Introduction To Fixed Income Products: Charlotte Scott July 2007

Introduction to
Fixed Income
Products
Charlotte Scott
July 2007
Introduction to Fixed Income Products

Agenda
Characteristics of Bonds
Fixed Income Market Participants
Price and Yield
Fixed Income Product Types
Economic Dynamics: The Federal Reserve
The Bond Markets
Page 2
Introduction to Fixed Income
What is a Fixed Income product?

Instruments
that represent a loan, where the issuer is the

debtor and the investor is the lender
Investor expects to have the capital or principal returned
together with some sort of compensation (interest) for the
use of the principal
Page 3
Fixed Income Security
A fixed income security or commonly referred

to as debt
Short or long term obligation
Issuer/borrower agrees to pay a series of
cash flows or coupons
Over the life of the obligation to the
lender/investor
From investor point of view it is a loan
Page 4
Bond issuers borrow money (leverage)

Bondholders are not owners but rather
creditors
Bondholders receive the issuers promise to
repay debt service
Page 5
Issuers of Fixed Income products

Issuers
Corporations
Governments
Domestic
vs Foreign
Municipalities
Agencies
Whats
What
in it for the issuer and the investor?
are the risks?

Page 6
Terminology for Fixed Income

Par
Value
Face Value or Principal or Notional
$1,000
Maturity Date or Due Date
Quoted by mm/dd/yy
Date for return of principal and last interest payment
Interest Rate
Coupon rate, nominal yield
Percentage of Par
Stated annually, paid semi-annually
Page 7
Money Markets versus Bond Markets
Money Markets are instruments having maturities

less than one year
Bond markets are instruments having maturities
greater than a year.
Notes have maturities from 2 to 10 years
Bonds have maturities greater than 10 years
Page 8
Treasury
Bills
Commercial
Paper
Money
Markets
CDs
Interbank
Page 9
LIBOR
Source: isma.org
Page 10
Source: isma.org
Page 11
Source: bondmarkets.com
Page 12
Indenture
Formal Agreement between the issuer and the investor
Cash
Flows
Fixed rate
Variable Rate
Income Flow
Interest basis
Accrued Interest
Principal X Rate X Time
Page 13
Accruing Interest by Product

Type of Bond Payments per Days in Year Days in Month
Year
Settlement
Days
Corporate
Semi-Annual
360
30
Municipal
Semi-Annual
360
30
US Govt
Semi-Annual
365/366
Actual
Page 14
Accrued Interest
Buyer pays the seller the accrued interest
calculated by multiplying the coupon rate by the
number of days that have elapsed since the last
coupon
Start counting at: the last coupon date
Count up to but not including: settlement date of
the trade
Page 15
Accrued interest example:

Given: A XYZ corporate bond,
$1,000 par value, 8 % coupon,
has a due date of 5/15/08 is sold
on Monday, September 10 for
regular way settlement.
Days
of accrued interest:
Amount of Accrued Interest:

$85 X 118/360 = $27.86
Page 16
Months
Days
May
16
June
30
July
30
Aug
30
Sept
12
Total
118 days
Term
Short-term debt
Medium-term debt
Long-term debt
Proof
of Ownership
Bearer
Registered
Book Entry (dematerialized)
Page 17
Call provision
Repayment
option
Put
of principal prior to stated maturity, usually at issuers
provisions
Investor
has right to sell bond to issuer
Redemption
Security
Sinking
exchanged for cash value
Fund
Mandatory
retirement of principal according to maturity
Conversion
Allows
the exchange of a debt security or preferred stock for a

specified number of equity shares in the issuers corporation
Page 18
Fixed Income Market Participants

Investors
Institutional
Retail
Intermediaries
Investment
Banks
Primary Dealers
Dealers
Brokers
Banks
Industry
Service
Organizations
Utilities
or For-Profit Providers
Page 19
Market Participants and Cash Flows
Investors
Issuers
Intermediary
Page 20
International Bonds
Agencies
Euro Currency
Foreign
GNMA
Sallie Mae
ISSUERS
Federal
Governments
Local
Governments
Page 21
Corporations
Asset/Money
Managers
Pension Funds
INVESTOR
S
Buy Side
Mutual Funds
Insurance
Companies
Page 22
Commercial
Banks
Intermediari
es
Sell Side
Brokers
Dealers
Page 23
Primary versus Secondary Market
Primary Market The original or new issue

is sold in the market
Issuers and dealers or investors interact
directly
Page 24
Primary Market
Investors/Dealers
Issuers
In the US primary markets are

over the counter transactions
Page 25
Primary Market
US government issues notes and bonds through an auction

process. Must be a primary dealer to bid
Corporations will issue debt through an investment
bank/underwriter/syndication
Buy debt and accept risk of new issue: Earn a fee
Sell debt only: Earn a fee
Do both and get both fees
Page 26
Primary versus Secondary Market
Secondary Market Once the debt has been

initially placed it can be resold in the secondary
market.
Crucial for liquidity
Broker/dealer earns bid-offer spread
When issued market (WI)
Page 27
Secondary Market
Investors/Traders
Investors/Traders
Intermediary
In the US, the secondary market can be

OTC or exchange related transactions
Page 28
Issuer
Creditworthiness
Monetary Policy
Fiscal Policy
Determinan
ts of Rates
Issuer Tax
Status
Collateral
Backing issue
Page 29
Features
Call
Put
Price and Yields

Prices of fixed income instruments move in the opposite
direction of market price interest rates
Interest
Bond
Rates
Price
10%
94
9%
93
8%
92
7%
91
6%
90
5%
89
Page 30
Yield Calculations
Coupon or nominal yield
Current Yield
Annual Interest/ Market Price
Yield
to Maturity
The formula for the rule of thumb yield to maturity is a variation of

the current yield formula:
Discount
+
Years to Maturity
Annual Interest
OR
_
Premium
+
Years to Maturity
Tax-Equivalent
Yield
Page 31
Yield Curves
Correlates price and yield over time
Defines the term structure of interest rates
Shown as a graph of rates of return of the same credit
worthiness against maturities ranging from shortest to
longest available.
Page 32
Yield Curves
Positive
Yield Curves
Page 33
Yield Curves
Inverted
Yield Curves
Treasury Yield Curve
Treasury Yield Curve
10.50%
10.00%
9.50%
9.00%
8.50%
8.00%
7.50%
7.00%
6.50%
6.00%
5.50%
3
6
Mos.
Yr.
10
Maturities
Page 34
30
Fixed Income Product Types

Discount Securities
Short Term Debt
Discount Yields
Medium and Long Term Debt
Corporate Bonds
U.S. Government Bonds
Municipal Bonds
Page 35
Mortgage Backed Securities

Pass
Through Securities
Structural
characteristics of pass throughs

Pool of similar mortgages
Mortgage Servicing through cash disbursement
Factors affecting principal prepayments
Refinancing current rate versus contract rate
Housing demand demographic and economic factors
influencing housing stock turnover
Measuring prepayment speed
Page 36
Mortgage Backed Securities

Issuers
of Mortgage Backed Securities
The
Agencies - Ginnie Mae, Freddie Mac and Fannie Mae

conforming mortgages
GNMA Government National Mortgage Association
FHLMC Federal Home Loan Mortage Corporation
FNMA Federal National Mortgage Association
Private Issuers
Non-conforming mortgages jumbos, high loan to value, high
credit risk
Commercial and residential Whole Loans
Page 37
To reduce the uncertainties surrounding the cashflows generated by

pass-throughs, other securities were created
These securities are known as Real Estate Mortgage Investment
Conduits (REMICS) or
Collateralized Mortgage Obligations (CMOs)
Page 38
CMOs
Structured as a series of bonds (called classes or tranches) whose

cashflows are generated from the payments on a pool of mortgages,
or a pool of pass-throughs
CMOs are superior to pass-throughs because the pooled cashflows
were not simply passed through to the bondholders, but could be redistributed in ways that gave priority to some tranches in the CMO
structure over others
Page 39
Example
A CMO
structure with 3 tranches A,B, C
Bonds
from each tranche are sold to investors

The tranches share the interest portion of the payments made
from the pool of underlying mortgages on a pro-rata basis
However, the principal portion of the payments (including any
pre-payments) would be distributed via a hierarchy of claims
Page 40
Example
A CMO
structure with 3 tranches A,B, C
All
principal, including pre-payments, received are first distributed

to holders of the A Tranche until that tranche is retired
Once the A Tranche is retired, all principal and pre-payments
received are then distributed to holders of the B tranche, until that
tranche is retired
All mortgage payments would then be passed through to the C
Tranche holders until retirement
Page 41
A broad variety of individual underlyings have been

securitized:
Mortgages
Car loans
Credit card receivables
Student Loans
Uniformity: are the underlying cash flows homogeneous or not
Creditworthiness: how likely are they to be received
Page 42
P&I
Payments
Consumers
Sells
Autos
Provides
Loans
Auto Dealerships
Trust
Investors
True Sale
Of Loans
Loan Payments
Excess
Servicing
Loan
Payments
Unused
Funds
Special Purpose
Corporation
Sells
Loans
Loan
Payments
Provides
Credit
Enhancement
Credit-Reserve
Account
True Sale
Of Loans
Auto-Finance
Company
Page 43
Asset Backed Securities
Excess
Released
The Fixed Income Markets
Page 44
Fixed Income Markets
A highly decentralized, national network of securities dealers who

sell, trade, and make markets fixed income instruments
Fixed income trades are executed OTC between dealers rather than
on an exchange.
A handful of corporate bonds trade on the NYSE using the ABS
(Automated Bond System).
Dealers provide quotes (bids and offers) for the securities that they
make a market in.
Governed by the rules of the NASD
Page 45
Example of the challenge of a diverse Fixed Income Market!
US Treasuries
Highly liquid
Easy to value
Tight margins
Corporates
Moderate liquidity
Heterogeneous
Wider margins
Trade at spread
Municipals
Illiquid
Few dealers
Tax considerations
Page 46
Corporate Bond Market
The $4.3 trillion corporate bond market exceeds both the Treasury
and muni markets
Corporate bond dealers may specialize by high yield vs investment
grade
Specialize by the maturity range of the bond
TRACE (Trade Reporting and Compliance Engine), an NASD
system, now publishes trade date for the entire universe of corporate
bonds (approx. 29,000 issues)
Page 47
Government Securities Market
Universe of about 1,700 dealers

Volume is concentrated largely among 22 primary dealers and a
handful of interdealer brokers
Among the primary dealers, most trading activity is concentrated
among 5 to 10 dealers.
Trading activity includes dealer financing (repo) transactions and
outright purchases and sales on behalf of customers and for the
dealers own accounts
Page 48
Municipal Bond Market
Universe of about 2,700 dealers who are registered with the MSRB
(Municipal Securities Regulatory Board)
There are about 2 million separate issues of Municipal bonds
50,000 states and local entities issue muni bonds
Many issues trade very infrequently with little turnover
Page 49
Repo Processing
Why do we need a repo market?
Financing dealers market making activities

Short-term, safe investment
Liquidity for the bond markers
Cover short positions
Profit-making (Matched Book)
Putting securities out to work!
FOMC (Fed Open Market Committee) adjust money supply
Page 50
Repo
A repo (RP) is the sale of a security coupled with an agreement to
repurchase the security at a slightly higher price to reflect the interest
charge.
A reverse repo (RR) is the other side of the transaction, where the
security is being purchased with the agreement to sell it back.
Page 51
Repo
Example:
A government securities dealer, as part of their market-making activity,
purchases $10 million in par value of U.S. Treasury Bonds. The current
market value of these bonds is 97-11/32 or $9,734,375. The dealer
also pays the seller accrued interest of $125,000.
The net money due on the trade is:
$9,734,375.00
+ 125,000.00
$9,859,375.00
Page 52
Repo
Example (continued):
To finance the trade, the dealer sells the bonds in the repo market for
$9,859,375.00 with an agreement to buy them back the next day.
Assume a repo rate of interest of 2%. The dealer will repurchase the
securities at the original selling price plus interest. The interest he owes
is $9,859,375 X 2% X 1/360 = $547.74
The net money due on the closing leg of the repo will be
$9,859,375.00
+
547.74
$9,859,922.74
Page 53
Repo
Opening Leg
Same day Settlement
1. Repo out (deliver) bonds
1. Reverse in (receive) bonds
Bonds
2. Pay cash
2. Receive cash
Cash
Page 54
Repo
Closing Leg
Same Day Settlement
1. Reverse in (receive) bonds
1. Deliver bonds
Bonds
2. Receive cash
2. Pay cash
Cash
Page 55
Repo
Terminology
Opening Leg
Closing Leg
Hair cuts
Matched Book Repo
Tri-Party Repos
Page 56
Fixed Income Trading
Page 57
Fixed Income Trading

Fixed Income traders are grouped by product and term.
They are often positioned next to product specialty sales teams.
Inquiries from sales to trading are often conducted by outcry or
personal visit to the trader (e.g., MBS and Corporates).
Inquiries for Treasuries are increasingly transmitted electronically.
Interdealer brokers (IDBs) act as middlemen between bond dealers;
known as brokers brokers in the Corporate debt world.
Primary market includes underwriting activity for corporate and
municipal debt, and participation in the auctions for Treasury securities.
Page 58
Shopping the Street

Clients look for the best bid or offer price they can find
Call many dealers in a security to get the best price.
Client finds a market maker with a quote that is within his target range
Firm quote; On the wire
An assured bid or offer ready to trade now
Subject quote (or nominal quote)
An estimate of value, not an invitation to trade
Page 59
Shopping the Street

Sometimes the best bid or offer price is higher or lower than the client
would like.
Arriving at an actual sale price may involve a number of workout
quotes to negotiate and finalize the deal.
If no bids or offers are received, broker will advertise Bid wanted or
Offer wanted.
Trade execution may result from:
Trade directly with a counterparty

From dealers inventory
On an exchange (e.g., NYSEs ABS for corporates)
Interdealer broker; brokers broker
Electronic trading system
Page 60
Traditional Client-Dealer Bond Trading has been

Heavily Dependent on the Telephone
Client
Trader
Salespeople
at multiple
dealers
Salesperson
InterDealer
Broker
Client
Dealers
Trading
Book
Page 61
Electronic Multi- Dealer Offering System
TradeWeb
Lehman
Request Offerings
Inventory
&
Prices
Morgan Stanley
Buy-Side
Trader
Hit Bid / Lift Offer
Credit Suisse
Bear Stearns
Page 62
Interdealer Brokers (IDBs)

Collect dealer quotes
Post quotes to electronic services
Execute trades between dealers
Provide liquidity and anonymity
About 1/3 of dealer-to-dealer trades are executed through an IDB.
Examples: Cantor Fitzgerald, Garban/ICAP
Page 63
Inter-dealer Brokers (IDB)

Accept Order
Dealer
Dealer
Place Order
Advertise Order
Dealer
Inter-Dealer
Broker or IDB System
Receives commission
Retains dealer anonymity
Counterparty on both sides
Provides liquidity to the bond
market
Dealer
Dealer
Page 64

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Introduction to

Introduction to Fixed Income Products

Introduction to Fixed Income

What is a Fixed Income product?

that represent a loan, where the issuer is the

Introduction to Fixed Income

Fixed Income Security

A fixed income security or commonly referred

Introduction to Fixed Income

Bond issuers borrow money (leverage)

Introduction to Fixed Income

Issuers of Fixed Income products

in it for the issuer and the investor?

are the risks?

Introduction to Fixed Income

Terminology for Fixed Income

Introduction to Fixed Income

Money Markets versus Bond Markets

Money Markets are instruments having maturities

Introduction to Fixed Income

Introduction to Fixed Income

Introduction to Fixed Income

Introduction to Fixed Income

Introduction to Fixed Income

Introduction to Fixed Income

Accruing Interest by Product

Introduction to Fixed Income

Introduction to Fixed Income

Accrued interest example:

Amount of Accrued Interest:

Introduction to Fixed Income

Introduction to Fixed Income

of principal prior to stated maturity, usually at issuers

has right to sell bond to issuer

exchanged for cash value

retirement of principal according to maturity

the exchange of a debt security or preferred stock for a

Introduction to Fixed Income

Fixed Income Market Participants

Introduction to Fixed Income

Market Participants and Cash Flows

Introduction to Fixed Income

Introduction to Fixed Income

Introduction to Fixed Income

Introduction to Fixed Income

Primary versus Secondary Market

Primary Market The original or new issue

Introduction to Fixed Income

In the US primary markets are

Introduction to Fixed Income

US government issues notes and bonds through an auction

Introduction to Fixed Income

Primary versus Secondary Market

Secondary Market Once the debt has been

Introduction to Fixed Income

In the US, the secondary market can be

Introduction to Fixed Income

Introduction to Fixed Income

Price and Yields

Introduction to Fixed Income

Annual Interest/ Market Price

The formula for the rule of thumb yield to maturity is a variation of