Introduction to Fixed Income Securities
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Readings
• Fabozzi
• Chapter 1
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Outline
WHAT ARE FIXED MARKET PARTICIPANTS EXAMPLES OF DEBT HOW FIXED INCOME
INCOME SECURITIES? SECURITIES AND THEIR SECURITIES ARE
RISKS TRADED
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What are fixed income securities?
Bonds, notes and bills were originally called fixed income
securities because they paid fixed cash flows at know points in
time. Today, fixed income securities also include floating rate
bonds, swaps, bond options and credit risk derivatives, although
their cash flows are no more ‘fixed’.
Some important features of fixed income securities:
• The cash flows represent contractual obligations of the issuers
• Their value depends on the interest rate
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Market participants
Issuer of debt securities Financial Intermediaries Investors
1. Government and their 1. Dealers 1. Government
agencies 2. Investment banks 2. Institutional
2. Corporations 3. Credit rating investors (domestic
3. Commercial banks agencies and foreign)
4. Municipalities 4. Credit and liquidity 3. Households
5. Special purpose vehicles enhancers
6. Foreign institutions
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Composition of Domestic Debt Market 2021
Total debt value $ 51.817.5billion
Money Market Municipal
1,090.4 3,809.7
Asset-backed
1,644.3
Treasuries
15,922.1
Mortgage-related
9,880.6
Federal Agencies Corporate
1,869.4 9,466.9
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Historical Market Value
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Average Daily Trading Volume 2021
1,200.0
1,000.0
Tresuries
800.0 Agency MBS
Corporate
600.0 Total debt
NYSE
400.0
200.0
0.0
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Historical Trading Volume
600
500
400
NYSE
300 Tresuries
MBS
200
100
0
1970 1980 1995 2006
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Examples of fixed income
securities and their risks
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Example 1: T-bond
Bullet
bond
5.375%, 2-15-2031 noncallable U.S. T-bond
• Original issue date: 02/15/2001
• Maturity date: 02/15/2031
• Time to maturity:
• Principal amount: $1,000,000
• Coupon: 5.375% fixed
• Interest payment: semiannual
• Amount issued: $16,428,000,000
Note the coupon payment in $ = 5.375%*1,000,000/2 = $26,875
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Risks associated with
5.375%, 2-15-2031 noncallable U.S. T-bond
Dimension of Risk Level of Risk
Credit risk ?
Price risk ?
Liquidity risk ?
Future cash flows ?
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Source: WSJ 14
5.375%, 2-15-2031 noncallable U.S. T-bond
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Risks associated with
5.375%, 2-15-2031 noncallable U.S. T-bond
Dimension of Risk Level of Risk Note Fitch
downgrade
Credit risk Low; probability of U.S. default is low.
Price risk High; fixed-rate bond
Liquidity risk Low; high trading volume and low bid/ask spread
Future cash flows Low; fixed-rate non-callable bond (cash flows are
known)
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Example 2:
Treasury Inflation-Protected Securities(TIPS)
2-3/8% TIPS due January 15, 2027
• Original issue date: 01/31/2007
• Maturity date: 01/15/2027
• Time to maturity:
• Principal amount: adjusted for inflation using CPI-U
• Coupon: 2 3/8 % fixed
• Interest payment: based on the inflation-adjusted
principal; semiannual (Jan. 15 and July 15)
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2-3/8% TIPS due January 15, 2027
Index Date Ref CPI Index Ratio
9/5/2023 305.1866 1.51334
9/4/2023 305.1672 1.51324
9/3/2023 305.1478 1.51315
9/2/2023 305.1284 1.51305
9/1/2023 305.109 1.51295
8/31/2023 305.07732 1.5128
8/30/2023 305.04565 1.51264
8/29/2023 305.01397 1.51248
8/28/2023 304.98229 1.51232
8/27/2023 304.95061 1.51217
8/26/2023 304.91894 1.51201
8/25/2023 304.88726 1.51185
8/24/2023 304.85558 1.5117
8/23/2023 304.8239 1.51154
8/22/2023 304.79223 1.51138
8/21/2023 304.76055 1.51123
8/20/2023 304.72887 1.51107
8/19/2023 304.69719 1.51091
8/18/2023 304.66552 1.51075
8/17/2023 304.63384 1.5106
8/16/2023 304.60216 1.51044
8/15/2023 304.57048 1.51028
8/14/2023 304.53881 1.51013
8/13/2023 304.50713 1.50997
8/12/2023 304.47545 1.50981
Source: [Link]
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2-3/8% TIPS due January 15, 2027
Dimension of Risk Level of Risk
Credit risk ?
Price risk ?
Liquidity risk ?
Future cash flows ?
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“TIPS break-even”
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Example 3: Corporate Bond
Note: Use Amount Outstanding to judge Liquidity Risk
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What can we say about the risk associated with
the Banco Santander bond?
Dimension of Risk Level of Risk
Credit risk ?
Price risk ?
Liquidity risk ?
Future cash flows ?
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Practice Problem
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What can we say about the risks associated
with ALLY bonds
Dimension of Risk Level of Risk
Credit risk ?
Price risk ?
Liquidity risk ?
Future cash flows ?
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How debt securities
are traded
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Government securities markets: Players
• U.S. Treasury
• issues securities (T-bills, T-notes, and T-bonds) and decides on the
composition of the securities and mechanism for selling (currently
Dutch auction)
• Federal Reserve System
• acts as an agent of Treasury in conducting the auctions and in handling
payment and collections
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Government securities markets: Players
• Primary dealers
• participate in Treasury auctions, distribute T-securities, act as
‘market makers’
• See list
[Link]
• Interdealer brokers
• Aggregate information about the bids and offers posted by various
dealers without revealing the identities of the dealer
• Investors
• Can purchase directly from [Link]
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Primary
dealers
Source:
[Link]
ers, 09/2021
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Interdealer brokers
• Aggregate information about the bids and offers posted by various dealers
without revealing the identities of the dealer
• Provide this information to primary dealers, in some cases, to other
institutions as well
• Dealers pay commissions for this service
• Interdealer brokers: Cantor Fitzgerald; Garban; Liberty; RMJ; Hillard Farber;
Icap; Tullet; Traditon; BGC and Tokyo
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Primary Dealer Transactions in U.S. Government Securities
(Daily Average Figures In millions of Dollars)
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Repo transaction
Step 1.
T-securities ( dealer retains the right
on any cash flow)
Dealer Repo dealer
Cash equal to the
market price minus hair cut
(borrowed funds)
Step 2.
T-securities
Dealer Repo dealer
Borrowed funds plus
repo interest
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Repo transactions: Terminology
• Repurchase agreements (repos) – one party sells securities to another party
while agreeing to repurchase those securities at a later date
• Reverse repurchase agreements –one party buys securities from another
party while agreeing to resell those securities at a later date.
• Collateral –securities used in repo transactions
• Hair cut – the difference between the market price of the collateral and
funds received by the seller
• The term of repo transactions – a few days to over 30 days. Usually
overnight or a few days.
• Repo rates – interest rate paid by the selling party
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Repo Transaction
On June 10, 2020, Dealer X wished to finance $10 mill. par
amount of a hypothetical 7.25%, 5-15-2036 T-bond.
Date Ask Price Bid Price
6/10/20 94.16 94.03
6/11/20 94.97 94.84
6/12/20 95.03 94.91
6/13/20 96.91 96.78
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Example (continued)
The following transactions occurred on June 10,2020
1. The dealer bought a T-bond (in the morning)
Price: 94.03 + accrued interest =
94.03 + 0.5122 = 94.5422%
$ Price: $ 9,454,220
2. Delivered the T-bond to a repo dealer and received cash. Hair cut
was 0.5% of market value (in the afternoon)
Amount borrowed: $ 9,454,220 – hair cut =
$ 9,454,220 – $47,271.10 =
$9,406,948.90
3. Paid for the T-bond (in the evening)
$ Price = Amount borrowed + Out-of-pocket Cash =
$9,406,948.90 + $47,271.10 = $ 9,454,220
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Example (continued)
The following transactions occurred on June 13, 2020
1. Took possession of the T-bond and sold it in the market (in the
morning)
Price: 96.91 + accrued interest =
96.91 + 0.5713 = 97.4813 %
Received: $ 9,748,130
2. Paid amount borrowed plus the repo rate of interest, 6% (in the
afternoon)
Interest: $9,406,948.90 X 0.06 X 3/360 = $4,703.47
Paid: $9,406,948.90 + $4,703.47 = $9,411,625.37
Dealer’s profit: $9,748,130 – $9,411,625.37 – $47,271.10
= $289,233.53
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Repo Transactions and Risks
1. What is the purpose of the hair cut?
2. The dealer’s profit is $289,233.53. Is this a riskless profit? What
are the risks?
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Primary Dealers Fails to Deliver
Source: NY FED
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Fails
1000000
1500000
2000000
3000000
2500000
0
500000
Source: NY FED
7/4/1990
7/4/1991
7/4/1992
7/4/1993
7/4/1994
7/4/1995
7/4/1996
7/4/1997
7/4/1998
7/4/1999
7/4/2000
Historical
7/4/2001
Total Treasury Receive
As-of Date
7/4/2002
Primary Dealers Fails to Deliver
7/4/2003
7/4/2004
7/4/2005
7/4/2006
7/4/2007
7/4/2008
Total Treasury Deliver
7/4/2009
7/4/2010
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Repo Rates
Note: Secured Overnight Financing Rate (SOFR)
Source: [Link] 41
Corporate Debt Market
• Many issuers with relatively small issues
• Majority of corporate bonds are traded in the dealer market. Small
percentage is traded on exchanges.
• The major treasury dealers are also the key corporate security dealers
• Credit rating agencies
• Low liquidity
• less than 5% of outstanding bonds are actively traded in any given
year
• Relatively low transparency
• Improvement: TRACE system
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Municipal Debt Market (Munis)
• Some bond issuers must be approved by the taxpayers (general
obligation bonds)
• The major treasury dealers are also the key players in the municipal
market
• Broker’s brokers –assist dealers in secondary-market trading
• J. J. Kenny , Chapdeliane
• Rating agencies
• Credit enhancers and insurers
• AMBAC, MBIAC, FGIC, and BIG
• Transactions reporting system developed by Municipal Securities
Rulemaking Board (MSRB)
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Munis Performance
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Non-US Bonds
• Sovereign debt market
• Corporate debt market
• Yankee bonds (see my paper on Yankee bonds )
• Eurobond market
• Underwritten by an international syndicate
• Offered simultaneously to investors in different countries
• Issued outside the jurisdiction of any single country
• Unregistered with SEC
Sovereign debt
• Sovereign debt is the obligation of a country' central government
• Sovereign debt is rated by rating agencies (Moody’s, S&P, and
Fitch)
• Foreign currency debt rating
• Local currency debt rating
• Sovereign debt contract presents major challenges in ensuring that
the lenders will have access to the assets of the borrower
• Reputation costs
• Sanctions and trade barriers
Sovereign debt
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What Hedge Funds Do
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What Hedge Funds Do
• Year 2001
• Argentina defaulted on $80 bill. of bonds; 93% of creditors agreed to walk
away with 30% of what they owed.
• Elliott Capital refused the deal…
• Tactics
• Attempts to claim money deposited by the country’s central bank in the U.S.
and Europe;
• to seize two satellite launch contracts between Argentina and SpaceX;
• and an Argentinian ship in Ghana.
• “VULTURES”, “FINANCIAL TERRORISTS”
• Year 2016
• Argentina agreed to pay $2.4 billion to Elliott….The bonds were purchased
for about $117 mill.
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What Hedge Funds Do
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Brady Bonds
• Brady bonds were created by converting sovereign loans to bonds
• Debt restructuring in exchange for some economic reform
and/or debt reduction and/or additional lending
• Several design features of Brady bonds
• Grace period – principal is not amortized
• Partial capitalization of interest payment
• Floating rate
• Some collateralized using US Treasury Strips
Ecuador Brady
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Summary
• Fixed income securities are contractual obligations whose value depends
on the interest rate.
• Fixed income is the biggest financial market both in terms of market value
and trading value.
• Treasuries, mortgage-related securities and corporates are the largest
sector of the market.
• Price risk, liquidity risk, credit risk and future cash flow risk are the major
risks associated with fixed income securities.
• Most fixed income securities are traded on the OTC market.
• US Treasuries are issued via Dutch auction. The single most important
source of financing for government dealers is the repo market.
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End Notes
Practice Problems Readings
posted on BlackBoard Chapter 2, Chapter 3 (pp. 35-45), Chapter
4 (pp. 58-84)
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