Session 1: Overview of Fixed Income Markets & Securities

Instructor: Fotini Tolias

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RSM 430H1F Course Overview

Instructor: Fotini Tolias

Email Address:

Fotini.Tolias@rotman.utoronto.ca

Office: RSM 432

Office Hours: TBD

Assignment #1: 10% due October 16th

Midterm 30% on October 25th

Assignment #2: 10% due December 2nd

Final exam: 50% TBD

Assignments may be done in groups of 2 to 4 students

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Session/Date Topic

1: Sept. 9 Overview of Fixed Income Markets: overview of the markets and

participants, the yield curve and interpolation Chapters 1,2

2: Sept. 16 Building the Yield Curve: Government Bond Auctions - single vs. multiple

price and inflation protected securities (RRBs, TIPS)- begin bond features

Chapters 1,2/Class

Notes

3: Sept. 23 Overview of Securities (fixed rate, floating rate and convertible bonds) and

Bond valuation

Chapters 3, 19

(selected pages)

4: Sept. 30 Other yield measures and bonds with embedded options Chapter 3, Class

Notes

5: Oct. 7

Understanding the Yield Curve

Spot Rates, Forward Rates, Bootstrapping and bond stripping Chapters 5

Oct. 14 THANKSGIVING MONDAY - NO CLASSES

Wed. October 16th - Assignment #1 due by 4:00 p.m. at Rotman Commerce Office

Week of Oct. 21 Friday, October 25th - Mid Term Exam

6: Oct. 28 Measuring Interest Rate Risk

Duration, Convexity, PV of a basis point, basic yield curve trades Chapter 4

7: Nov. 4

Corporate Bond Market : Bond payment structures (bullet, amortizing and

defeasance), rating agencies, shadow rating a company and bond

covenant analysis

Chapters 7, 20

Nov. 11/12 STUDY BREAK - NO CLASSES FOR MONDAY SECTIONS

8: Nov. 18 Corporate Bond Market: Documentation and Offering methods Chapters 7, 20

9: Nov. 25 Corporate Credit Spreads and Interest Rate Models

(KMV, Merton)

Chapter 16/Class

Notes

Mon. December 2nd - Assignment #2 due by 4:00 p.m. at Rotman Commerce Office

10: Dec. 2 Securitization – Structuring Basics (incl. CDO’s) , Asset Backed

Securities

Chapter 15/ Class

Notes

11: Dec. 4 Securitization - Mortgage Backed Securities/Covered Bonds

Chapter 13/ Class

Notes

Who Am I? Fotini Tolias, B.Comm., MBA

• 20 years of experience on a fixed income trading floor

• Spent over 10 years working for 2 major Canadian dealers

• Covered corporate clients to issue bonds into the capital

markets

• Helped Canadian companies raise money for their financial

requirements

– Sectors covered included financial institutions, media & telecom

and special situations

– Deal size ranged from $50 million to $1 billion

– Full time instructor at Rotman since 2009 teaching primarily

fixed income in undergraduate, MBA and Master of Finance

programs

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Linking bond theories with practice - use of 'mini' cases

in class to demonstrate/apply theory to real issuers

Understanding of bond mathematics, bond pricing and

relative value of product across the credit spectrum

Building knowledge of current fixed income markets and

issues

Structuring deals - ability to understand and analyze a

prospectus and bond trust indenture

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Major asset classes for investing ◦ Equities

◦ Fixed income Securities

◦ Other asset classes

Real Estate, Private Equity, Hedge Funds, Commodities a.k.a

“Alternative Asset Classes”

What distinguishes a fixed income security from equity or stock?

◦ A fixed income security is a financial (and contractual) obligation of an

entity that entitle the holder to receive a pre-determined stream of

future cash flows

The entity that promises to make the payments is called the issuer

◦ Failure to pay may result in ‘default’

The investor in the fixed income security is a creditor (or lender)

The instrument has a ‘maturity date’ where afterwards it is retired

and ceases to exist

Equity/Preferred Shares

Cannot force bankruptcy if no dividend paid

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Who Issues Bonds?

1. Governments and their agencies – sovereign bonds

2. States, provinces and municipalities

3. Companies (senior secured debt, senior unsecured debt,

subordinated debt)

4. Commercial Banks (senior unsecured debentures as deposit

liabilities, subordinated debt for capital purposes)

5. Special-purpose vehicles or trusts (ABS, MBS)

6. Foreign institutions (Maple or global bonds)

Purpose?

Raise capital..i.e. $$$$

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Who Buys Bonds?

1. Governments, foreign institutions, Sovereign wealth funds

2. Pensions funds

3. Insurance companies

4. Mutual funds , hedge funds and asset management companies

5. Commercial banks

6. Retail investors

Purpose?

Objectives differ depending on the risk profile and risk appetite of the buyer

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Overview of Issuers and some characteristics Federal or Provincial Government (s) Treasury Bills

◦ Pure discount securities placed through auction ◦ Maturity 13, 26 and 52 weeks

Treasury Notes and Bonds

◦ Semi-annual pay coupons (North American convention) ◦ Maturity 2, 3, 5, 7, 10 (notes) and 30 years (bonds) ◦ Sold in denominations of $1,000

Agency Securities - Issued by different organizations

In the US:

◦ Federal National Mortgage Association (Fannie Mae)

◦ Federal Home Loan Mortgage Corporation (Freddie Mac)

◦ Student Loan Marketing association (Sallie Mae)

Agencies have at least two common features:

1. were created to fulfill a public (social) purpose

2. the debt of most agencies is not guaranteed by the government (until

recently at least) i.e. Canadian government borrows on behalf of Crown

corporations (CMHC)

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Overview of Issuers and some characteristics Municipal Bonds

Issued by state and local governments

◦ Exempt from federal income tax

◦ Exempt from (issuing) state local tax

Market is virtually non-existent in Canada because of no preferential tax

treatment for the coupon

Types of “munis”

◦ General obligation bonds: backed by the “full faith & credit” of the issuer

(taxing power)

◦ Revenue bonds (riskier): issued to finance specific projects (airports,

hospital, etc.)

Corporate Bonds

◦ Typically pays semi-annual coupons (North American convention)

◦ Subject to default risk

◦ Bond trust indenture stipulates collateral and specific terms

◦ Different “seniority” classes - Secured Bonds; Subordinated debentures

Who is the

target investor?

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Overall Bond Market

Generally speaking, the bond market can be divided into 6 sectors

(in both the US and Canada):

Government bond sector

Agency Sector

Municipal Sector

Corporate Sector

Asset-backed securities sector - ‘ABS’

Mortgage Sector - ‘ MBS’

The bond market is the total outstanding issuance from these sectors of

these instruments

Muni’s, Govi’s, T-bonds, MBS’, Provi’s, Corporates in market ‘lingo’

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Overall Bond Market

• Global bond market estimated to be USD $95 trillion 1 of outstanding

bonds

– US bond market is approximately USD $37 trillion 2

– Canadian Bond market is approximately CAD $2 trillion 3

Note the increased issuance of treasuries as a result of the financial crisis

1 source: Bank for International Settlements, quarterly review, June 2011. 2 source: Securities Industry and Financial Markets Association (SIFMA), April 2012. 3 source: PC Bond, February 2013. 4 source: SIFMA, February 2013.

312.4 380.7 571.6

745.2 853.3

746.2 788.5 752.3

1,037.3

2,074.9

2,304.0 2,103.1

2,308.8

0.0

500.0

1,000.0

1,500.0

2,000.0

2,500.0

2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012

4 Treasury Issuance - USD$ billions

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Overall Bond Market

The landscape of the Canadian bond market has changed significantly

over the last decade

The primary driver of this shift has been the rush by all levels of

government in Canada to join the global trend toward fiscal discipline

‘Balanced budgets’ have resulted in less borrowing by the federal

and provincial governments

Outstanding Government of Canada Bonds (all maturities)

Note: issuance of treasury bills increased 57%

and issuance of bonds increased 40% during the

financial crisis

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Overall Bond Market

With declining supply of government bonds, non-government borrowers

such as traditional corporate issuers to the more recently created "alphabet

soup" of fixed income securities (MBS, CMBS, ABS and so on) have been

quick to fill the bond supply pipeline

◦ Note the shift from government bond issuance to corporate

issuance

Government of

Canada

57%

Corporate

19%

Municipals

2%

Provincial

22%

Canadian Bond Sector Weight - 1999

Provincial

24%

Corporate

28%

Municipals

1%

Government of

Canada

47%

Canadian Bond Sector Weight - 2011

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Historical 10 year Canadian Government of Canada Bond Yields – 1998 - 2013

Second key driver for the shift away from government bonds… Interest Rates..

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NIM12 ‘Go’ Bloomberg = New Issue Monitor Canada

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NIM1 ‘Go’ Bloomberg = New Issue Monitor US

Bond call option – determined by dividing the new

issue credit spread by 4 (1/4 of the new issue

spread) = bond market convention

140bps/4=35 bps 17

Coupon is determined by

adding the yield of the

benchmark Government bond

to the credit (or default) spread

of 140 bps or 1.40%

(1 basis point = 1/100 of 1%)

‘Benchmark or Pricing Bond’

CAN = Gvt of Canada Bond

S/A = semi-annual

coupon payments

‘Bullet Structure’ =

entire principal

amount is repaid at

the maturity date

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Pepsico issued $1.25 billion of

bonds with a 10 year term to

maturity – all companies must

state a ‘use of proceeds’ i.e.

what will they do with the

money!

Pepsico is extending the

maturity of their debt (CP) and

‘fixing’ their rate of interest

‘Benchmark or Pricing Bond’

T is US Treasury Bond

About the Yield Curve

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The Nominal Yield Curve The nominal yield curve is defined by treasury bills or bonds issued by the

Federal government

Nominal = real interest rate + inflation

Each yield associated with a specific term to maturity is called the risk

free rate

Both Canada and the U.S. have a sovereign credit rating of ‘AAA’

◦ US government bonds downgraded to AA+ by S&P in August 2011

◦ US debt at $16 trillion (Globe – Sep 2012)

The bonds are backed by the “full faith and credit” of these governments

◦ Generally accepted by investors that the Canadian and US governments

will never default on their loan obligations = full powers of taxation

◦ The full faith and credit of these governments essentially confers risk-free

status to securities such as Government of Canada bonds and US

Treasuries

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Gov’t Yield Curve = min. rate of interest accepted by investors Short-end of the yield curve (up to 2 years) – monetary policy

Mid area of the yield curve (3-10 years)

Long end of the yield curve (over 10 years)

(YCRV Go Bloomberg)

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U.S. Canada

Divergent

monetary policy

Cda vs. US

reflected in the

short end of the

yield curve

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What do we observe and why do we care?

• We should notice that the yield curves indicate that the longer the term to maturity the higher the yield = a ‘normal yield curve’

• The ‘shape and steepness’ of the yield curve has implications for investors, economists, traders etc

– An ‘inverted’ yield curve indicates that the longer the maturity the lower

the yield

– A ‘flat’ yield curve is approximately the same for any maturity

Inversion typically to

the 5 year term to

maturity 22

Yield Curve Inversions

A classic yield curve inversion is precipitated by a major event

• In 2000/2001, the major event was the bursting of the dot-com bubble

• The yield curve inverts because it implies the market is expecting that the

economy will slow down

– Central banks will have to cut rates (likely aggressively) to stimulate growth

– Funds flow to the ‘mid’ area of the yield curve (safe haven)

• Central banks can only affect the “overnight rate”. The move of funds into the

long end is not typical because investors usually require that the higher risks

of borrowing long term should be compensated by higher returns

• Generally speaking the market predicts the state of the economy 6 months

forward

• The peak of the dot.com bubble was roughly March 2000 when the NASDAQ

composite reached its all time high

– In May of 2000, the Fed funds rate was at a high of 6.50% and was kept there until

year end. In January of 2001, the Fed cut rates by 50 bps to 6.00% and by another

50 bps by the end of January to 5.50%. By December 2001, the

overnight rate had been cut 10 times and stood at 1.75%

– http://www.federalreserve.gov/fomc/fundsrate.htm.

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Yield Curve Steepness – how to measure…

◦ A steep yield curve implies the beginning of an economic expansion -

inflationary

This type of curve can be seen at the beginning of an economic expansion (or

after the end of a recession)

In this case, economic stagnation will have depressed short-term interest rates;

the central banks will have aggressively lowered the overnight rates

Rates begin to rise once the demand for capital is re-established by growing

economic activity

2

4

(50)

(25)

0

25

50

75

100

125

Jan-97 Dec-97 Nov-98 Oct-99 Sep-00 Aug-01 Jul-02 Jun-03 May-04

Spr

ead

(in b

ps)

(50)

(25)

0

25

50

75

100

1255 vs. 10 Yr. GOCs

10 vs. 30 Yr GOCs

5/10 & 10/30 YEAR YIELD CURVE DIFFERENTIALS

5 vs. 10 Year GOCs

10 vs. 30 Year GOCs

Maximum 106.5 bps 73.4 bps

Minimum -17.6 bps -59.9 bps

Average 43.7 bps 30.2 bps

Current 73.80 bps 46.4 bps

These bonds are the most recently auctioned government bonds

and are used as a pricing benchmark by the financial markets

◦ They are the most traded in the secondary market and therefore the most liquid

Coupon rate

on the bond

Price where

you can buy

or sell the

bond

Yield to Maturity

associated with the

market price of the bond

On-the-run Government of Canada bonds

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Off-the-run Government of Canada bonds

‘Off the run

bonds can

be identified

by their

coupons

• Once the bonds are no longer used as a pricing benchmark by the market they

are considered ‘off-the-run’

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In practice, interpolation usually occurs between two bonds that are

usually considered ‘liquid’ to arrive at a yield for a particular date

◦ Note that GoC bonds all have a Mar 1, Jun 1, Sep 1 or Dec 1 coupon

date

The concept of interpolation also exists in the ‘swap’ or derivatives

market

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Interpolation - Interpolation is often used for pricing of primary

bonds when no government benchmark bond exists

Example of interpolation:

◦ What would be the benchmark yield on a bond to be issued September 1,

2010 and maturing September 1, 2016?

Step 1: find two close ‘on-the-run’/liquid government bonds

4.0% due June 1, 2016 and 4% due June 1, 2017

Yields of 2.97% and 3.17% respectively

Step 2: Calculate the number of days between the two bonds =365 days

Step 3: Yield difference between the two bonds is: 3.17%-2.97% = 20 bps

Step 4: this equates to 20 bps/36 5 days = 0.000005479 bps per day or

0.0005479%

Step 5: Find the number of days between the Jun 1 and Sep 1 = 92 days

Step 6: Calculate the basis points to be added to the lower yielding bond (4.00%

due Jun 1, 2016) = 92 days x 0.0005479 bps per day= 0.050410 % or 5 bps

◦ Yield on new Sep 1, 2016 bond = 2.97% + 0.05 % =3.02%

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Interpolation - Interpolation is often used for pricing of primary

bonds when no government benchmark bond exists

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Interpolated yield curve

Used to calculate a

Government yield to a specific

calendar date

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Interpolation – Not as common in the US given the supply of

US T-bonds issued

UST bond prices are quoted in dollars and fractions of a dollar. By market

convention, the normal fraction used for Treasury security prices is 1/32

Price on #63: 1.375% due Sep 2018 has a bid price of 97.625

A key function of the yield curve (the government curve) is to serve as a

benchmark for pricing all other bonds

◦ The coupon on any other bond will be composed of:

The benchmark yield + a credit spread

‘Credit spread’ or ‘Default risk premium’ is equal to the premium

necessary to compensate the investor for the risks associated with

investing in the bond

It is the difference between the coupon offered on the bond and the yield on the

Government reference bond

◦ Market convention for quoting yield spreads is in basis points (or bps)

1 bps is equal to 1/100 of 1% or 0.0001

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Importance of the Yield Curve

Moody’s S&P DBRS Summary Description

Aaa AAA AAA

highest credit quality, with exceptionally strong

protection for the timely repayment of principal

and interest

Aa1 AA+ AA(high) Superior credit quality, and protection of

interest and principal is considered high Aa2 AA AA

Aa3 AA- AA(low)

A1 A+ A(high) Good credit quality, and protection of interest

and principal is considered high A2 A A

A3 A- A(low)

Baa1 BBB+ BBB(high) Long-term debt rated BBB is of adequate

credit quality. Protection of interest and

principal is considered acceptable,

Baa2 BBB BBB

Baa3 BBB- BBB(low)

Ba1-Ba3 BB+/BB/BB- BBh/BB/BBl Considered low grade, speculative

B1-B3 B+/B/B- Bh/B/Bl Considered highly speculative

Caa CCC CCC May be in default, very speculative

D D D Default

Investment

Grade

High Yield

A large determinant of the credit spread will be the credit rating of the issuer

Credit ratings are provided by Moody’s, Standard & Poor’s, Dominion Bond

Rating Service or Fitch

◦ These rating agencies score “the probability of continued & uninterrupted

streams of interest & principal payments to investors”

Default

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Note the credit spread and the

credit rating on the Sprint 10

year bond offering