Debt Markets and Interest Rates

Introduction to Fixed Income Securities

Lecture 1: Learning Objectives
• Introduction to fixed income market
• Bond properties
• Risks inherent in fixed income securities

© Your Name, 2019 2

Fixed Income Securities
• Fixed Income Securities are assets that
contractually specify future CF’s (or at
least a formula) that they ‘promise’ to pay.
• vs. equity, which makes no promises regarding
future dividend payments
Examples:
– Treasuries
– Corporate bonds (‘promise’ vs. default)
– Floating rate bonds (formula vs. fixed coupon)
– Convertible bonds (exchange for equity) 3
US Bond Market: Components
• SIFMA ($ Billions)

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Topics to be Discussed:

Treasuries and related securities

– Bills, Notes, Bonds
– Repurchase agreements (Repo)
– Collateralized lending (leverage)
– Treasury Inflation Protected Securities (TIPS)
– Treasury Strips
– Forward rates (vs. expected future spot rates)

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Securities to be Discussed
• Inverse relation between prices and yields
– Relation holds by definition, not by “causality”

• Ex: time-0 price of zero that pays $T1 at date-T.

PT(0) = 1 / (1 + yT)T

• Yields {yT} as a function of maturity T define

Term Structure of Interest Rates, or Yield Curve

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Securities to be Discussed
Defaultable Bonds:
• Default risk / credit spreads
• Credit Default swaps (CDS)
• Collateralized Debt Obligations (CDO)
• Sovereign risk

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Securities to be Discussed
Mortgage-Related Securities
• Mortgage loans
• Securitization: (MBS)
• Mortgage derivatives
– Collateralized mortgage obligations (CMO)
– Interest only (IO)
– Principal only (PO)

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Securities to be Discussed
Miscellaneous
• Floaters, inverse floaters
• Fed Fund Futures
• Swaps
• Callable bonds
• LIBOR transition to secured overnight floating rate
(SOFR)
• https://www.jpmorgan.com/commercial-banking/insights/the-global-move-away-from-LIBOR

• Green bonds
• Agency bonds
• Municipal bonds
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Topics to be discussed
Miscellaneous
• Duration, convexity
 Immunization (i.e., hedge interest rate risk)
• Theories of yield curve
Dynamic yield curve model

• Pension obligations
• Federal Reserve balance sheet
US default risk
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Bond Features
Indenture:
– Contract between issuer and bondholder
– coupon rate, maturity, payments per year

 Positive covenants (actions firms must do)

 Maintain sufficient liquidity to pay bondholders
 Submit to periodic audits
 Negative covenants (restrictions on firms)
 Limit future debt issuances
 Limit asset sales 11
Bond Features
• Time to Maturity:
– # years over which CF’s are paid
• Principal = Face Value = Par Value
– Amount that issuer agrees to pay at maturity
• Coupon Rate:
– % face value to be paid as annual interest
– in US, typically semi-annual payments

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Bond Features
• Fixed rate bonds
– coupon rate (and thus, all CF’s) fixed

• Floating rate bonds

– coupons move with benchmark interest rates
– ex: adjustable-rate mortgages (ARM’s)

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Bond Features
Q? are prices of fixed or floaters more volatile?

A! floating rate bonds are very insensitive to

changes in interest rates because CF’s
move in the same direction as discount rates y:

• In contrast, CF’s don’t adjust for fixed-rate bonds

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Floating Rate Bond
• Can specify so that price(floater) = 1
always….
• Principal = 1,
• Set (floating coupon)t equal to discount rate
= yt.

• 1-period to maturity T:
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Floating Rate Bond
• Can specify so that price(floater) = 1 always….
• Principal = 1,
• Set (floating coupon)t equal to discount rate = yt.

• 2-periods to maturity T:

• repeat argument (Dynamic Programming)

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Floaters and Inverse Floaters
Floating rate: SOFRt + 1%
Inverse floating rate: 14% - SOFRt
Case 1: if future SOFRt = 5%
– Floater receives (5% + 1%) = 6%
– Inverse floater receives (14% - 5%) = 9%
Case 2: if future SOFRt = 9%
– Floater receives (9% + 1%) = 10%
– Inverse floater receives (14% - 9%) = 5%

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Floaters and Inverse Floaters
• Securitization: repackage CF’s of existing
securities to create new securities (Financial Engineering)
• Ex: create (floater / inverse floater) from
two coupon bonds (C = 7.5% , F = $4100 )

Date 1 2 3 4
1 coupon bond 7.5 7.5 7.5 107.5
2 coupon bonds 15 15 15 215

Floater (S + 0.01) (100)(S + .01) (100)(S + .01) (100)(S + .01) 100 + (100)(S + .01)
Inverse (0.14 – S) (100)(.14 – S) (100)(.14 – S) (100)(.14 – S) 100 + (100)(.14 – S)
sum 15 15 15 215
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Floaters and Inverse Floaters
Q? Rank floater, inverse floater, and fixed-
coupon
bond in terms of volatility.

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Floaters and Inverse Floaters
Q? Rank floater, inverse floater, and fixed-coupon
bond in terms of volatility.
A!
Floater: (y, CF) move in same direction
 low volatility
Coupon bond: (CF constant)
 moderate volatility
Inverse floater: (y, CF) move in opposite directions
 high volatility
 Orange County bankruptcy.
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Bond Features
Amortization feature
 Principal partly repaid over life of bond
 Mortgages
 Sinking fund provision

Embedded options
Call: gives issuer right to retire debt early

Put: gives bondholder right to sell bond at

par on select dates
Convertible: gives bondholder right to exchange
bond for stock 21
Bond Features
Q? For fixed (C, F), order prices
• Callable bond
• Puttable bond
• Option-free bond

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Bond Features
Q? For fixed (C, F), order prices
• Callable bond
• Puttable bond
• Option-free bond
A!
• Call option belongs to firm  lowers bond price
• Put option belongs to bondholder  raise bond price

 Pput > Pno option > Pcall

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Risks Inherent in Bonds
• Interest Rate Risk
• Reinvestment Risk
• Call Risk
• Default Risk
• Inflation Risk
• Exchange Rate Risk
• Liquidity Risk
• Volatility Risk

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Interest Rate Risk
• If investor sells bond prior to maturity date,
value of the bond depends upon prevailing
interest rates.

– If rates rise, bond prices will fall, and

investor will lose money

– If rates fall, bond prices will rise, and

investor will make money
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Interest Rate Risk: Example
• T = 1Y, zero coupon bond (default-free).
• Required rate of return = 4%.
• Original investment = $01000

Q1) Determine face value on bond

Q2) Required rates of return immediately

jump to 5%, and investor forced to sell.
Determine loss on investment.

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Interest Rate Risk: Example

A1) Face Value = ($01000)(1.04) = $11040

 Whatever happens to required rates of
return, face value never changes

A2) After rates increase to 5%, bond value drops:

 Agent loses: (990.48 – 1,000.00) = -$09.52

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Reinvestment Rate Risk
• If investor receives CF’s earlier than desired
holding period, the rate at which she will be
able to reinvest her CF’s is unknown today.
 If rates fall in interim, then the reinvestment
rate will be below today’s prevailing rates.
• Reinvestment rate risk moves in the opposite
direction of interest rate risk.
 Combined, two effects can cancel each other
Immunization takes advantage of this

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Reinvestment Rate Risk: Example
• Agent $01000 to invest, 2Y horizon. Today, can:
1) purchase a 2Y zero with 5% yield.
2) Purchase a 1Y zero with a 5% yield and
reinvest the proceeds one year from now
into another one-year bond.

Q1? What is year-2 wealth of 1st strategy?

Q2? What is year-2 wealth of 2nd strategy?

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Reinvestment Rate Risk: Example
A1! V2 = ($01000) (1.05)2
= $21102.50

( > $21100.00, due to compounding of interest)

A2! V2 = ($01000) (1.05) (1 + y1,2)

-- Cannot determine: depends on prevailing

one-year market rate one year from now (y1,2)

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Call Risk:
• Call provision allows issuer to retire debt
before maturity date.
• Issuer will exercise option when firm can
reissue debt at lower interest.
 General decline in market interest rates.
 Leverage reduction due to increase in firm value
• Call provision exposes bondholder to potential
reinvestment-risk
• Homeowners refinance mortgage = call option
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Default Risk:
• Default risk is risk that promised payments
(coupon and/or principal) will not be paid

• Judicial Protection:
– US Corporations
 Chapter 11: bankruptcy / reorganization
 Chapter 7: liquidation

– Sovereign
 repeated game issues
https://voxeu.org/article/how-creditor-lawsuits-are-reshaping-sovereign-debt-markets
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Inflation Risk:
• Even if promised future CF’s are default-free,
purchasing power of these CF’s is not.

 Ex: US Treasury, maturity T = 1Y, yield y = 2%.

 If inflation = 1% over the next year,

purchasing power increased (2% - 1%) = 1%

 If inflation = 3% over the next year,

purchasing power decreased (2% - 3%) = -1%

• Investors lost purchasing power in 1970’s, 2020’s

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Inflation Risk:
• Nominal interest rates increase with
expected inflation E[Infl]

rnom  rreal + E[Infl] + “risk premia”

 Countries with higher expected inflation
tend to have high interest rates

• Treasury inflation-protected Securities

(TIPS) introduced to hedge inflation risk
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Exchange Rate Risk:
• US citizen purchases a T = 1Y zero, with
face value F = €1100.
– Even if bond CF’s guaranteed when measured
in €1, its value measured in $1 is not.

– If X1 is the future ($1/€1) exchange rate, then

$1value of bond at T= 1 is:

W1 = $1 (100 X1 )

 Since X1 unknown at time-0, so is W1.

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Exchange Rate Risk:
• Can eliminate FX risk via forward contract:
 Commit to exchange future €1 for future $1
 Forward Rate determined by no-arbitrage argument

Forward Market
$1 €1

US Bond Market Euro Bond Market

$0 €0

Foreign Exchange Market 36

Exchange Rate Risk:
• Can eliminate FX risk via forward contract:
 Commit to exchange future €1 for future $1

• No arbitrage  Covered interest rate

parity:
1) local risk-free rate (r$)
2) foreign risk-free rate (r€ )
3) today’s FX rate (X) (units ($0/€0))
4) the forward FX rate (F) (units ($1/€1)) 37
Liquidity Risk:

• Prices do not always reflect “fundamentals”

• Security prices with nearly identical CF’s may differ

 During financial crisis, large spread between

corporate bond spreads and credit default swap
(CDS) spreads.
 On-the-run vs. off-the-run spreads vary.

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Volatility Risk:
Option prices increase with volatility….

Q? What impact does increase in interest

rate volatility have on a callable bond?

Q? What impact does increase in interest

rate volatility have on a puttable bond?

Q? What impact does increase in stock

volatility have on a convertible bond?
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Volatility Risk:
• Price(bond with option) = ( Price(bond) ± Price(option) ),
where sign (± ) depends on who owns option

Due to an increase in volatility….

A1! Callable bond price will decrease

A2! Puttable bond price will increase

A3! Convertible bond price will increase

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Repo Market (Repo)
• Repurchase Agreements

• Buy security $100; agree to sell back later at

predetermined price [ $100 (1 + r) ]
 Equivalent to secured (~ collateralized) lending
 r is the interest rate of the loan
 ‘Hair cut’ taken from collateral (~pawn shop)

Reverse Repo: sell security, agree to buy back

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Repo Market (Repo)
• Off-the-run Treasury collateral can secure a
loan at general collateral rate
• On-the-run Treasury collateral “on special”
– Allows owner to borrow at lower rate
– Helps justify higher price

• Repo important source of financing for dealers

– Opportunity to create leverage
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Leverage Effect: Example

Define:
 E = equity (i.e., own money)
 D = debt (i.e., amount borrowed)
 V = (D + E) = Investment

 Leverage increases gains/losses by a

factor:
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Leverage Effect: Example
• Binomial investment return: gain/lose 20%
– R = (R, R) = (1.2, .8)
• E = $100
• D = $0, $100, $400  (L = 0, 0.5, 0.8)
– Assume interest-free loan

Leverage 0.0 0.5 0.8

Wealth $120 $140 $200
Wealth $80 $60 $0

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