Fixed Income Analysis

CFA Institute's essential guide to fixed-income portfolio management, revised and updated

Now in its fourth edition, Fixed Income Analysis offers authoritative and up-to-date coverage of how successful investment professionals analyze and manage fixed-income portfolios.

With contributions from a team of financial experts, the text is filled with detailed information from CFA Institute and contains a comprehensive review of the essential topics in the field. Fixed Income Analysis introduces the fundamental concepts of fixed-income securities and markets and provides in-depth coverage of fixed-income security valuation and portfolio management. The book contains a general framework for valuation that is designed to be accessible to both professionals and those new to the field. The fourth edition provides updated coverage of fixed-income portfolio management including detailed coverage of liability-driven and index-based strategies, the major types of yield curve strategies, and approaches to implementing active credit strategies.

The authors include examples that help build the knowledge and skills needed to effectively manage fixed-income portfolios. Fixed Income Analysis gives a real-world understanding of how the concepts discussed are practically applied in client-based scenarios.

Investment analysts, portfolio managers, individual and institutional investors and their advisors, and anyone with an interest in fixed-income markets will appreciate this accessible guide to fixed-income analysis.

Barbara S. Petitt is Director, Curriculum Projects, EMEA, in the Education Division at CFA Institute.

Preface xv

Acknowledgments xvii

About the CFA Institute Series xix

Part I Fixed Income Essentials

Chapter 1 Fixed-Income Securities: Defining Elements 3

Learning Outcomes 3

1. Introduction 3

2. Overview of a Fixed-Income Security 4

2.1. Basic Features of a Bond 5

2.2. Yield Measures 10

3. Legal, Regulatory, and Tax Considerations 10

3.1. Bond Indenture 10

3.2. Legal and Regulatory Considerations 18

3.3. Tax Considerations 21

4. Structure of a Bond’s Cash Flows 23

4.1. Principal Repayment Structures 23

4.2. Coupon Payment Structures 28

5. Bonds with Contingency Provisions 34

5.1. Callable Bonds 34

5.2. Putable Bonds 36

5.3. Convertible Bonds 37

6. Summary 40

Practice Problems 42

Chapter 2 Fixed-Income Markets: Issuance, Trading, and Funding 47

Learning Outcomes 47

1. Introduction 47

2. Overview of Global Fixed-Income Markets 48

2.1. Classification of Fixed-Income Markets 48

2.2. Fixed-Income Indexes 55

2.3. Investors in Fixed-Income Securities 56

3. Primary and Secondary Bond Markets 57

3.1. Primary Bond Markets 58

3.2. Secondary Bond Markets 62

4. Sovereign Bonds 65

4.1. Characteristics of Sovereign Bonds 65

4.2. Credit Quality of Sovereign Bonds 66

4.3. Types of Sovereign Bonds 66

5. Non-Sovereign Government, Quasi-Government, and Supranational Bonds 68

5.1. Non-Sovereign Bonds 68

5.2. Quasi-Government Bonds 69

5.3. Supranational Bonds 69

6. Corporate Debt 70

6.1. Bank Loans and Syndicated Loans 71

6.2. Commercial Paper 71

6.3. Corporate Notes and Bonds 74

7. Structured Financial Instruments 79

7.1. Capital Protected Instruments 79

7.2. Yield Enhancement Instruments 79

7.3. Participation Instruments 80

7.4. Leveraged Instruments 80

8. Short-Term Funding Alternatives Available to Banks 82

8.1. Retail Deposits 82

8.2. Short-Term Wholesale Funds 82

8.3. Repurchase and Reverse Repurchase Agreements 84

9. Summary 87

Practice Problems 89

Chapter 3 Introduction to Fixed-Income Valuation 93

Learning Outcomes 93

1. Introduction 93

2. Bond Prices and the Time Value of Money 94

2.1. Bond Pricing with a Market Discount Rate 94

2.2. Yield-to-Maturity 98

2.3. Relationships between the Bond Price and Bond Characteristics 100

2.4. Pricing Bonds with Spot Rates 104

3. Prices and Yields: Conventions for Quotes and Calculations 107

3.1. Flat Price, Accrued Interest, and the Full Price 107

3.2. Matrix Pricing 111

3.3. Annual Yields for Varying Compounding Periods in the Year 114

3.4. Yield Measures for Fixed-Rate Bonds 118

3.5. Yield Measures for Floating-Rate Notes 121

3.6. Yield Measures for Money Market Instruments 125

4. The Maturity Structure of Interest Rates 130

5. Yield Spreads 138

5.1. Yield Spreads over Benchmark Rates 138

5.2. Yield Spreads over the Benchmark Yield Curve 140

6. Summary 143

Practice Problems 145

Chapter 4 Introduction to Asset-Backed Securities 153

Learning Outcomes 153

1. Introduction 153

2. Benefits of Securitization for Economies and Financial Markets 154

3. How Securitization Works 155

3.1. An Example of a Securitization 156

3.2. Parties to a Securitization and Their Roles 157

3.3. Structure of a Securitization 159

3.4. Key Role of the Special Purpose Entity 161

4. Residential Mortgage Loans 164

4.1. Maturity 165

4.2. Interest Rate Determination 165

4.3. Amortization Schedule 166

4.4. Prepayment Options and Prepayment Penalties 167

4.5. Rights of the Lender in a Foreclosure 167

5. Residential Mortgage-Backed Securities 169

5.1. Mortgage Pass-Through Securities 170

5.2. Collateralized Mortgage Obligations 175

5.3. Non-agency Residential Mortgage-Backed Securities 182

6. Commercial Mortgage-Backed Securities 182

6.1. Credit Risk 183

6.2. CMBS Structure 183

7. Non-Mortgage Asset-Backed Securities 187

7.1. Auto Loan ABS 187

7.2. Credit Card Receivable ABS 190

8. Collateralized Debt Obligations 191

8.1. CDO Structure 192

8.2. An Example of a CDO Transaction 192

9. Summary 195

Practice Problems 197

Chapter 5 Understanding Fixed Income Risk and Return 203

Learning Outcomes 203

1. Introduction 204

2. Sources of Return 204

3. Interest Rate Risk on Fixed-Rate Bonds 212

3.1. Macaulay, Modified, and Approximate Duration 212

3.2. Effective Duration 220

3.3. Key Rate Duration 224

3.4. Properties of Bond Duration 224

3.5. Duration of a Bond Portfolio 230

3.6. Money Duration of a Bond and the Price Value of a Basis Point 233

3.7. Bond Convexity 235

4. Interest Rate Risk and the Investment Horizon 245

4.1. Yield Volatility 245

4.2. Investment Horizon, Macaulay Duration, and Interest Rate Risk 247

5. Credit and Liquidity Risk 251

6. Summary 252

Practice Problems 255

Chapter 6 Fundamentals of Credit Analysis 261

Learning Outcomes 261

1. Introduction 261

2. Credit Risk 262

3. Capital Structure, Seniority Ranking, and Recovery Rates 264

3.1. Capital Structure 264

3.2. Seniority Ranking 265

3.3. Recovery Rates 267

4. Rating Agencies, Credit Ratings, and Their Role in the Debt Markets 270

4.1. Credit Ratings 271

4.2. Issuer vs. Issue Ratings 273

4.3. Risks in Relying on Agency Ratings 274

5. Traditional Credit Analysis: Corporate Debt Securities 279

5.1. Credit Analysis vs. Equity Analysis: Similarities and Differences 280

5.2. The Four Cs of Credit Analysis: A Useful Framework 280

6. Credit Risk vs. Return: Yields and Spreads 298

7. Special Considerations of High-Yield, Sovereign, and Non-Sovereign Credit Analysis 307

7.1. High Yield 307

7.2. Sovereign Debt 315

7.3. Non-Sovereign Government Debt 319

8. Summary 321

Practice Problems 324

Part II Fixed Income Term Structure, Advanced Valuation and Credit Analysis

Chapter 7 The Term Structure and Interest Rate Dynamics 335

Learning Outcomes 335

1. Introduction 336

2. Spot Rates and Forward Rates 336

2.1. The Forward Rate Model 338

2.2. Yield to Maturity in Relation to Spot Rates and Expected and Realized Returns on Bonds 346

2.3. Yield Curve Movement and the Forward Curve 349

2.4. Active Bond Portfolio Management 351

3. The Swap Rate Curve 355

3.1. The Swap Rate Curve 355

3.2. Why Do Market Participants Use Swap Rates When Valuing Bonds? 356

3.3. How Do Market Participants Use the Swap Curve in Valuation? 357

3.4. The Swap Spread 360

3.5. Spreads as a Price Quotation Convention 362

4. Traditional Theories of the Term Structure of Interest Rates 364

4.1. Local Expectations Theory 364

4.2. Liquidity Preference Theory 365

4.3. Segmented Markets Theory 366

4.4. Preferred Habitat Theory 366

5. Modern Term Structure Models 369

5.1. Equilibrium Term Structure Models 369

5.2. Arbitrage-Free Models: The Ho–Lee Model 374

6. Yield Curve Factor Models 377

6.1. A Bond’s Exposure to Yield Curve Movement 377

6.2. Factors Affecting the Shape of the Yield Curve 378

6.3. The Maturity Structure of Yield Curve Volatilities 382

6.4. Managing Yield Curve Risks 383

7. Summary 386

References 387

Practice Problems 387

Chapter 8 The Arbitrage-Free Valuation Framework 397

Learning Outcomes 397

1. Introduction 397

2. The Meaning of Arbitrage-Free Valuation 398

2.1. The Law of One Price 399

2.2. Arbitrage Opportunity 399

2.3. Implications of Arbitrage-Free Valuation for Fixed-Income Securities 400

3. Interest Rate Trees and Arbitrage-Free Valuation 401

3.1. The Binomial Interest Rate Tree 403

3.2. What Is Volatility and How Is It Estimated? 407

3.3. Determining the Value of a Bond at a Node 408

3.4. Constructing the Binomial Interest Rate Tree 410

3.5. Valuing an Option-Free Bond with the Tree 417

3.6. Pathwise Valuation 419

4. Monte Carlo Method 423

5. Summary 425

Practice Problems 426

Chapter 9 Valuation and Analysis of Bonds with Embedded Options 435

Learning Outcomes 435

1. Introduction 436

2. Overview of Embedded Options 436

2.1. Simple Embedded Options 437

2.2. Complex Embedded Options 438

3. Valuation and Analysis of Callable and Putable Bonds 441

3.1. Relationships between the Values of a Callable or Putable Bond, Straight Bond, and Embedded Option 441

3.2. Valuation of Default-Free and Option-Free Bonds: A Refresher 442

3.3. Valuation of Default-Free Callable and Putable Bonds in the Absence of Interest Rate Volatility 443

3.4. Effect of Interest Rate Volatility on the Value of Callable and Putable Bonds 446

3.5. Valuation of Default-Free Callable and Putable Bonds in the Presence of Interest Rate Volatility 451

3.6. Valuation of Risky Callable and Putable Bonds 459

4. Interest Rate Risk of Bonds with Embedded Options 465

4.1. Duration 465

4.2. Effective Convexity 472

5. Valuation and Analysis of Capped and Floored Floating-Rate Bonds 475

5.1. Valuation of a Capped Floater 475

5.2. Valuation of a Floored Floater 478

6. Valuation and Analysis of Convertible Bonds 480

6.1. Defining Features of a Convertible Bond 481

6.2. Analysis of a Convertible Bond 483

6.3. Valuation of a Convertible Bond 487

6.4. Comparison of the Risk–Return Characteristics of a Convertible Bond, the Straight Bond, and the Underlying Common Stock 488

7. Bond Analytics 492

8. Summary 493

References 495

Practice Problems 495

Chapter 10 Credit Analysis Models 507

Learning Outcomes 507

1. Introduction 507

2. Modeling Credit Risk and the Credit Valuation Adjustment 508

3. Credit Scores and Credit Ratings 517

4. Structural and Reduced-Form Credit Models 522

5. Valuing Risky Bonds in an Arbitrage-Free Framework 526

6. Interpreting Changes in Credit Spreads 542

7. The Term Structure of Credit Spreads 548

8. Credit Analysis for Securitized Debt 554

9. Summary 558

References 559

Practice Problems 560

Chapter 11 Credit Default Swaps 569

Learning Outcomes 569

1. Introduction 569

2. Basic Definitions and Concepts 570

2.1. Types of CDS 571

2.2. Important Features of CDS Markets and Instruments 572

2.3. Credit and Succession Events 574

2.4. Settlement Protocols 575

2.5. CDS Index Products 577

2.6. Market Characteristics 578

3. Basics of Valuation and Pricing 580

3.1. Basic Pricing Concepts 581

3.2. The Credit Curve 584

3.3. CDS Pricing Conventions 585

3.4. Valuation Changes in CDS during Their Lives 587

3.5. Monetizing Gains and Losses 588

4. Applications of CDS 589

4.1. Managing Credit Exposures 590

4.2. Valuation Differences and Basis Trading 594

5. Summary 596

Practice Problems 597

Part III Fixed Income Portfolio Management

Chapter 12 Overview of Fixed-Income Portfolio Management 605

Learning Outcomes 605

1. Introduction 605

2. Roles of Fixed-Income Securities in Portfolios 606

2.1. Diversification Benefits 606

2.2. Benefits of Regular Cash Flows 608

2.3. Inflation Hedging Potential 609

3. Fixed-Income Mandates 611

3.1. Liability-Based Mandates 611

3.2. Total Return Mandates 615

4. Bond Market Liquidity 619

4.1. Liquidity among Bond Market Sub-Sectors 620

4.2. The Effects of Liquidity on Fixed-Income Portfolio Management 621

5. A Model for Fixed-Income Returns 622

5.1. Decomposing Expected Returns 623

5.2. Estimation of the Inputs 626

5.3. Limitations of the Expected Return Decomposition 627

6. Leverage 628

6.1. Using Leverage 628

6.2. Methods for Leveraging Fixed-Income Portfolios 629

6.3. Risks of Leverage 632

7. Fixed-Income Portfolio Taxation 632

7.1. Principles of Fixed-Income Taxation 633

7.2. Investment Vehicles and Taxes 634

8. Summary 636

References 637

Practice Problems 638

Chapter 13 Liability-Driven and Index-Based Strategies 643

Learning Outcomes 643

1. Introduction 643

2. Liability-Driven Investing 644

3. Interest Rate Immunization—Managing the Interest Rate Risk of a Single Liability 648

4. Interest Rate Immunization—Managing the Interest Rate Risk of Multiple Liabilities 660

4.1. Cash Flow Matching 661

4.2. Duration Matching 664

4.3. Derivatives Overlay 670

4.4. Contingent Immunization 674

5. Liability-Driven Investing—An Example of a Defined Benefit Pension Plan 675

6. Risks in Liability-Driven Investing 685

7. Bond Indexes and the Challenges of Matching a Fixed-Income Portfolio to an Index 689

8. Alternative Methods for Establishing Passive Bond Market Exposure 695

9. Benchmark Selection 701

10. Laddered Bond Portfolios 704

11. Summary 708

References 711

Practice Problems 712

Chapter 14 Yield Curve Strategies 721

Learning Outcomes 721

1. Introduction 721

2. Foundational Concepts for Active Management of Yield Curve Strategies 722

2.1. A Review of Yield Curve Dynamics 724

2.2. Duration and Convexity 727

3. Major Types of Yield Curve Strategies 729

3.1. Strategies under Assumptions of a Stable Yield Curve 730

3.2. Strategies for Changes in Market Level, Slope, or Curvature 737

4. Formulating a Portfolio Positioning Strategy Given a Market View 747

4.1. Duration Positioning in Anticipation of a Parallel Upward Shift in the Yield Curve 748

4.2. Portfolio Positioning in Anticipation of a Change in Interest Rates, Direction Uncertain 751

4.3. Performance of Duration-Neutral Bullets, Barbells, and Butterflies Given a Change in the Yield Curve 752

4.4. Using Options 765

5. Inter-Market Curve Strategies 770

6. Comparing the Performance of Various Duration-Neutral Portfolios in Multiple Curve Environments 784

6.1. The Baseline Portfolio 784

6.2. The Yield Curve Scenarios 785

6.3. Extreme Barbell vs. Laddered Portfolio 787

6.4. Extreme Bullet 788

6.5. A Less Extreme Barbell Portfolio vs. Laddered Portfolio 789

6.6. Comparing the Extreme and Less Extreme Barbell Portfolios 790

7. A Framework for Evaluating Yield Curve Trades 793

8. Summary 802

Practice Problems 804

Chapter 15 Fixed-Income Active Management: Credit Strategies 817

Learning Outcomes 817

1. Introduction 817

2. Investment-Grade and High-Yield Corporate Bond Portfolios 818

2.1. Credit Risk 819

2.2. Credit Migration Risk and Spread Risk 820

2.3. Interest Rate Risk 821

2.4. Liquidity and Trading 824

3. Credit Spreads 826

3.1. Credit Spread Measures 826

3.2. Excess Return 831

4. Credit Strategy Approaches 832

4.1. The Bottom-Up Approach 832

4.2. The Top-Down Approach 842

4.3. Comparing the Bottom-Up and Top-Down Approaches 850

4.4. ESG Considerations in Credit Portfolio Management 851

5. Liquidity Risk and Tail Risk in Credit Portfolios 853

5.1. Liquidity Risk 853

5.2. Tail Risk 857

6. International Credit Portfolios 859

6.1. Relative Value in International Credit Portfolios 860

6.2. Emerging Markets Credit 861

6.3. Global Liquidity Considerations 862

6.4. Currency Risk in Global Credit Portfolios 862

6.5. Legal Risk 863

7. Structured Financial Instruments 863

7.1. Mortgage-Backed Securities 864

7.2. Asset-Backed Securities 865

7.3. Collateralized Debt Obligations 865

7.4. Covered Bonds 867

8. Summary 867

References 869

Practice Problems 869

Glossary 875

About the Editors 891

About the CFA Program 893

Index 895