Topic 8: Fixed Income

Expanded Study Notes — CFA Level I

1–5. Features, Types, Issuance — Fixed Income for Corporate &

Government Issuers
1. Bond Basics
A fixed income (FI) security is a contractual promise by the issuer (the borrower) to make specified cash payments
to the bondholder (the lender) over a defined period. The legal contract that spells out these obligations — the
payment schedule, the issuer's duties, and the bondholders' rights — is called the bond indenture. It is the
foundational legal document behind every bond issue.
• Source of repayment differs by issuer type: governments repay from tax revenue and infrastructure-related
income, while companies repay from operating cash flow (CFO) and may pledge security, a lien, a pledge, or
collateral against specific assets.
• Covenants are clauses in the indenture that protect the bondholder by restricting or requiring certain issuer
behavior:
◦ Affirmative covenants require the issuer to do something — e.g., use bond proceeds for a stated purpose,
provide timely financial statements, allow early redemption at a premium if the issuer is acquired, honor
pari passu (equal) ranking with other unsecured debt, and comply with cross-default clauses. These
impose no additional cost on the issuer.
◦ Negative covenants restrict the issuer from doing something — e.g., limiting new investments,
prohibiting the issuance of new debt senior to the existing bonds, or restricting the disposal of assets.
• A yield curve plots the yield to maturity (YTM) of bonds from the same issuer across a range of maturities,
and is a key tool for assessing how required return changes with time to maturity.

2. Types of Fixed Income Securities

Bonds can be classified by how principal is repaid and how the coupon is determined.

By repayment structure
• Bullet bond: the entire principal is repaid in a single payment at maturity; only interest is paid periodically
before that.
• Amortizing debt: principal is repaid gradually alongside interest over the life of the bond (e.g., a mortgage
loan). Two variants exist:
◦ Fully amortizing: the entire principal is paid off by maturity; partially amortizing: a portion remains as a
lump-sum "balloon" payment at maturity.
◦ A sinking fund requires the issuer to retire a portion of the bond's principal each year, which reduces
credit risk (the risk that the borrower fails to repay).
◦ Amortizing debt increases near-term cash flow needs but decreases credit risk because outstanding
liabilities shrink over time. Investors face reinvestment risk — the risk that they cannot reinvest the

Periodic Payment Amount: A = [r × Principal] / [1 − (1 + r)^(−N)]

returned principal at the original interest rate.

◦ On a financial calculator: input N (number of periods) and I/Y (periodic rate), then use the amortization
function — PRN (principal portion), INT (interest portion); PRN + INT = total payment (PMT).
 ◦ For a partially amortizing bond, only (Principal − PV of the balloon payment) is amortized through
periodic payments.
◦ Waterfall structures describe the priority order in which cash flow is distributed to different tranches
(slices) of a securitized bond issue, and therefore the relative risk each tranche bears.

By coupon / interest structure

• Variable-rate instruments: coupons reset periodically rather than staying fixed.
◦ Floating Rate Notes (FRNs): coupon = Market Reference Rate (MRR) + a fixed credit spread. Unlike
compound interest calculations, this spread is not compounded.
◦ Step-up bonds: the coupon rate increases if a specified event occurs (typically a decline in the issuer's
credit quality), protecting the investor from a deteriorating credit.
◦ Payment-in-Kind (PIK) bonds: instead of paying cash interest, the issuer pays the coupon by issuing
additional bonds or adding the amount to the outstanding principal.
◦ Interest-indexed bonds: coupon payments are linked to an inflation or other index — as the index
changes, so does the interest payment.
◦ Capital-indexed bonds (e.g., U.S. TIPS — Treasury Inflation-Protected Securities): the principal itself is
periodically adjusted for changes in a price index. If deflation reduces the principal, investors are still
guaranteed to receive the greater of the inflation-adjusted principal or the original par value at maturity.
• Zero-coupon bonds (discount bonds): pay no periodic coupon; they are issued at a discount to face value and
the investor's return comes entirely from price appreciation to par at maturity. They are useful for funding a
fixed, known future obligation because there is no reinvestment risk on coupons.

3. Contingency Provisions
Many bonds embed options that give either the issuer or the investor the right — but not the obligation — to take an
action such as calling or converting the bond.
• Convertible bonds give the holder the right to convert the bond into a fixed number of the issuer's common

Conversion ratio = Convertible bond par value / Conversion price

shares.

Conversion value = Conversion ratio × Current share price

• Warrants give the holder an option to buy the issuer's stock at a fixed exercise price on or before the expiration
date; they are often attached to bonds as a sweetener.
• Contingent Convertible Bonds (CoCos): automatically convert into equity if a specified trigger event occurs
(commonly used by banks to bolster regulatory capital in a crisis).
• Fixed-price call provision: gives the issuer the right to redeem ("call back") the bond at a pre-specified price
before maturity — valuable to the issuer if rates fall, since it can refinance more cheaply.
• Make-whole call: the issuer can call the bond, but must pay a price calculated from the sovereign bond yield
plus a spread, which keeps the payoff closer to fair value for the investor than a fixed-price call.

4. Foreign / International Bond Types

Terminology here always describes the bond relative to Country A, the domestic market of the investor.
• Foreign bond: sold in Country A, denominated in Country A's currency, but issued by an issuer based in
Country B. Example: a UK company issuing yen-denominated bonds to investors domiciled in Japan.
• Eurobond (bearer bond): issued outside the country whose currency it is denominated in — i.e., issued in
Country B and denominated in Country B's currency, but registered/cleared in Country A's clearing system.
Examples: a Japanese company issuing euro-denominated bonds to UK investors, or an Australian company
issuing USD-denominated bonds to Japanese investors.
 • Global bonds: issued simultaneously in the Eurobond market and one or more domestic markets, broadening
the investor base.

5. Issuance and Trading

• Investment grade: rated BBB− or higher (S&P/Fitch scale) or equivalent — considered lower default risk.
• Fallen angels: bonds downgraded from investment grade to high-yield / speculative / "junk" status.
• Compared with equity indices, FI indices differ in that: (1) a single issuer can have many different bonds
outstanding, producing a very large number of constituent securities; (2) bonds have finite maturities and are
issued more frequently, requiring monthly index rebalancing; and (3) constituents are weighted by the market
value of debt outstanding (analogous to market-cap weighting for equities). FI markets are also generally less
regulated, more dealer-driven, and less liquid than equity markets.
• FI markets are typically quote-driven — trading occurs over-the-counter (OTC) through dealer counterparties
rather than on a centralized exchange.
• A debut issuer is a company issuing bonds publicly for the first time, often as part of a transition from private
to public financing.

FI Markets for Corporate Issuers

Corporations access debt markets through several instruments: bonds, notes, bills, loan agreements, mortgages, and
asset-backed securities/short-term paper.
• Lines of Credit (LOC):
◦ Uncommitted LOC: unsecured, flexible, cheap — but least reliable, since the bank can refuse to lend.
Because it is not guaranteed, the bank needs to hold minimal capital reserves against it until it is actually
drawn.
◦ Committed LOC: unsecured but carries renewal risk at maturity; the borrower pays an upfront
commitment fee, and lenders can form a syndicate to share the exposure.
• Revolvers: multi-year committed facilities that typically carry covenants.
• Secured loans: backed by a pledge recorded on the issuer's financial statements. Example: factoring, where a
company sells its accounts receivable to a lender (the "factor"), which then takes on credit-granting and
collection responsibilities.
• Deposits: retail banks fund themselves through customer deposits. Savings deposits generate Certificates of
Deposit (CDs) — non-negotiable CDs carry an early-withdrawal penalty, while negotiable CDs can be sold in
the open market before maturity.
• Interbank market: used by banks/governments for short-term reserve management, e.g., via repurchase
agreements (repos).
• Commercial Paper (CP): short-term, unsecured paper used for bridge or temporary financing, typically rolled
over at maturity. Asset-backed commercial paper (ABCP) is the secured variant.

Repurchase Agreements (Repos)

A repo is a form of secured lending in which one party sells a security and simultaneously agrees to buy it back at a
specified higher price on a specified future date (the repurchase date). The difference between the sale and
repurchase price reflects the repo rate — effectively the interest on the loan.
• A general collateral repo allows any security within an agreed-upon class to serve as eligible collateral (as

Initial Margin (IM) = Security Price₀ / Purchase Price₀

opposed to one specific security).

Haircut = (Security Price₀ − Purchase Price₀) / Purchase Price₀

• IM of 100% means the loan is fully collateralized; above 100% means overcollateralization.
 Variation Margin = (IM × Purchase Priceₜ) − Security Priceₜ
• Variation margin is additional collateral requested during the life of the repo to restore the original initial-

Repurchase Price = Purchase Price × [1 + repo rate × (days/360)]

margin cushion as the security's market value moves.

• Repos are used to: (1) finance the ownership of a security, (2) earn short-term income by lending funds on a
secured basis, and (3) borrow a security in order to sell it short.
• Key repo risks: default risk, collateral risk, margining risk (delays in revaluing collateral and posting variation
margin during liquidation), legal risk, and netting/settlement risk.
• High-yield issuers often prefer equity financing because long-term debt covenants can be restrictive. When
they do issue bonds, they retain financial flexibility through leveraged loans, prepayment options, or call
provisions — a callable bond lets the issuer refinance if it believes its own creditworthiness (and hence
borrowing cost) will improve, though the investor's upside is capped at the call price.

FI Markets for Government Issuers

• Governments generally use cash-based accounting, which excludes depreciation of public infrastructure and
the accrual of unfunded liabilities such as pensions — a key difference from corporate accrual accounting.
• Under Ricardian equivalence (an extension of the Modigliani–Miller framework applied to the public sector),
rational taxpayers anticipate that government debt today must be repaid through higher future taxes. As a
result, a sovereign government should theoretically be indifferent between raising revenue via taxation now or
via debt of any maturity.
• Governments seek to minimize interest-rate and rollover risk by spreading (distributing) debt issuance across a
range of maturities rather than concentrating it.
• Sovereign bonds are typically issued through a public auction run by the national treasury. Investors can
submit competitive bids (specifying an acceptable price/yield and quantity) or non-competitive bids (agreeing
to accept whatever price the auction determines). All non-competitive bids are filled; competitive bids are
ranked from the lowest yield (highest price) upward until the issue is fully subscribed.
• Single-price auctions: all winning bidders pay/receive the same clearing price — this produces a lower cost of
funding for the issuer and a broader distribution of the issue.
• Multi-price auctions: each winning bidder pays the price they bid, which can lead to a narrower distribution
concentrated among large, sophisticated bidders.
• Some investors (e.g., central banks holding reserves) have non-economic objectives for buying government
debt, such as meeting reserve requirements, rather than purely maximizing return.
• Government agencies (quasi-government entities) issue non-sovereign debt to fund a specific public service or
operation.
• General Obligation (GO) bonds: issued by non-sovereign (local/municipal) government authorities and repaid
from general local tax revenue.
• Revenue bonds: issued by non-sovereign government authorities and repaid specifically from the cash flows
generated by the project the bond finances (e.g., a toll road or airport).

6–8. Bond Valuation and Yield / Yield-Spread Measures

6. Bond Valuation
The core idea of bond valuation is that a bond's price is the present value of all its future promised cash flows,
discounted at the rate the market currently requires for taking on that risk.
• The Market Discount Rate (MDR), also called the required yield, required rate of return, or yield to maturity
(YTM), is the internal rate of return (IRR) on the bond's cash flows — the single discount rate at which the
present value of all future coupon and principal payments equals the bond's price.
 • A bond trades at a discount (price below face value) when its stated coupon (PMT) is lower than the current

PV(Full) = PV(Flat) + AI, where AI (Accrued Interest) = (t / T) × PMT

market discount rate (MDR).

• PV(Flat) is the "clean" price quoted in the market; on a financial calculator, the computed PRI (price) plus AI
gives the Full ("dirty") price actually paid by the buyer, which includes the interest accrued since the last
coupon date.

Price sensitivity relationships

Three effects govern how sensitive a bond's price is to a change in yield:
• Coupon effect: for a given change in yield, a bond with a lower coupon experiences a larger percentage price
change than a bond with a higher coupon, all else equal — because more of a low-coupon bond's value is tied
up in the single, distant repayment of face value, which is highly sensitive to discounting.
• Maturity effect: for a given change in yield, a longer-maturity bond experiences a larger percentage price
change than a shorter-maturity bond — with the notable exception of a long-term, low-coupon bond trading at
a discount, where this relationship can break down.
• Convexity effect: the percentage price increase from a yield decrease is always larger in magnitude than the
percentage price decrease from an equivalent yield increase — this asymmetry is due to the convex (curved)
shape of the price–yield relationship.
• General rule: bond prices are more volatile when the market discount rate is low, the coupon is small, and
maturity is long — all three raise interest rate risk.
• Inverse relationship: rising interest rates (often driven by rising inflation) raise the market discount rate, which
lowers bond prices, and vice versa.

7. Fixed-Rate Bond Yield Measures

Yield conventions
• Effective Annual Rate (EAR): a rate with a periodicity (compounding frequency) of exactly one time per year,

Current Yield (CY) = Annual coupon payment / Bond price

allowing fair comparison across bonds with different payment frequencies.

• Street convention: calculates yield while ignoring the effect of holidays and weekends on payment dates.
• True yield: calculates yield while accounting for the actual effect of holidays and weekends (more precise,
slightly lower than street convention when payments are delayed).
• Government equivalent yield: restates a YTM calculated on a 30/360 day-count basis onto an actual/actual
basis, to allow comparison with government bond yields.
• Simple yield: the sum of coupon payments plus the straight-line-amortized annual share of any capital gain or
loss to maturity, divided by the flat (clean) price.

Yield spreads
Spreads measure the extra yield an investor demands over a benchmark, compensating for the additional risks
(credit, liquidity, optionality) of the bond relative to that benchmark.
G-spread = Bond YTM − Yield on a government bond of the same maturity
I-spread = Bond YTM − Swap rate of the same tenor/currency
• The I-spread is useful for comparing fixed-rate bonds against floating-rate alternatives and as a general

Z-spread (zero-volatility spread): the constant spread added to every point on the
measure of a bond's credit risk.

government/swap spot curve so that the present value of the bond's cash flows, each
discounted at benchmark spot rate plus the spread, equals the bond's price.
 Option-Adjusted Spread (OAS) = Z-spread − option value (in basis points per year)
• OAS strips out the value attributable to any embedded option (such as a call feature), isolating the spread that
compensates purely for credit and liquidity risk.
• When cash flows must be valued using multiple different discount rates (rather than one single YTM), each
cash flow must be discounted individually at its own matching rate rather than using one blended rate.

Floating-rate note (FRN) yield measures

Coupon = Market Reference Rate (MRR) + Quoted Margin (QM)
• The Required Margin (RM), also called the Discount Margin (DM), is the yield spread that would price the
FRN exactly at par on its next rate-reset date. It can move due to changes in the issuer's credit risk, the bond's
liquidity, or its tax status.
• If the Quoted Margin exceeds the Discount Margin (QM > DM), the FRN trades at a premium — its
credit/liquidity has improved since issuance.
• Calculation approach: (1) find the coupon payment as PMT = (MRR + QM) × (Face Value / m); (2) solve for
the discount rate r using the current required margin; (3) express that rate as r = (MRR + DM) / m.
• This valuation approach assumes: (1) the FRN is priced on a rate-reset date with evenly spaced periods, so
there is no accrued interest and the flat price equals the full price; (2) a 30/360 day-count convention; and (3)
the same market reference rate applies to every cash flow.

Money market yield measures

Discount Rate (DR) = (360/Days) × [(FV − PV) / FV], so PV = FV × [1 − (Days/360) ×

• Money market instruments (maturities under one year) are quoted using two different conventions:

DR]
◦ The DR includes the interest within the face value itself, and it understates both the true rate of return to
the investor and the true cost of borrowing to the issuer. Common examples: commercial paper, Treasury

Add-On Rate (AOR) = Bond Equivalent Yield (BEY) = Investment Yield = (365/Days) ×
bills, and bankers' acceptances.

[(FV − PV) / PV], so PV = FV / [1 + (Days/365) × AOR]

◦ The AOR is quoted as interest added on top of principal (rather than deducted from face value). Common
examples: bank certificates of deposit, repos, and market reference rate indexes.
• Comparing money market instruments is inherently tricky because they can be quoted on (1) a discount-rate
basis or an add-on-rate basis, (2) a 360-day or 365-day year, and (3) a face-value-at-maturity basis (as with
DR) versus a price-at-issuance basis (as with AOR).

9. The Term Structure of Interest Rates: Spot, Par, and Forward Curves
Bonds with different maturities, credit quality, currencies, liquidity, tax treatment, and coupon frequency
(periodicity) will generally have different yields to maturity, even from the same issuer.
• Spot rate (Z): the yield on a single zero-coupon bond of a given maturity. Spot rates for consecutive periods

(1 + 0y1y) × (1 + 1y1y) × (1 + 2y1y) = (1 + Z₃)³

are linked through forward rates, for example:

Spot rates are used to:

• Find par rates: the YTM/coupon rate at which a bond's cash flows, discounted at the relevant single spot rate
for each maturity, produce a present value equal to par (100).
• Find bond prices using spot rates: apply the standard present-value formula, but discount each cash flow using
its own single matching spot rate rather than a single blended YTM.
 • Find bond prices using forward rates: apply the present-value formula using compounded (multiple) forward
rates — i.e., chaining together each year's implied one-year forward rate to discount a cash flow arriving in
that year.

Implied Forward Rate (IFR)

The Implied Forward Rate (also called the forward yield) is the breakeven reinvestment rate — the future interest
rate implied by today's spot-rate structure that links a short-term zero-coupon bond to a longer-term one.
2y5y notation = a 5-year rate, 2 years forward (i.e., starting in year 2 and running for 5
more years) = FR(2,5)
(1 + Zₐ)^A × (1 + IFR_(A, B−A))^(B−A) = (1 + Z_B)^B
• The first number in the notation (A) is the time from today until the forward period begins (e.g., "in 2 years");
the second number (B−A) is the length/tenor of the forward rate itself (e.g., a "5-year" rate).
• In the formula, Z_A is the spot rate to the start of the forward period, Z_B is the total spot rate to the end of
the forward period, and (B − A) is the tenor of the forward rate.

Types of curves
• Par curve: a sequence of YTMs for bonds priced exactly at par, each derived from a single (matching-
maturity) spot rate — used to assess the maturity structure of yields.
• Forward curve: constructed from a series of forward rates, which are themselves derived from the spot curve.
• Government bond spot curve (strip curve): the YTMs of zero-coupon government bonds across all maturities.
• Relationship between the three curves depends on the shape of the term structure:
◦ Upward-sloping term structure: Par rate < Spot rate < Forward rate.
◦ Flat term structure: Par rate = Spot rate = Forward rate.

10–13. Interest Rate Risk & Return; Duration, Convexity, and

Curve-Based Risk Measures
A change in interest rates affects a bondholder in two offsetting ways: it changes the rate at which coupon payments
can be reinvested, and it changes the price at which the bond could be sold before maturity.

Horizon yield
Horizon Yield (realized rate of return) r = (FV / PV)^(1/T) − 1
This is the investor's total annualized rate of return over the holding period, including reinvested coupons —
effectively the IRR of the whole investment expressed as an annualized rate.
• Horizon yield equals the original YTM only if: (1) coupons are reinvested at a rate equal to the original YTM,
and (2) the bond is sold at a price that lies exactly on its constant-yield price trajectory (i.e., its carrying value)
— meaning there is no capital gain or loss upon sale.
• To compute it: find the future value of the coupon stream reinvested at the changed rate over the holding
period, then add the present value of the expected sale price for the remaining years to maturity (face value is
usually 100 unless the bond is trading at a discount or premium).
• YTM decomposes into coupon income plus interest earned on the reinvestment of those coupons.
• Carrying value = purchase price minus the amortized amount of any premium, if the bond was originally
purchased above par.
Two offsetting interest rate risks
• Reinvestment risk: the risk that interest rates fall, reducing the future value of reinvested coupon payments.
This risk matters most to buy-and-hold, long-term investors, and it increases with a higher coupon rate (more
cash flow to reinvest). A zero-coupon bond has no coupons to reinvest and is therefore not exposed to
reinvestment risk.
• Price risk: the risk that interest rates rise, reducing the bond's sale price if it must be sold before it matures.
This risk matters more when the investor's holding period is short relative to the bond's maturity.

Macaulay duration
Macaulay duration (measured in years) captures a bond's price sensitivity to a change in yield (YTM). It is the
present-value-weighted average time to receipt of the bond's cash flows, and it identifies the exact holding period for
which reinvestment risk and price risk offset one another following a single, instantaneous parallel shift in the yield
curve — at that horizon, the investor is guaranteed to realize the bond's original market discount rate regardless of
which way rates move.
• Macaulay duration increases with: longer time to maturity (T), lower coupon rate (c), lower yield to maturity
(r), and more time elapsed since issuance (t/T).
• A premium bond (high coupon rate) carries higher reinvestment risk.
• Exception: a long-term discount bond (coupon below YTM) can, counterintuitively, have a lower duration
despite its long maturity.
• As interest rates rise, bond prices fall; but simply as time passes (holding yield constant), a bond's price is
pulled toward par as it approaches maturity.
• If a bond pays semiannual coupons, the annualized Macaulay duration must be divided by 2.
• Special cases: a zero-coupon bond's Macaulay duration equals its time to maturity; a perpetuity's duration
equals (1 + r)/r; an FRN's duration equals (T − t)/t (time remaining to the next reset).
• A bond portfolio's overall duration is calculated using market-value weights of its constituent bonds.
• Yield inputs to duration formulas are expressed in decimal form.
• Duration gap = Macaulay duration − investment horizon. A duration gap of zero means the position is
immunized (interest rate risk-neutral) against a single yield shift.
• If investment horizon > Macaulay duration: reinvestment risk dominates (negative gap) — the investor is hurt
by falling interest rates.
• If investment horizon = Macaulay duration: reinvestment risk and price risk offset exactly.
• If investment horizon < Macaulay duration: price risk dominates (positive gap) — the investor is hurt by rising
interest rates.

Modified duration and related measures

Annualized Modified Duration = Macaulay Duration / (1 + r); %ΔPV(Full) ≈
−AnnModDur × ΔAnnYield
Approximate Modified Duration = [PV(y−) − PV(y+)] / [2 × Δyield × PV₀]
Modified duration measures the approximate percentage change in price for a given change in YTM — it is the first
derivative of the bond's price with respect to yield.
Effective Duration = [PV(y−) − PV(y+)] / [2 × Δcurve × PV₀] = Σ (Key Rate Durationᵏ)
Unlike modified duration, effective duration measures price sensitivity to a shift in the benchmark yield curve
(assuming all points move by the same amount), and — critically — it can be calculated for bonds that lack a well-
defined IRR/YTM, such as bonds with embedded options.
Key Rate (Partial) Duration: KeyRateDurᵏ = −(1/PV) × (ΔPV/Δrₖ)
Key rate duration measures a bond's sensitivity to a change in the benchmark yield at one specific maturity point
along the curve — useful for capturing non-parallel shifts. Summing all key rate durations across the curve equals
the effective duration when yields move by the same amount everywhere.
Money Duration = Annualized Modified Duration × PV(Full); %ΔPV(Full) ≈ −Money
Duration × ΔAnnYield
Money duration expresses the dollar (currency) price change for a given yield change, typically stated per 100 of par
value or for an actual position size.
Price Value of a Basis Point (PVBP), also called PV01: PVBP = [PV(y−) − PV(y+)] / 2
PVBP measures the dollar price change resulting from a one-basis-point change in yield.

Convexity
Convexity describes the curved, non-linear shape of a bond's price–yield relationship — it is the second-order (non-
linear) effect of a yield change on price, complementing the first-order (linear) effect captured by duration.
• For an option-free bond, positive convexity means that as YTM rises, both duration and interest rate risk fall;

Approximate Convexity = [PV(y−) + PV(y+) − 2×PV₀] / [(Δyield)² × PV₀]

conversely, higher coupon and longer maturity increase interest rate risk.

Percent Price Change: %ΔPV = (−AnnModDur × ΔAnnYield) + (0.5 × AnnConvexity ×

ΔYield²)
The total percentage price change combines the first-order effect from modified duration with the second-order
convexity adjustment; annualized convexity is conventionally stated in whole numbers (multiplied by 100).
• Empirical duration: duration estimated from observed price–yield relationships across different interest rate
environments over time.
• Analytical duration: duration derived from mathematical formulas that assume yields and spreads move
independently of one another (i.e., are uncorrelated).
• If futures prices are positively correlated with interest rates, the futures price will exceed the corresponding
forward price.

14. Credit Risk

Credit risk is the risk that a borrower fails to meet its debt obligations (defaults). Credit analysis traditionally
organizes the drivers of credit risk into the "C's" of credit analysis:
• Bottom-up (issuer-specific) factors: Covenants (indenture protections), Capacity (the issuer's ability to repay
on time), Capital (resources available to reduce reliance on debt), Collateral (the quality of pledged assets),
and Character (the quality of management).
• Top-down (macro) factors: Conditions (the broader economic environment), Country, and Currency.

Loss calculation
Expected Loss (EL, $) = Loss Given Default (LGD) × Probability of Default (POD) ≈
Credit Spread
Expected loss is the probability-weighted amount an investor stands to lose from default.
Loss Given Default (LGD, $) = Expected Exposure (EE) × (1 − Recovery Rate)
• Expected Exposure (EE): the total projected exposure at the time of default — reduced by the value of any
collateral held.
• Recovery Rate (RR, %): the percentage of the loss amount that is ultimately recovered following default.
• Loss severity = 1 − RR.
 • Probability of Default (POD, %): typically expressed as a conditional probability (assuming no prior default
has already occurred). POD is driven by profitability (higher is better), coverage (sufficient cash flow relative
to obligations, higher is better), and leverage (lower is better).
• An investor is fairly compensated for taking on credit risk if the credit spread exceeds POD × LGD.
• For a distressed bond, market pricing focuses less on the coupon/yield mechanics and more directly on the
expected timing of default and the expected recovery rate.
• Credit rating outlooks tend to track current market conditions more closely and more quickly than the
underlying credit ratings themselves, which change less frequently.
• Two bonds from the same issuer can share the same probability of default but differ in loss given default,
because LGD depends on seniority, subordination, and the source of repayment — this is referred to as
notching for lower-ranked seniority.

Credit spread risk

Credit spread risk is the risk of greater expected loss arising from a deterioration in an issuer's credit condition, and
it is reflected in changes to the bond's yield.
• Liquidity spread: derived by finding the present value implied by the bid and ask prices separately, then
comparing the resulting yields — the difference reflects compensation demanded for illiquidity.
• Credit spread = Yield − Benchmark yield − Liquidity spread.

15–16. Credit Analysis for Government and Corporate Issuers

Sovereign (Government) Issuers
A sovereign government is generally considered more creditworthy when its domestic currency functions as a
reserve currency — one that is fully convertible and widely held by foreign central banks and investors. Sovereign
creditworthiness is assessed through both qualitative and quantitative lenses.

Qualitative factors
• Government institutions and policy: the stability and predictability of executive, legislative, and judicial
institutions and policies; the government's willingness to pay its debts; and adherence to the rule of law.
• Fiscal flexibility: the ability to adjust revenue and expenditure, maintain fiscal discipline, and use debt
prudently.
• Monetary effectiveness: the credibility of monetary policy, the exchange rate regime in place, and the
development of the domestic financial and debt markets.
• Economic flexibility: the diversification of the economy, its competitiveness, and its adaptability to economic
shocks.
• External status: the country's global currency status, its access to external funding, and its exposure to
geopolitical risk.

Quantitative factors
• Fiscal strength — debt burden (debt to GDP or revenue, indicating relative solvency) and debt affordability
(interest expense to GDP or revenue, indicating relative debt coverage).
• External stability — the balance of payments; external debt burden (long-term external debt / GDP); external
debt due (external debt maturing within 12 months / GDP); and currency reserves (FX reserves / GDP or
external debt).
• Economic growth and stability — cyclicality of the economy; average real GDP growth and its volatility
(standard deviation); economic size (GDP in PPP terms); and per-capita GDP (GDP / population).
Corporate Issuers
Qualitative factors
• Corporate governance: how proceeds are used, and the quality of legal, tax, accounting, and covenant
compliance.
• Business model: the stability and predictability of demand, revenue, and margins, and the quality of the
company's assets.
• Industry and competition: the structure and concentration of the industry, competitive intensity, and long-term
growth and demand prospects.
• Business risk: potential deviations from expected demand, revenue, and margin.

Quantitative factors
• Macro (top-down) approach: broad macroeconomic conditions (GDP growth, cyclicality); industry conditions
(addressable market size, market share); and event risk (assessed via scenario analysis and consideration of
external shocks).
• Issuer-specific (bottom-up) approach: balance sheet analysis (liquidity, leverage), income statement analysis
(revenue growth, operating profit), and cash flow statement analysis (debt service or interest coverage).
• Creditworthiness ratios: profitability (EBIT margin); coverage (EBIT to interest expense, or interest
coverage); and leverage (debt to EBITDA, and retained cash flow to net debt, where RCF/Net Debt =
Retained Cash Flow / [Debt − Cash & marketable securities]).

Ratings and seniority

Credit rating agencies typically provide two distinct types of ratings:
• Issuer credit rating (Corporate Family Rating): applies to the issuer's senior unsecured debt and addresses its
overall creditworthiness as a borrower.
• Individual issue rating (Corporate Credit Rating): applies to a specific financial obligation and factors in issue-
specific characteristics such as seniority.
• Because of structural subordination, senior unsecured bonds issued by a holding company typically rank
below (are subordinated to) bonds issued directly by a major operating subsidiary, since the subsidiary's cash
flows and assets sit closer to the operating business.

17–19. Securitization: ABS and MBS Market Features

Securitization is the process of pooling financial assets (such as loans or receivables) and issuing securities backed
by the cash flows those assets generate.
• Typical order of the process: an asset is transferred from the Originator / Depositor / Seller to a Special
Purpose Entity (SPE) — that is, the original source of the asset pools assets with similar features, then a bank
sells the pool to an SPE, which in turn issues asset-backed securities (ABS) to investors.
• The SPE and the originator sign a purchase agreement and prospectus that lay out the structure of the
securitization; a trustee is appointed to safeguard the pooled assets.
• A key benefit of the SPE structure is bankruptcy remoteness: the SPE is legally insulated from the bankruptcy
of the seller of the collateral, so investors' claims on the pooled assets are protected even if the originator fails.
• SPE-backed financing benefits multiple parties: for the issuer, the financing stays off its own balance sheet;
for the bank, SPE sponsor, or backup credit provider, issuing commercial paper generates cash while reducing
the cost of capital through an undrawn backup liquidity facility (versus holding short-term loans directly); and
for investors, it provides a liquid instrument that is otherwise hard to access directly. Rollover risk on the
commercial paper is mitigated through liquidity enhancement or a backup line of credit, ensuring the company
can fully repay maturing paper.
Examples of Asset-Backed Securities
(1) Covered Bonds (CB)
• Collateral: commercial or residential mortgages, or public-sector assets. Crucially, the collateral pool remains
on the issuer's own balance sheet, so a covered bond is not a full (true-sale) securitization.
• A covered bond consists of a single bond secured by a single cover pool — unlike typical ABS, which issue
multiple tranches against a pool.
• Covered bonds have a dual recourse nature: investors have a claim both on the ring-fenced loans in the cover
pool and on the unencumbered assets of the issuing institution generally.
• Because of this dual recourse, strict eligibility criteria for the cover pool, dynamic management of the pool,
and defined redemption regimes in the event of default, covered bonds typically carry lower credit risk and
lower yield than comparable ABS.
• Investor protection is further reinforced through overcollateralization, a set (capped) loan-to-value (LTV)
ratio, and ongoing third-party monitoring.
• Variants: a hard-bullet covered bond triggers immediate default and accelerated payment if a scheduled
payment is missed. A soft-bullet covered bond delays default and accelerates payment only until a new,
extended final maturity date (typically one year after the original maturity). A conditional pass-through
covered bond converts into pass-through securities after the original maturity date if payment is delayed.

(2) Collateralized Debt Obligations (CDOs)

A CDO is a security backed by a diversified pool of one or more types of debt obligations. It is a leveraged structure
in which equity-tranche holders use borrowed or issued funds to try to generate a return above their funding cost.
• Examples: CBO (backed by bonds) and structured finance CDOs (backed by other CDOs).
• CLOs (Collateralized Loan Obligations) come in several forms: cash flow CLOs (interest and principal cash
flows are redistributed into tranches), market value CLOs (tranche value is affected directly by the market
value of the underlying loans), and synthetic CLOs (built from a portfolio of credit default swaps rather than
the loans themselves).
• A CLO manager actively buys and sells the underlying debt obligations, with two goals: (1) paying off the
various bond-class holders on schedule, and (2) generating an attractive return for the equity tranche and the
manager itself.
• After the initial "ramp-up" period but before the underlying loan collateral matures, the collateral manager can
substitute loans in the portfolio, provided any new assets satisfy the portfolio's selection criteria.
• Investor recourse in a CLO is limited to the collateral pool itself.
• Equity-tranche investors take on equity-like risk with the potential for equity-like returns, and they play an
outsized role in determining whether a CLO is viable — the structure must offer them a competitive return,
which effectively makes them the marginal, price-setting investors in the deal.

(3) Mortgage-Backed Securities (MBS)

• Collateral: residential and commercial mortgage loans.
• Foreclosure allows the lender to take possession of the pledged property and sell it to recover funds owed on
the defaulted loan.
• Two key underwriting metrics: Loan-to-Value (LTV) ratio — a lower LTV means greater borrower equity and
a lower probability of default; and Debt-to-Income (DTI) ratio — monthly debt payments divided by monthly
pre-tax gross income.
• A prime loan typically has low LTV and DTI; a subprime loan has higher LTV and/or DTI, reflecting greater
credit risk.
• Valuing an MBS requires estimating prepayment risk, which combines contraction risk and extension risk:
 ◦ Contraction risk: the risk that borrowers repay principal faster than expected, shortening the cash flow
stream. Investors are forced to reinvest the returned principal at (typically lower) prevailing rates, and the
prepayment option also caps the bond's potential price appreciation.
◦ Extension risk: the risk that borrowers repay principal more slowly than expected, lengthening the cash
flow stream. This typically coincides with rising rates, which both reduces the present value of the now-
later cash flows and means investors' payments are discounted at a higher rate over a longer horizon.
• Time tranching is the primary structural tool used to redistribute and mitigate prepayment risk across different
tranches of an MBS.

Residential MBS (RMBS)

• Collateral: a large pool of many residential mortgages, most commonly structured as mortgage pass-through
securities.
• Key contingencies: the borrower's prepayment option; recourse loans (the lender can pursue the borrower for
any shortfall if the house's sale doesn't cover the outstanding loan); and non-recourse loans (the lender's claim
is limited to the property itself).
• Agency RMBS: guaranteed either by a federal government agency (backed by the full faith of the government,
with specific established underwriting standards) or by a government-sponsored enterprise (GSE), which fully
guarantees payment in exchange for a fee.
• Non-agency RMBS: issued by private entities and carry no government or GSE guarantee.
• Mortgage pass-through securities: pool many mortgages together and pass through the combined monthly cash
flow of principal, interest, and any prepayments to investors. The mortgage itself is securitized. The difference
between the pool's Weighted Average Coupon (WAC) and the pass-through rate paid to investors represents

WAC = Σ [individual mortgage rate × (its current balance / total current balance)]
the servicing fee retained by the SPE.

• Current Balance (CB) refers to the outstanding principal value of a mortgage.

• The mortgage pool is removed from the originator's balance sheet and transferred to the SPE, which then
issues securities backed by that pooled asset.

Collateralized Mortgage Obligations (CMOs)

A CMO securitizes mortgage pass-through securities further, using tranching to redistribute prepayment risk across
different classes of investors with different risk appetites. A common structural example is the sequential-pay CMO
(a form of time tranching), which contains several specialized tranche types:
• Z-tranche (accretion / accrual bond): receives no interest until a pre-set date, at which point both accrued
interest and principal payments begin. It is the longest-term and last-paid tranche, and it benefits the other
tranches by freeing up cash flow for them to be paid down faster. It carries no reinvestment risk.
• Principal-Only (PO) securities: receive only principal repayments (up to face value). Their value is highly
sensitive to prepayment speed and interest rates — when rates fall or prepayments accelerate, PO value rises,
since principal is returned sooner.
• Interest-Only (IO) securities: receive only interest payments; these positions are usually hedged given their
high sensitivity to prepayment speeds.
• Floating-rate tranche: coupon linked to a reference index or rate.
• Residual tranche: receives any cash flow remaining after all other tranche obligations are met. Typically held
by long-term institutional investors or hedge funds; banks tend to avoid it due to the associated capital
requirements.
• Planned Amortization Class (PAC): receives a fixed, predictable cash flow schedule, with any prepayment risk
absorbed instead by an associated support tranche.

Commercial MBS (CMBS)

• Collateral: a smaller number of commercial mortgages (as opposed to the large pools typical of RMBS).
 • Structural features: loans are typically balloon loans that are not fully amortizing, requiring a down payment /
large final payment.
• Call protection guards against early prepayment. Under a sequential-pay tranche structure, lower (junior)
tranches can only be prepaid after senior tranches have been fully retired, and any principal losses are always
absorbed by the junior tranches first. Call protection typically proceeds through stages: a prepayment lockout
period (no prepayment allowed) → prepayment allowed but with a penalty → defeasance, where the borrower
must purchase a portfolio of government securities that fully replicates the remaining scheduled principal and
interest cash flows (including the balloon payment); the cost of assembling this replicating portfolio is borne
by the issuer.

DSCR = Net Operating Income (NOI) / Debt Service

• Key credit-performance indicators include LTV and the Debt Service Coverage Ratio (DSCR):

NOI = Rental income − Cash operating expenses − Replacement reserves

• NOI excludes principal and interest payments, capital expenditures, depreciation, and amortization. Cash
operating expenses include property tax, insurance, and property maintenance.
• Balloon risk: the risk that the borrower fails to make the large balloon payment at maturity, triggering default.
The lender must then extend the loan into a "workout period" and modify the original terms — this is a
specific form of extension risk.

(4) Non-Mortgage ABS

• Collateral examples: credit card receivables (which are non-amortizing) and solar lease or loan payments.
• Lockout / revolving period: an initial period during which there is no prepayment risk, because any principal
repaid by borrowers is reinvested to originate additional loans of equal principal amount. Once the lockout
period ends, principal repayment to investors begins.
• Further examples of structures include collateralized debt/loan/bond obligations, and CDO-squared (a CDO
backed by tranches of other CDOs).
• Credit card receivables ABS: generates additional fee income for the sponsor. A rapid amortization provision
requires early principal amortization to begin if a specified trigger event occurs during the revolving period.
• Solar ABS: green loans collateralized by debt (mortgages, loans, or receivables) that can be further secured by
a lien on the installed solar systems, on the underlying property, or both — combining multiple liens helps
mitigate default risk.

Credit Enhancement for ABS

• Internal credit enhancement: overcollateralization (pledging more collateral than the securities issued) and

Excess spread = coupon earned on the underlying collateral − coupon paid out on the
subordination / credit tranching (junior tranches absorb losses first, protecting senior tranches).

issued securities
• Excess spread builds up a reserve that can be used to support overcollateralization over time.
• External credit enhancement: a financial guarantee from a bank or insurance company, a letter of credit
(LOC), or a cash collateral account.

End of expanded Topic 8 notes.