Fixed-income instruments

On the surface, MV analysis is not especially difficult to implement. For example, it is very easy to guess at future stock and bond returns and use historical variances and correlations to produce an optimum portfolio. It is not so simple to create a multidimensional portfolio consisting of multiple equity and fixed income instruments combined with tiltemative assets such as private equity, venture capital, hedge ftmds, and other wonders. Sophisticated applications require a lot of groundwork, creativity, and rigor. 

A bond is a debt capital market instrument issued by a borrower, who is then required to repay to the lender/investor the amount borrowed plus interest, over a specified period of time. Bonds are also known as fixed income instruments, or fixed interest instruments in the sterling markets. Usually bonds are considered to be those debt securities with terms to maturity of over one year. Debt issued with a maturity of less than one year is considered to be money market debt. There are many different types of bonds that can be issued. The most common bond is the conventional (or plain vanilla or bullet) bond. This is a bond paying periodic interest pay-... 

In this chapter, we will provide a basic description of the various types of fixed-income instruments encountered in the European markets as well as the definitions of some key terms and concepts that will assist the reader throughout the remainder of the book. Important groups of investors in these markets are briefly discussed in the last section of the chapter. 

We compare in Exhibit 23.16 the volatilities of a few selected euro and US dollar factors. The common denominator is that euro volatilities are less than their US dollar counterparts. This is true for all factors if we ignore the volatility bursts sometimes observed over a few months for some factors (for instance the Industrial A factor in Exhibit 23.16). The average level of systematic risk observed amongst euro-denomi-nated fixed income instruments is more generally low compared to other markets. Exhibit 23.16 shows one case where euro volatilities seem to be catching up with US levels. A more systematic analysis of how euro volatilities have recently evolved since 2002 would show that this is an exception. On average, euro volatilities have remained low with respect to US ones. Note that this is consistent first with the predictions of the swap factor model, euro spread levels and swap volatility being low compared to other markets. 

Most market participants are familiar with the concept of duration and its effect on the returns from fixed income instruments. However, the difference in the calculations of duration of a bond and a portfolio is worth noting. Most index and analytics providers (including Barclays Capital) calculate index and portfolio duration as the market value weighted duration of individual bonds that constitute the index or portfolio. The other measure, known as cash flow duration, calculates the duration based on the cash flow of the entire portfolio, using the internal rate of return (IRR) of those cash flows and then measuring the sensitivity of portfolio value to change in that IRR. 

Bonds are debt instruments that represent cash flows payable during a specified time period. They are essentially loans. The cash flows they represent are the interest payments on the loan and the loan redemption. Unlike commercial bank loans, however, bonds are tradable in a secondary market. Bonds are commonly referred to 3S fixed-income instruments. This term goes back to a time when bonds paid fixed coupons each year. That is... 

Since fixed-income instruments are essentially collections of cash flows, it is useful to begin by reviewing two key concepts of cash flow analysis discounting and present value. Understanding these concepts is essential. In the following discussion, the interest rates cited are assumed to be the market-determined rates. 

The modified duration and convexity methods we have described are only suitable for use in the analysis of conventional fixed-income instruments with known fixed cash flows and maturity dates. They are not satisfactory for use with bonds that contain embedded options such as callable bonds or instruments with unknown final redemption dates such as mortgage-backed bonds. For these and other bonds that exhibit uncertainties in their cash flow pattern and redemption date, so-called option-adjusted measures are used. The most common of these is option-adjusted spread (OAS) and option-adjusted duration (OAD). The techniques were developed to allow for the uncertain cash flow structure of non-vanilla fixed-income instruments, and model the effect of the option element of such bonds. 

When evaluating convertible securities, the investor will consider the expected performance of the underlying shares, the future prospects of the company itself, and the relative attraction of the bond as a pure fixed-income instrument in the event that the conversion feature proves to be worthless. The investor will also take into account the credit quality of the issuer, the yield give-up suffered as a result of purchasing the convertible over a conventional bond, the conversion premium ratio, and the fixed-income advantj e gained over a purchase of the underlying shares in the first place. 

This discussion covers the main factors affecting bond returns in the European fixed income market, namely, the random fluctuations of interest rates and bond yield spreads, the risk of an obligor defaulting on its debt, or issuer-specific risk, and currency risk. There are also other, more subtle sources of risk. Some bonds such as mortgage-backed and asset-backed securities are exposed to prepayment risk, but such instruments still represent a small fraction of the total outstanding European debt. Bonds with embedded options are exposed to volatility risk. However, it is not apparent that this risk is significant outside derivatives markets. 

Part One describes fixed-income market analysis and the basic concepts relating to bond instruments. The analytic building blocks are generic and thus applicable to any market. The analysis is simplest when applied to plain vanilla default-free bonds as the instruments analyzed become more complex, additional techniques and assumptions are required. 

In this equation the percentage for C is not expressed as a decimal. Current yield ignores any capital gain or loss that might arise from holding and trading a bond and does not consider the time value of money. It calculates the coupon income as a proportion of the price paid for the bond. For this to be an accurate representation of return, the bond would have to be more like an annuity than a fixed-term instrument. 

A zero-coupon bond is the simplest fixed-income security. It makes no coupon payments during its lifetime. Instead, it is a discount instrument, issued at a price that is below the face, or principal, amount. The rate earned on a zero-coupon bond is also referred to as the spot interest rate. The notation P t, T) denotes the price at time r of a discount bond that matures at time T, where T >t - The bond s term to maturity, T - t, is... 

This part also considers the primary fixed-income derivative instruments. These are not securities in the cash markets and are fixed-income derivatives (or interest rate derivatives) in the synthetic markets. 

Up to now, the discussion has centered essentially on plain vanilla securities, bonds with a fixed-coupon and maturity date. However, much of the fixed-income markets revolves around more complex instruments, arranged to meet specific investor requirements. These include ... 

FRNs in general are highly interest rate sensitive. This is because the leverage involved in the coupon calculation endows them with the highest duration of any instrument traded in the fixed-income market. The note in figure 13.1, for example, has a calendar maturity of three years. As shown in FIGURE 13.2, however, its modified duration is much higher. 

A comprehensive yet succinct coverage of fixed income debt market instruments, which will be instructive for investors as well as analysts and bankers. ... 

The banking and liquidity crisis of 2007-2009, which led to global recession and the first examples of deflation in developed economies since the Second World War, had a profound effect on financial markets. Its aftermath is an opportune time to update a textbook on fixed-income securities and derivatives, as we can review the impact that the crisis had on the instruments concerned. 

This constant demand for tax-exempt instruments means prices for municipal bonds tend to remain steadier,- municipal bonds tend to have more subdued highs and lows than other fixed-income securities. In order to compare a municipal bond s return with that of other types of fixed-income securities, it is... 

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