rating
adjustments, as the potential LGD difference carries more weight in assessing credit risk.

In addition to Probability of Default (POD) and Loss Given Default (LGD), rating agencies consider structural subordination, which
can occur when a corporation has debt at both its parent holding company and operating subsidiaries. Debt at operating
subsidiaries is serviced first, before funds can be used to pay the parent company's debt.

93
Fixed Income - Learning Module 17
for the CFAâ exam

Fixed-Income Securitization
Learning Outcomes :

The candidate should be able to:

a) Explain benefits of securitization for issuers, investors, economies, and financial markets
b) Describe securitization, including the parties and the roles they play

1. Introduction

Asset-backed securities (ABS) are a type of financial instrument that is backed by a group of loans or receivables. These securities
allow for the pooling of assets, which helps to spread risk and allocate capital more efficiently. The cash flows generated from the
underlying assets are then used to repay investors in a predetermined manner. Securitization is a global practice that provides
flexibility to issuers and investors and creates a new subordination structure for the assets involved. This learning module provides
an overview of the benefits of securitization, the process involved, and common structures used in securitization transactions.

2. The Benefits of Securitization

LOS (a) : Explain benefits of securitization for issuers, investors, economies, and financial markets

Securitization involves pooling and transferring ownership of cash flow generating assets, like loans or receivables, from the
original lender to a separate legal entity. This entity then issues securities backed by these assets to investors, who receive interest
and principal payments. This process creates a direct connection between investors and borrowers and offers benefits for all
parties involved, as well as for the economy and financial markets. The steps of the securitization process are outlined in the image
below:

Asset-backed
with similar
of assets entity (SPE)
features

Asset transfer from originator to SPE

There are several different types of securitized products. In order of increasing complexity, the following products are examples
of ABS.

o Covered bonds are a type of securitization structure used by European banks. These bonds are backed by a specific pool of
mortgage loans held by the bank, which serves as collateral (“cover”) for the bonds. If the bank defaults on the bond,
investors can use the collateral to receive payment. Unlike other securitizations, the underlying assets remain on the bank's
balance sheet, and investors are paid directly by the bank rather than from the cash flow generated by the specific
mortgage pool.
o Pass-through securities is true securitization - a pool of assets, typically loans are transferred from the sponsor’s balance
sheet to a separate and independent legal entity. This entity then issues securities backed by these assets, with investors
receiving principal and interest payments from the assets as they are "passed through" the legal entity. These securities
distribute payments proportionally across different tranches, allowing investors to take on varying levels of risk. The
payments received by investors depend on the overall credit risk of the asset pool and its payment patterns.
o Bonds with structural enhancements improve the reliability of payments for pass-through securities by redistributing cash
flows and creating a pre-set payment schedule. This helps to mitigate the impact of unexpected changes in payment
patterns. Tranches within these bonds are ranked in order of risk, with lower tranches taking on more risk. These
enhancements also help to reduce the credit risk associated with securitized loans by adding additional protections for
investors.
o Mortgage-backed securities (MBS) are asset-backed securities (ABS) that are backed by a pool of mortgages. Distinction
between MBS and ABS’s backed by non-mortgage assets is common in the US and is shown in the table below:

94
 Pass-Through Securities Subgroup
o Residential Mortgage-Backed Securities (RMBS)
o Commercial Mortgage-Backed Securities (CMBS)
Mortgage-backed securities o Collateralized Mortgage Obligation (CMO)

o Collateralized Debt Obligation (CDO)

o Collateralized Loan Obligation (CLO)
Non-Mortgage-backed securities o Collateralized Bond Obligation (CBO)
o Collateralized Debt Obligation Squared (CDO Squared)

In securitization transactions, subordination involves creating different classes or tranches of bonds that receive cash flows from
underlying assets. These classes are categorized as senior or subordinated (also known as non-senior or junior bond class). This
tranching determines the order of payments and the absorption of losses by investors. A sample structure is shown in the image
below (details will be discussed in later module):

2.1. Benefits to Issuers

Banks act as the intermediary between borrowers and investors and underwrite loans for borrowers to finance purchases and
investments, which remain on their balance sheets until fully repaid. These loans are illiquid. By separating loan origination from
loan financing, they can improve their profitability, earning origination fees and reducing capital requirements for loans that are
sold to investors. By removing assets and lending risks from their balance sheet, banks sell illiquid assets and operate more
efficiently on a risk-adjusted basis. Selling assets also generates fee income. Ultimately, securitization enables banks to expand
lending origination beyond their balance sheets

2.2. Benefits to Investors

Institutional or individual investors often lack the necessary resources and expertise to directly manage loans and receivables.
Having similarities to standard bonds in terms of their characteristics, ABS as an investment allows them to gain exposure to
private debts without the need to directly underwrite loans or assume the risks and costs of banking. It distributes the skills and
risks to appropriate parties, making it a more efficient investment instrument.

EXAMPLE
Benefits of Securitized Debt for Long-term Investors

An investment manager for a defined benefit pension fund at a large manufacturer is evaluating investment options and
expectations. A number of parameters and expectations influence the investments selected for the pension fund, starting with
asset and income diversification. The fund seeks safe, diversified assets and income streams, which offer low risk. Anticipated
pension payments or outflows from the fund drive the need for liquid and stable investments, which mature or can be sold easily
to match the timing of required cash outflows. Any fund investments must be highly rated. Because pension pay-outs take place
over many years into the future, pension assets must be invested long-term, too. And the fund’s assets must grow over time in
order to produce promised pension payments at the levels required in the future. While public, government-issued debt is highly
rated and typically safe, it alone may not produce sufficient returns to meet future obligations. By contrast, holding investment-
95
grade, publicly traded, securitized debt, which can be traded, will allow the manager to garner higher returns and to respond
quickly to changes in market sentiment, risk sensitivity, or funding needs at low transaction costs.

2.3. Benefits to Economies and Financial Markets

o Securitization converts loans into tradable securities, which are more liquid than the original loans held by banks and hence
improves liquidity in the overall financial system. This also allows for increased efficiency in financial markets as investors can
determine fair prices through trading in the secondary market.
o Securitization provides companies with a cost-effective alternative way to fund their operations by pooling securitizable
assets (like receivables and loans), thus reducing funding costs and increasing returns on capital
o Corporate issuers can boost sales by offering credit to customers through their financing subsidiary. These subsidiaries
specialize in financing and leasing and often sell a significant portion of the corporation's debt to banks or special purpose
entities (SPEs). The company can then securitize these loans, receiving cash from the SPEs and selling them to investors. This
allows the company to fund financing for new customers and sell more products. By securitizing these loans, the company
can access cheaper funding from the financial markets without increasing their overall leverage or financing costs.

Securitization can involve pooling revenue-generating assets from different industries to create investment opportunities. This
process benefits various parties involved. Manufacturers can outsource debt servicing, leading to cost reductions for consumers.
Investors, on the other hand, benefit from diversified investment options.

Securitization has numerous advantages for economies, but it is not without its risks. These risks can be divided into two main
categories: timing risks, which are related to the cash flows of asset-backed securities (ABS) and include contraction risk and
extension risk, and credit risks, which are associated with the underlying loans and receivables of the ABS. The following modules
will discuss how securitization structures mitigate these risks. It is worth noting that some of these risks were considered to be
significant factors in the financial market turmoil of 2007-2009

3. The Securitization Process

LOS (b) : Describe securitization, including the parties and the roles they play

Securitization involves meeting legal and regulatory requirements and involves multiple parties to facilitate the transaction.

3.1. An Example of a Securitization

Bright Wheel Automotive (BRWA), a car manufacturer, has a financing subsidiary that offers fixed-rate loans to its customers.
These loans are backed by the vehicles purchased and typically last for four years. They are structured as fully amortizing loans,
where borrowers make equal monthly payments that cover both the interest and principal repayment. The financing subsidiary
is responsible for both granting credit to customers and managing the loans. This includes tasks such as collecting payments,
contacting delinquent borrowers, and repossessing and selling vehicles if necessary to recover the outstanding loan amount in
case of default. While BRWA currently services the loans itself, in some cases, loan servicing may be outsourced to another entity.

96
Suppose, BRWA is looking to raise EUR1,000 million and has two options: issuing a four-year corporate bond or creating an asset-
backed security (ABS) backed by its car loans. The goal is to secure the lowest interest rate compared to the benchmark rate, with
the difference representing the credit spread. Car manufacturers, unlike banks and financial institutions, have capital-intensive
operations. Holding car loans on their balance sheet ties up capital that could be used more efficiently. Selling these loans frees
up capital and allows the company to realize profits to
support its core business.

BRWA establishes a separate legal entity called Car Loan

Trust (CLT), which is a special purpose entity (SPE), to
which it sells EUR1,000 million worth of car loans. CLT,
an independent entity from BRWA, becomes the sole
owner of these loans and used these loans as collateral
to issue asset-backed securities (ABS). This separate
legal entity structure ensures that if BRWA faces
bankruptcy, the loans backing the ABS issued by BRWA
are protected within CLT, and BRWA's creditors cannot
make claims on them. This entire structure is shown in
the adjoining image. The process of creating these
separate legal structures and transferring the loans to
the SPE can be complex and varies by jurisdiction.

3.2. Parties to a Securitization

In a securitization, there are three primary parties:

o The seller of the collateral, often referred to as the depositor (e.g., BRWA in this example).
o The special purpose entity (SPE) that acquires the loans or receivables and uses them as collateral to issue asset-backed
securities (ABS), such as Car Loan Trust (CLT in this case).
o The servicer of the loans, which in this example is BRWA's financing subsidiary.

Additionally, various other parties are involved, including independent accountants, lawyers, trustees, underwriters, rating
agencies, and sometimes financial guarantors. These parties are considered third parties to the securitization because they are
distinct from the seller of the collateral and play different roles in the transaction.

In the securitization process, in addition to the standard bond indenture and its covenants, two crucial legal documents are
involved:

o The purchase agreement: This document establishes the agreement between the seller of the collateral (original lender) and
the special purpose entity (SPE). It outlines the representations and warranties made by the seller regarding the assets being
sold. These representations and warranties provide assurance to investors regarding the quality of the assets, which is a key
factor in assessing the risks associated with the asset-backed securities (ABS).
o The prospectus: This document describes the structure of the securitization, including details about the priority and amount
of payments to be made to the servicer, administrators, and ABS holders. It also provides information about the credit
enhancements used in the securitization, offering a comprehensive view of the transaction's structure and terms.

A disinterested trustee, often a financial institution, plays a crucial role in a securitization. They safeguard the assets sold to the
special purpose entity (SPE), hold funds on behalf of asset-backed securities (ABS) holders, and regularly provide cash flow reports
to these ABS holders as outlined in the prospectus terms. These reports are the primary means through which investors can assess
the creditworthiness of the ABS

3.3. The Role of the SPE

The legal protection provided by a special purpose entity (SPE) is essential in securitization, ensuring the safety of both the issuer
and investors. An SPE is not affected by the bankruptcy of the collateral seller, making securitization a cost-effective way to raise
funds compared to a corporate bond secured by the same assets.

97
In securitization, seniority is fixed by law in most jurisdictions, and the bankruptcy of the originating company does not impact the
SPE. Transferring assets to the SPE effectively separates the credit risk of the entity seeking funds from the bond classes issued by
the SPE. This emphasizes the critical importance of the legal separation between the issuer and the SPE.

Investors in securitization primarily face credit risk from borrowers potentially defaulting on their loans. However, as long as
borrowers make their interest and principal payments, the SPE remains capable of fulfilling its cash payment obligations to security
holders.

In many countries, securitization is legally recognized as a true sale, where all rights of the lender are completely and irrevocably
transferred to the special purpose entity (SPE). The SPE gains full legal ownership of the securitized assets, which are removed
from the seller's balance sheet. However, it's worth noting that transfers to bankruptcy-remote entities like an SPE can potentially
face legal challenges as fraudulent transactions, which could lead to them being reversed.

It's essential to acknowledge that legal frameworks vary between countries. Some nations may have less developed trust laws,
leading to obstacles in issuing asset-backed securities (ABS). Therefore, investors should carefully consider the legal aspects
relevant to the jurisdictions where they intend to purchase ABS.

98
Fixed Income - Learning Module 18
for the CFAâ exam

Asset-Backed Security (ABS) Instrument and Market Features

Learning Outcomes :

The candidate should be able to:

a) Describe characteristics and risks of covered bonds and how they differ from other asset-backed securities
b) Describe typical credit enhancement structures used in securitizations
c) Describe types and characteristics of non-mortgage asset-backed securities, including the cash flows and risks of each type
d) Describe collateralized debt obligations, including their cash flows and risks

1. Introduction

Asset-backed security (ABS) securitization involves various types of assets like loans, receivables, residential, or commercial
mortgages. These assets can be divided into different tranches with specific payment patterns and associated risks. This approach
reduces cash flow variability and reallocates risks, offering benefits such as risk transfer, flexibility for issuers and investors, and
efficient capital allocation.

2. Covered Bonds

LOS (a) : Describe characteristics and risks of covered bonds and how they differ from other asset-backed securities

Covered bonds are senior debt obligations issued by financial institutions and secured by a segregated pool of assets, often
commercial or residential mortgages or public sector assets. In some cases, covered bonds can also be backed by assets like ships
and commercial aircraft. The typical structure of covered bond transaction is shown below :

Covered bonds are similar to ABS, but the loans stay on the issuer's balance sheet, segregated into a separate cover pool. In case
of bankruptcy, investors have two levels of recourse: first on the ringfenced loans in the cover pool, and second on the
unencumbered assets of the issuing institution. There is a growing trend in issuing covered bonds for financing environmental
projects and investments in renewable energy and infrastructure. These "green covered bonds" are backed by cover pools
primarily consisting of mortgages on green-certified buildings

Covered bonds typically have one bond class per cover pool. They feature a dynamic cover pool, monitored by a third party for
performance and adherence to underwriting standards. The issuer must replace prepaid or non-performing assets to ensure
consistent cash flows until the bond matures.

99
Covered bonds provide two risk-mitigation tools for investors. Firstly, they often have collateral exceeding the bond face value,
known as overcollateralization. Secondly, mortgages in the pool must meet specific loan-to-value (LTV) standards; any non-
compliant mortgages are replaced with compliant ones.

Redemption regimes in covered bonds aim to maintain cash flows close to the original maturity schedule in case of financial
sponsor default. There are hard-bullet bonds with accelerated payment in case of default, soft-bullet bonds with delayed default
and extended maturity, and conditional pass-through bonds converting to pass-through securities after the original maturity.
Covered bonds are a stable funding source due to their dual recourse, eligibility criteria, dynamic cover pool, and redemption
mechanisms. Consequently, they generally have lower credit risk and offer lower yields compared to similar ABS.

Ultimately, covered bonds and ABS serve different purposes. ABS package and sell private credit risk, offering higher returns.
Covered bonds help banks secure long-term funding at a lower cost, with the underlying assets enhancing the issuer's promise to
repay but not offering exposure to those assets. Their payment structures also differ: ABS typically have floating interest rates and
pass through early payments, while covered bonds pay fixed interest rates and mature on set dates. Securitization, while having
disadvantages like banks selling their loans, has advantages. It increases the financial system's lending capacity by reducing the
capital banks need to hold. Covered bonds, which keep loans on banks' balance sheets, do not provide this benefit.

3. ABS Structures To Address Credit Risk

LOS (b): Describe typical credit enhancement structures used in securitizations

In a simple securitization transaction, a single class of ABS, such as Bond Class A, may be sold. For example, in the case of Bright
Wheel Automotive (BRWA) and Car Loan Trust (CLT), CLT might raise EUR1,000 million by issuing 1,000,000 certificates for ABS
Bond Class A. Each certificate has a par value of EUR1,000, granting the holder a 1/1,000,000 share of collateral payments after
servicing and administrative fees are paid. In this setup, investors are directly exposed to the default risk of the pool's assets and
other factors affecting payments. To mitigate these risks, securitization structures often feature multiple classes of ABS debt.

3.1. Credit Enhancement

Securitization structures typically consist of multiple tranches, each with a distinct role, and some tranches assume risk from
others. Credit risk is a central concern in securitization, and it's addressed through credit enhancement, a support which absorbs
losses from loan defaults. There are three primary types of internal credit enhancements commonly used in securitization
transactions.

o Overcollateralization ensures that the collateral's value is greater than the bond's face value. This cushion protects
bondholders from defaults in the pool, ensuring there's enough to cover principal and interest payments. For instance, if a
EUR1,000 million securitization is backed by EUR1,200 million in assets, with a 10% default rate, there's still EUR1,080 million
to cover losses, making both senior and subordinated tranches more appealing to investors.
o Excess spread is the difference between the interest earned on the underlying collateral and the interest paid on the
securities. It can absorb collateral shortfalls or be used to build reserves.
o Subordination, or credit tranching, in a securitization involves creating different bond classes, with senior and subordinated
classes that share losses from defaults in the collateral pool. This structure determines the order of payments to investors
and the sequence in which losses are absorbed.

There are also external credit enhancements, such as financial guarantees by banks or insurance companies, letters of credit, and
cash collateral accounts, which we do not cover here.

3.2. Credit Tranching

100
Subordination serves as credit protection for senior bond classes by absorbing losses first, before impacting the more senior ones.
This protection is often likened to a "waterfall" structure due to the sequential flow of payments between bond classes in case of
defaults.

In the BRWA securitization, CLT acquired a pool of car loans and issued four bond classes totalling EUR1,000 million: Class A
(senior), Class B (mezzanine), Class C (junior), and Class D (subordinated). These bond classes determine the capital structure, with
Class A receiving principal payments first, having the lowest risk, and the lowest return. Class B carries slightly more risk but offers
higher returns, while Class D absorbs losses first and has the highest risk with potentially the highest yield. Class D is often referred
to as the "equity" tranche due to its residual claims to cash flows. The tranches have different yields and degrees of risk, and they
are affected differently in case of default, with specific terms outlined in the structure. This structure, shown below is common in
securitizations.

Four-Year Asset-Backed Notes Issued by CLT

Issuer: Car Loan Trust (CLT)
Tranche A Notes
Face value: EUR825 million
Interest rate: MRR + 0.50%
Credit enhancement features: Subordination of the Class B Notes, the Class C Notes, and the Class D
Notes

Tranche B Notes
Face value: EUR100 million
Interest rate: MRR + 1.50%
Credit enhancement features: Subordination of the Class C Notes and the Class D Notes
Tranches:
Tranche C Notes
Face value: EUR50 million
Interest rate: MRR + 2.50%
Credit enhancement features: Subordination of the Class D Notes

Tranche D Notes
Face value: EUR25 million
Interest rate: Variable (higher spread than Tranche C)
Credit enhancement features: None
The Class A Notes are senior to the Class B, C, & D Notes.
Status and Ranking of The Class B Notes are senior to the Class C & D Notes and junior to the Class A Notes.
Payments: The Class C Notes are senior to the Class D Notes and junior to the Class A & B Notes.
The Class D Notes are junior to the Class A, B, & C Notes.
Monthly commencing 30 days from [Settlement Date] to be paid each month, with final payment on
Interest Payment:
[Maturity Date]
Seniority: The Notes are secured obligations of CLT
Business Days: Frankfurt

The senior/subordinated structure, a form of credit tranching, divides the risk associated with collateral. In this structure, Class D
absorbs the first EUR25 millions of losses, followed by Class C for up to EUR50 million, and Class B for up to EUR100 million. If
losses in the CLT pool are under EUR175 million, Class A is fully repaid its EUR825 million. For instance, with a total loss of EUR70
million, Class D loses its investment, Class C gets only EUR5 million back, and Classes A and B continue receiving payments without
loss. Class A incurs a loss only if total losses exceed EUR175 million and all junior tranches are wiped out. This structure allows
investors to choose their preferred risk level and corresponding return, and by adjusting tranche features, investors can balance
maturity, risk, and return characteristics.

4. Non-Mortgage Asset-Backed Securities

101
LOS (c) : Define key rate duration and describe its use to measure price sensitivity of fixed-income instruments to benchmark yield
curve changes

Securitization involves a wide range of non-mortgage assets as collateral, including auto loans, credit card receivables, personal
loans, and commercial loans. These assets can be categorized as amortizing or non-amortizing. Amortizing assets, like traditional
residential mortgages and auto loans, have scheduled principal and interest payments. As these loans are paid off, investors
receive principal repayments, and prepayments are distributed based on payment rules. In contrast, non-amortizing assets, such
as credit card debt, lack scheduled principal repayments. In this case, loans paid off during the lockout period are reinvested to
maintain/replenish the collateral pool, but once the amortization period begins, any repaid principal is distributed to ABS holders.
This module focuses on non-mortgage ABS, specifically credit card receivable ABS and residential solar ABS.

4.1. Credit Card Receivable ABS

Credit cards, issued by various entities, allow convenient payments and credit extensions. When a purchase is made, the
cardholder borrows from the issuer and agrees to repay the borrowed amount plus finance charges. These card receivables can
be pooled and used as collateral for credit card receivable ABS. A typical term sheet for such ABS includes details like a 3-year
revolving period followed by a 6-year amortization period. Credit card issuers benefit from securitization as it removes receivables
from their balance sheets, increases capital efficiency, lowers funding costs, reduces default risk, and generates additional fee
income. In the following term-sheet, Commercial Finance Partners AG pools credit card receivables denominated in CHF.

Nine-Year Credit Card-Backed Notes Issued by Commercial Finance Partners AG Prospectus Summary
Issuer: Commercial Finance Partners AG
Issue Size: CHF900,000,000
Maturity Date: [Nine Years from Settlement Date]
Revolving Period [Starts on the Settlement Date and Ends Three Years from Settlement Date]
Amortization Period: [Starts Three Years and One Business Day After the Settlement Date and Ends Nine Years from Settlement Date]
Portfolio comprises credit card loan receivables originated in, and to individuals in, Switzerland. Aggregate
The Collateral: receivables are CHF925 million, with an average principal balance of CHF2,300, with a weighted average interest
rate of 12%.
Tranche A Notes
Face value: EUR400 million
Interest rate: 7.00%
Credit enhancement features: Subordination of the Class B, C, & D Notes
Tranche B Notes
Face value: EUR300 million
Interest rate: 8.00%
Credit enhancement features: Subordination of the Class C & D Notes
Tranches
Tranche C Notes
Face value: EUR150 million
Interest rate: 10.50%
Credit enhancement features: Subordination of the Class D Notes
Tranche D Notes
Face value: EUR50 million
Interest rate: Variable
Credit enhancement features: None
Monthly commencing 30 days from [Settlement Date] to be paid each month, with final payment on [Maturity
Interest Payment:
Date]

In a pool of credit card receivables, cash flows include finance charges, fees, and principal repayments. Finance charges are interest
rates applied to the unpaid balance on the credit card, which can be fixed or floating (often capped). Fees consist of late payment
fees and annual membership fees. Credit card loans are non-amortizing, so during the revolving period (the initial 3 years in this
case), noteholders receive payments only from finance charges and fees collected by the lender. The impact of the revolving and
amortization periods on cash flows for ABS that securitize receivables is illustrated below :

102
Credit card receivable ABS may include early amortization or rapid amortization provisions to protect the credit quality of the
issue, especially during the revolving period. If repayments during this period can't replenish the pool or defaults significantly
change the pool, a rapid amortization clause is triggered, altering principal cash flows and allowing noteholders to receive their
investments earlier, which they can reinvest in more attractive opportunities. These clauses are particularly valuable during times
of economic uncertainty.

Credit card ABS usually incorporate various credit enhancements, often using subordination. For instance, in the CFP termsheet
shown above, there are four tranches, overcollateralization (CHF25 million), a rapid amortization provision, and other tools to
support different risk/return preferences. In this case, losses must exceed CHF75 million or 8.33% of the ABS issue's face value
before affecting Tranche C Notes.

4.2. Solar ABS

Specialized financing options, such as solar loans and solar leases, have become available for homeowners looking to install solar
energy systems and home energy efficiency improvements. Solar loans let consumers borrow the cost of purchasing and installing
the system, while solar leases involve renting the equipment from a solar company. Switching to solar energy not only benefits
the environment but also reduces household utility expenses, with expected savings often exceeding the upfront costs.
Institutional investors are increasingly interested in purchasing solar ABS (Asset-Backed Securities) as these investments offer a
chance to support sustainability while earning attractive risk-adjusted yields.

For example, Al-Shims Enterprises plans to securitize its solar energy system loans through a solar ABS. This ABS will issue EUR300
million notes, backed by 10,000 residential home improvement loans with a face value of EUR320 million. The loans have an
average balance of EUR32,500, an interest rate of 7.5%, and a maturity of 17 years, all of which are amortizing. The net proceeds
will be used to finance residential solar energy system installations, promoting green projects. For Al-Shims, this securitization
removes receivables from its balance sheet, enhances capital efficiency, and generates fee income. Additionally, the solar ABS
promotes environmentally sustainable benefits, potentially qualifying as green bonds. Institutional investors seeking ESG or
climate finance investments may find solar ABS an appealing choice

The legal structure of a solar ABS transaction and its collateral can vary by jurisdiction. Typically, ABS are backed by underlying
debt, such as mortgages, loans, or receivables. Solar energy system loans, when structured as residential home improvement
loans, essentially represent a subordinated (junior) mortgage on the property which is why Investors seek this type of debt. Usually
solar loan borrowers are home owners and prime borrowers with good payment records. They are protected through
overcollateralization, subordination, and excess spreads, which collectively reduce default risk in these securitizations.

Many solar ABS transactions include a pre-funding period, allowing the trust to acquire additional qualifying transactions meeting
specific eligibility criteria for a certain time after the transaction closes.

5. Collateralized Debt Obligations

LOS (d) : Describe the difference between empirical duration and analytical duration

Collateralized debt obligations (CDOs) are securities backed by diverse pools of one or more debt obligations. They can be backed
by various types of debt. CDOs backed by corporate and emerging market bonds are called collateralized bond obligations (CBOs),
those backed by leveraged bank loans are collateralized loan obligations (CLOs), those backed by other CDOs are structured

103
finance CDOs, and those backed by credit default swaps for other structured securities are synthetic CDOs. The most common
CDO structure is the CLO, with a collateral pool consisting of leveraged bank loans.

The following table summarizes features of CDOs, covered bonds, mortgage-backed securities (MBS), and non-mortgage ABS:

Overview of CDOs and Other Securitized Products

Covered Bonds CDO MBS Non-Mortgage ABS
Commercial and Credit card receivables (non-
Commercial or residential mortgages, or Leveraged bank
Collateral residential amortizing) and Solar
public sector assets loans (CLOs)
mortgage loans lease/loan payments
Collateral remains on the balance sheet Collateral
Impact on Issuer Collateral removed Collateral removed from
and ringfenced into a separate cover removed from
Balance Sheet from balance sheet balance sheet
pool balance sheet
Number of Bond One bond class with its associated
Typically several Typically several Typically several
Classes default expo- sure in its cover pool
Unstable with ongoing
Unstable with
Unstable with ongoing collateral collateral management; a pre-
Collateral Pool ongoing collateral Stable
management funding period is used by solar
management
ABS post-transaction
Dual recourse nature: first on the
ringfenced loans in the cover pool and Single recourse Single recourse
Recourse Single recourse nature
second on the unencumbered assets of nature nature
the issuing institution

CDO structures, like ABS structures, rearrange the cash flows generated by the underlying collateral pool and allocate them to
different tranches. In most CDOs, the collateral pools are not fixed, requiring a collateral manager to trade debt obligations within
the pool to ensure there are enough cash flows to meet the CDO bondholders' obligations. Apart from this, the securitization
process and structure are quite similar

CDO bond classes are funded through various sources, including interest payments, maturing assets, and asset sales. The
fundamental economics aim to ensure the return on the collateral pool exceeds the funding costs of the bond classes issued to
finance the transaction. Senior and mezzanine bondholders receive fixed returns, while equity tranche holders and the CDO
manager earn more equity-like returns. CDOs are essentially leveraged transactions where equity tranche holders use borrowed
funds (the bond classes) to generate returns above the funding cost.

The CDO market has evolved since the 2003-2007 period when it included a wider range of collateral types. Today, it primarily
consists of leveraged bank loans (CLOs). While regulatory and legal changes have made CDOs less attractive, the underlying
securitization framework remains similar, especially in the context of CLOs backed by senior secured bank loans.

5.1. Generic CLO Structure

In a generic CLO transaction, as illustrated below, funds to purchase collateral assets are raised through the issuance of debt
obligations, including senior, mezzanine, and subordinated/junior/equity tranches. Investors in senior or mezzanine classes can
earn higher yields than comparable corporate bonds or gain exposure to otherwise difficult-to-access debt products. Equity
tranche investors take on equity-like risks with the potential for equity-like returns. The viability of a CLO often depends on
competitive returns for the residual tranche.

104
CLOs come in various forms, with the most common being Cash Flow CLOs, where cash flows from interest and principal
repayments are distributed, Market Value CLOs, where tranches' value depends on the portfolio's market value, and Synthetic
CLOs, where the collateral pool is created synthetically through credit derivatives.

The ability of the manager to make interest and principal payments in a CLO depends on collateral performance, with various
performance tests and collateral limits to meet. If the manager fails these tests, a provision is triggered that requires payment to
the senior bond class until the tests are satisfied, reducing the CLO's leverage.

CLOs often have a feature where the collateral portfolio is not finalized until after the transaction closes. A ramp-up period follows,
during which additional assets are added to the pool, and the manager may replace loans as long as they meet criteria. The final
phase of the CLO lifecycle involves the use of proceeds from maturing loans to pay off tranches in order, with recourse primarily
limited to the collateral pool and minimal recourse to original issuers.

In a CLO, the cash flow waterfall, along with performance-based tests, provides varying levels of protection to the debt tranches.
The AAA tranche is the most senior, with the lowest yield but the highest claim on cash flows and the most protection against
losses. Mezzanine tranches offer higher coupons but are more exposed to losses and have lower ratings. The equity tranche, the
riskiest, is unrated and doesn't have a set coupon. Instead, it claims all excess cash flows once the obligations for the other debt
tranches have been fulfilled.

CLOs have coverage tests, such as the overcollateralization test, to ensure the cash flows from the underlying bank loan collateral
meet the distribution obligations for the CLO tranches. This test ensures the principal value of the underlying bank loan pool
doesn't exceed the total principal value of the CLO's issued notes. If the principal value falls below the overcollateralization test
trigger value, cash is redirected from equity and junior debt tranches to senior debt tranche investors. For example, in a
hypothetical CLO with a total promised principal of USD700 million, the CLO manager may need to use the capital raised to
purchase USD840 million of bank loans to maintain an overcollateralization ratio of 1.20 as required by investors and rating
agencies.

Each CLO debt tranche has its own specific overcollateralization ratio, acting as covenants. When these ratios are breached, cash
flows are redirected to purchase additional bank loan collateral or repay the senior-most CLO debt tranche.

CLOs are subject to various other protective tests, including assessing industry diversification, exposure to non-senior secured
loans, diversity of borrowers, and setting single obligor limits. There are also limitations on the inclusion of CCC-rated debt to
control negative credit drift.

The role of the collateral manager in CLO transactions is crucial. Their skill in asset selection, management, and exchanges directly
influences CLO performance, similar to an active bond portfolio manager determining the asset mix and risk in the collateral pool.

105
Fixed Income - Learning Module 19
for the CFAâ exam

Mortgage-Backed Security (MBS) Instrument and Market

Features
Learning Outcomes :

The candidate should be able to:

a) Define prepayment risk and describe time tranching structures in securitizations and their purpose
b) Describe fundamental features of residential mortgage loans that are securitized
c) Describe types and characteristics of residential mortgage-backed securities, including mortgage pass-through securities and
collateralized mortgage obligations, and explain the cash flows and risks for each type
d) Describe characteristics and risks of commercial mortgage-backed securities

1. Introduction

This module delves into mortgage-backed securities (MBS), which are a prominent type of asset-backed security (ABS). It builds
upon earlier modules that explained ABS and securitization benefits and processes. In particular, it covers mortgage loans and
their distinctive attributes, residential MBS (RMBS) like mortgage pass-through securities and collateralized mortgage obligations
(CMOs), and commercial MBS (CMBS). Additionally, it addresses risk management within securitization, discusses the various
tranches and their features, and analyses MBS cash flows and associated risks.

2. Time Tranching

LOS (a) : Describe characteristics and risks of covered bonds and how they differ from other asset-backed securities

The cash flows of ABS and MBS pass-through securities are uncertain due to variations between scheduled and actual payments.
This uncertainty is influenced by borrower actions like early interest and principal payments and payment delinquencies, which
depend on factors like borrower income, loan terms, and the sale of the underlying asset. To accurately assess these securities,
investors need to make assumptions about expected contractual payments, factoring in prepayment risk. Prepayment risk
encompasses two components: contraction risk and extension risk, both linked to changes in prevailing interest rates.

2.1. Prepayment Risk

When interest rates decrease, actual prepayments on fixed-rate mortgages tend to exceed forecasts because homeowners often
refinance at the lower rates. This is a common practice in the US due to the absence of loan prepayment penalties, which are
more common in other countries. Consequently, the maturity of a mortgage-backed security (MBS) ends up being shorter than
initially anticipated. This is known as contraction risk, where the borrower repays the principal faster than the scheduled payment
plan, resulting in reduced future payments for investors. This situation has two negative implications for investors: they must
reinvest the proceeds at lower interest rates, and it diminishes the potential for bond price appreciation.

When interest rates rise, actual prepayments on mortgages are typically lower than expected because homeowners are less
inclined to refinance and may postpone buying new homes. This leads to the maturity of a mortgage-backed security (MBS) being
longer than initially anticipated, known as extension risk. Extension risk is when the borrower repays the principal over a longer
period than the agreed-upon schedule. For investors, this poses challenges, as higher interest rates reduce the value of cash flows
they receive. This means that payments to investors will be discounted at a higher interest rate, and the extension prolongs the
duration of payments received

In securitization, the structure can be designed to redistribute "prepayment risk" among different bond classes. One way to
mitigate this risk is through time tranching, where bond classes are created with varying expected maturities. For example, in a
sequential tranching setup, principal repayments are directed to one tranche until it's fully repaid, and then to the next tranche
until it's repaid, and so on. This arrangement helps manage the impact of prepayments on different bond classes.

it is possible and quite common for a securitization to have structures with both credit tranching (subordinated structures) and
time tranching (different expected maturities).

106
3. Mortgage Loans And Their Characteristic Features

LOS (b): Describe fundamental features of residential mortgage loans that are securitized

This section explains the essential elements of mortgage loans, which serve as the foundation for the mortgage-backed securities
(MBS) market.

MBS are bonds created by bundling mortgages. Mortgage loans are backed by a specific real estate property and require the
borrower to make scheduled payments to the lender. The lender holds the first lien and can seize the property if the borrower
defaults. In case of default, the lender may foreclose on the property, take possession, and sell it to recover the outstanding debt

The difference between the loan amount and the property's purchase price is called the down payment. The loan-to-value ratio
(LTV) measures the loan amount relative to the property's value. A lower LTV indicates higher borrower equity, reducing the risk
of default for the lender. As the borrower makes payments and the property's value changes, the LTV changes over time. LTV is a
crucial measure in both residential and commercial mortgages.

Lenders assess a borrower's ability to manage debt through the debt-to-income ratio (DTI) in residential lending. DTI compares
monthly debt payments to pre-tax gross income. A low DTI indicates a balanced income-to-debt ratio, making the borrower more
eligible for additional debt. Conversely, a high DTI suggests excessive debt relative to income, which may make loan approval less
likely, as lenders prefer low DTI ratios.

In the United States, mortgages are categorized into two types based on borrower credit quality: prime loans and subprime loans.
Prime loans are for borrowers with strong credit, employment history, low debt-to-income ratios (DTI), significant property equity,
and a first lien on the property. Subprime loans are for borrowers with lower credit quality, high DTI, or higher loan-to-value ratios
(LTV), and may include second-lien loans that are subordinate to others.

3.1. Agency and Non-Agency RMBS

Mortgages in Mortgage-Backed Securities (MBS) can be either residential or commercial. Residential mortgage-backed securities
(RMBS) pertain to mortgages backed by residential properties. In the United States, Canada, Japan, and South Korea, RMBS can
be categorized as government or non-government guaranteed. In the U.S., there are three sectors for securities backed by
residential mortgages:

o those guaranteed by federal agencies,

o those guaranteed by government-sponsored enterprises (GSEs),
o and those issued by private entities without government guarantees.

The first two are called agency RMBS, with full government or GSE guarantees, while the third is non-agency RMBS, lacking such
guarantees. GSEs charge a fee for their guarantee but do not offer the full faith and credit of the government.

Non-agency RMBS, which were not government-backed and were issued by private entities, became scarce after the global
financial crisis due to stricter regulations and increased oversight. These private label MBS used various credit enhancement
methods, such as pool insurance, letters of credit, guarantees, or subordination. They typically securitized non-conforming or
high-risk mortgages, including subprime loans. Currently, there is a growing trend of securitizing residential home improvement
loans, like solar asset-backed securities (ABS), which are subordinated to primary mortgage liens.

3.2. Mortgage Contingency Features

Mortgages come with certain rights for both borrowers and lenders. The most significant borrower right is the option to prepay
the mortgage by making payments exceeding the scheduled principal repayment. Prepayment can be in full or partial before the
loan's maturity. However, this creates uncertainty in cash flows for lenders and investors, known as prepayment risk. Lenders
mitigate this risk by imposing a penalty on borrowers who prepay when interest rates are lower, compensating for the rate
difference. This mechanism provides certainty for lenders and reduces the incentive to prepay. Prepayment penalty mortgages
are common in Europe, but they are less prevalent in the United States.

When a borrower fails to make their mortgage payments, it can lead to a default, allowing the lender to potentially foreclose and
sell the property. In a recourse loan, the lender can claim any shortfall between the outstanding mortgage balance and sale
proceeds from the borrower. In a non-recourse loan, the lender can only rely on the property for recovery and can't pursue the
borrower for the deficiency. In the United States, recourse varies by state, with many residential mortgages being non-recourse.

107
In contrast, most European countries have recourse loans. This distinction is important when assessing default risk, especially for
mortgages with LTV exceeding 100%, often called "underwater mortgages."

If the mortgage is non-recourse, the borrower may have an incentive to strategically default on an underwater mortgage and
allow the lender to foreclose on the property, even if the borrower has resources available to continue to make mortgage
payments. Although there are negative consequences to a “strategic default,” such as lower credit scores and a reduced ability to
borrow in the future, some borrowers may make use of this approach. Where mortgages are recourse loans, a strategic default is
less likely because the lender can recover the shortfall from the borrower’s other assets and/or income.

4. Residential Mortgage-Backed Securities (RMBS)

LOS (c) : Describe types and characteristics of residential mortgage-backed securities, including mortgage pass-through securities
and collateralized mortgage obligations, and explain the cash flows and risks for each type

A mortgage pass-through security is a financial instrument created by mortgage lenders who bundle mortgages together and sell
them to investors. These securities distribute the cash flow generated from the mortgage pool, including monthly principal and
interest payments as well as prepayments, to the security holders. The pool can contain thousands or just a few mortgages. When
a mortgage is used as collateral for a mortgage pass-through security, it is referred to as being securitized. The cash flows of these
securities are based on the monthly cash flows of the underlying mortgage pool, covering both payments to security holders and
administrative fees for managing the pool. The structure of this arrangement is illustrated below :

Administrative fees for mortgage pass-through securities encompass tasks such as collecting borrower payments, disbursing funds
to loan owners, sending payment notifications, maintaining mortgage balance records, initiating foreclosure procedures when
required, and offering tax information to borrowers when needed. Moreover, the issuer or financial guarantor of the security may
impose fees for guaranteeing the issuance. These fees are generally a percentage of the mortgage rate.

Comparison of MBS and RMBS

Mortgage-Backed Securities (MBS) Residential Mortgage-Backed Securities (RMBS)
Underlying
Residential or commercial mortgages Residential mortgages and/or mortgage pass-through securities
collateral
o Mortgage pass-through securities
o Collateralized mortgage obligations (CMOs), including sequential pay,
o RMBS
planned amortization class (PAC), and support tranches
Subtype o CMBS
o Agency RMBS
o Non-Agency RMBS

The coupon rate of a mortgage pass-through security is known as the pass-through rate, and it is lower than the weighted average
mortgage rate of the underlying mortgage pool due to administrative charges. This rate, received by investors, is termed "net
interest" or "net coupon."

The mortgages in a securitization pool are diverse, varying in outstanding principal, interest rates, and maturities. Consequently,
for each mortgage pass-through security, two key metrics are calculated: the weighted average coupon rate (WAC) and the
weighted average maturity (WAM). WAC is determined by weighing the mortgage rate of each mortgage by its outstanding
balance relative to the total pool balance. Similarly, WAM is calculated by weighting the remaining months to maturity of each
mortgage by their outstanding balances relative to the total pool balance. Take five mortgages underlying a specific MBS:

108
 Mortgage Interest rate (i) Beginning Balance (BB) Current Balance (CB) Original Term Number of Months to Maturity
(months) (MM)
A 2.50% EUR300,000 EUR238,000 240 180
B 3.30% EUR420,000 EUR380,000 600 480
C 2.80% EUR100,000 EUR87,000 288 240
D 4.00% EUR280,000 EUR132,000 360 120
E 3.70% EUR350,000 EUR312,000 384 312
EUR1,450,000 EUR1,149,000

The weighted average coupon rate for this MBS is calculated as follows:

è WAC = 3.29%

The weighted average maturity for this MBS is calculated as follows:

è WAM = 313 months

4.1. Collateralized Mortgage Obligations (CMOs)

Collateralized mortgage obligations (CMOs) are financial instruments that securitize mortgage pass-through securities or multiple
loan pools. CMOs are designed to distribute cash flows to different bond classes or tranches, each with varying levels of exposure
to prepayment risk. This tranching structure, as illustrated in the following image, doesn't eliminate prepayment risk but
redistributes it among the tranches, providing varying degrees of insulation. CMO tranches are created to reduce uncertainties in
payment size and timing for investors and cater to the diverse needs of institutional investors. Typically, the more senior a tranche
is within a CMO, the lower its exposure to prepayment and default risks.

4.1.1. Sequential-Pay CMO

In sequential-pay CMO structures, tranches are retired in sequence, demonstrating time tranching. Principal payments are
directed to Tranche A until its balance reaches zero. Once Tranche A is paid off, principal payments shift to Tranche B, and
so on until all tranches are repaid. As an example, consider a hypothetical CMO with a collateral of USD 100 million, a 4%
pass-through coupon rate, a 4.55% weighted average coupon (WAC), and a 360-month weighted average maturity (WAM).
Three tranches are created from this collateral, each with varying coupon rates based on maturity and interest rate factors.
This creates a structured payment sequence, as shown in image below :

109
Sequential-pay CMO structures provide protection against prepayment risk for each tranche. This protection is achieved by
prioritizing the distribution of principal payments, safeguarding the shorter-term tranche (Tranche A) from extension risk, and
safeguarding the longer-term tranches (Tranches B and C) from contraction risk. Investors can choose tranches based on their risk
preferences and anticipated average life needs, as the actual principal repayment amounts depend on the collateral's prepayment
rate. This structure caters to various investor preferences, with Tranche A suiting those concerned about extension risk, Tranches
B and C suitable for those concerned about contraction risk, and different average life options accommodating specific investment
goals.

4.2. Other CMO Structures

The cash flows from an underlying mortgage pool can be structured in additional ways. The structures below describe various
tranches that are created through time tranching (Z-tranche and residual tranche) or by splitting up cash flows from the pool.

o Z-Tranches are a unique type of tranche in a CMO structure. They don't pay interest until a predetermined date when both
principal and accrued interest payments begin. During the accrual period, the Z-tranche's principal value is increased by the
stated coupon rate. These tranches are typically the last ones in a series of CMO tranches, and they benefit other tranches by
freeing up cash flows. Z-Tranche holders avoid reinvestment risk when market yields decline, but they come with longer
average lives (often over 20 years), making them more complex and challenging to value. They are also referred to as accretion
bonds or accrual bonds.
o Principal-Only (PO) securities pay only the principal repayments from a mortgage pool, and their value is highly sensitive to
prepayment rates and interest rates. Falling interest rates or accelerated prepayments lead to an increase in the value of PO
securities.
o Interest-Only (IO) securities, often paired with PO securities in a CMO, pay only the interest payments from the pool. They
have no face value. Increased prepayments result in reduced cash flows to IO investors, making IOs a tool for hedging against
interest rate risk in investment portfolios.
o Floating-Rate tranches have variable interest rates tied to an index or market reference, often with caps and floors. They're
influenced by interest rate changes and can be structured as inverse floaters. These tranches are used to hedge interest rate
risk in portfolios.
o Residual tranches collect leftover cash flows from the pool after fulfilling other tranche obligations. They're suitable for
investors like hedge funds and long-term institutions who can manage and hedge the risk, but banks typically avoid them due
to capital requirements.
o Planned Amortization Class (PAC) tranches in CMOs provide more predictable and stable cash flows by making scheduled and
fixed principal payments to investors over a set time period. This happens when prepayment levels fall within a specific range.
In such cases, the support tranche absorbs all prepayment risk.

5. Commercial Mortgage-Backed Securities (CMBS)

LOS (d) : Describe characteristics and risks of commercial mortgage-backed securities

110
Commercial mortgage-backed securities (CMBS) are
financial instruments backed by a collection of
commercial mortgages on income-generating
properties like apartments, office buildings,
warehouses, shopping centers, hotels, and
healthcare facilities. The repayment of these
securities comes from the rental income and
revenue generated by the properties. CMBS are
created by pooling commercial loans used to either
buy a commercial property or refinance an existing
mortgage. These securities are exemplified in the
adjoining image which shows a hypothetical
structure involving mortgages on properties owned
by Bright Wheel Automotive (BRWA), a car
manufacturer.

In this transaction, properties worth GBP123 million

secure GBP100 million in mortgages, resulting in an
81.3% loan-to-value ratio, providing GBP23 million
in extra collateral for the lender. The lender
transfers the GBP100 million mortgages to an
independent entity, Commercial Finance Associates, which securitizes them. The weighted average proceeds from the mortgages
(WAMP) are 4.66%, with a weighted coupon payment of 4.075%, including compensation for arranging the securitization. All
mortgages are fully amortizing, although commercial mortgages are often balloon loans.

A notable feature is that cash flows do not align immediately, including a Tranche A with a 3-year repayment period and a lower
interest rate than the underlying mortgages. Nevertheless, the pool generates sufficient cash flows for these payments, and the
mortgages do not permit prepayment during the first 5 years.

5.1. CMBS Structure

Both the CMBS and RMBS securitization processes and securitization structures, respectively are highly similar. However, two
features specific to CMBS structures are worth mentioning: the presence of call protection and the balloon maturity provision.

5.1.1. Call Protection

CMBS (Commercial Mortgage-Backed Securities) and RMBS (Residential Mortgage-Backed Securities) differ significantly due
to their protection against early prepayments. CMBS behave more like corporate bonds and offer call protection, which can
occur at either the structure or loan level. Structural call protection in CMBS is achieved through sequential-pay tranches,
where lower-rated tranches can't be paid down until higher-rated tranches are fully retired. Principal losses affect junior
tranches first.

Call protection at the individual loan level relies on three mechanisms: prepayment lockout, which prohibits prepayments
for a specified period; prepayment penalty points, where borrowers pay penalties for refinancing; and defeasance, allowing
prepayment but requiring the borrower to purchase a portfolio of government securities that replicates future cash flows.
The cost of assembling this portfolio is borne by the issuer and is known as the cost of defeasance.

5.1.2. Balloon Maturity Provision

Commercial mortgages, unlike residential mortgages, are often not fully amortizing. They typically involve interest payments
and partial principal repayments over the loan term, with the remaining principal paid in a single "balloon" payment at
maturity. Many commercial loans in CMBS are structured this way, and there's a risk that the borrower may not make the
balloon payment at maturity. This can happen due to various factors like the inability to refinance, unfavourable financial
conditions, or difficulty selling the property. When borrowers default on the balloon payment, lenders might extend the
loan in a "workout period" and modify its terms. This balloon risk is a form of extension risk.

5.2. CMBS Risks

RMBS (Residential Mortgage-Backed Securities) and CMBS (Commercial Mortgage-Backed Securities) differ significantly. RMBS
pools consist of thousands of residential mortgages from various locations, while CMBS often include fewer commercial
mortgages. In RMBS, individual defaults have minimal impact due to the small size of each mortgage, whereas a single default in

111
a CMBS can significantly affect investors. CMBS investors need to consider this unique concentration risk by analysing both the
CMBS structure and the individual loans, properties, and property owners.

In commercial real estate lending, key indicators of credit performance are the loan-to-value ratio (LTV) and the debt service
coverage ratio (DSC ratio). The DSC ratio is calculated as :

%&' )*&+,'-./ 0.123& (%)0)

è DSC =
6&7' 8&+9-1&

è NOI = (Rental income − cash operating expenses) − replacement reserves.

A DSC ratio exceeding 1.0 indicates that property cash flows can cover debt service while maintaining the property, and higher
DSC ratios indicate a better ability to meet debt-servicing requirements from property cash flows.

The following table compares representative aspects of CMBS and RMBS :

Aspect CMBS RMBS

Underlying From one to a pool of commercial mortgages on income- A pool of mortgages backed by residential properties or
assets producing property a pool of RMBS
Lenders, commercial banks, investment banks, or A government or a quasi-government entity or by a
Issuer
syndicates of banks bank, financial institution, or other private business
Rate for o Europe – Floating rate; may be capped o Either fixed or floating rate
security o US – typically fixed rate
o May be high, since the assets backing the CMBS can o Agency RMBS – Issued and fully guaranteed by the
be concentrated in one mortgage or a small number government or a quasi-government entity
Risk aspect: (as compared to the number backing an RMBS) o Non-agency RMBS – Issued by banks, financial
Credit Risk institutions, or other private businesses that use
credit enhancements to reduce credit risk

o contraction risk – Low No pre- payment risk since o contraction risk – High Particularly during periods of
commercial loans either do not offer a prepayment declining or persistently low interest rates, or when
option or make prepayment uneconomical the value of the underlying properties increase.
Risk aspect: o extension risk - High Balloon risk – Many commercial o extension risk – High Particularly during periods of
Prepayment loans backing CMBS are balloon. If balloon payment increasing interest rates or high interest rates, or
Risk not made, the lender may extend the life of the loan, when the value of the underlying properties stays
leading to extension risk stable or declines.

o Depends on: o Aggregate risk may be lower due to diversification

o Security held: Pool based on few mortgages (high) or from many small, uniform underlying mortgages.
Risk aspect:
RMBS pools (lower)
Default Risk
o Concentration of pool: Pool of few mortgages (high) vs.
a diversified pool (lower)

112
113