File Name: cfa level 1 equity and fixed income .zip
A bond is a debt instrument that entitles the buyer to future cash flows from the issuing entity. Bonds can be issued by a variety of organizations, including companies, governments, and even supranational groups like the European Union.
Fixed income investments includes bonds, debenture, government debt and mortgage backed securities yes those very financial products that gained infamy in the aftermath of the crisis! It also includes certain derivatives that have other underlying Fixed Income securities. These type of securities are directly affected by and are therefore very sensitive to interest rates.
A bond is a debt instrument that entitles the buyer to future cash flows from the issuing entity. Bonds can be issued by a variety of organizations, including companies, governments, and even supranational groups like the European Union. Bonds are categorized into three primary sectors based on issuer and structure: Government, Corporate, and Structured Finance. Bonds are also categorized by the level of credit risk they have.
This typically involves periodic payments of the interest and then a final repayment of the original principal amount at the maturity date. It will describe all the important information such as the issuer, par amount, coupon rate and frequency, and any covenants. The covenants are rules specific to that bond issue that the borrowers and lenders agree to at the time of the bond issuance. The indenture will also outline whether the bond is secured or unsecured and what assets are backing the bond if it is secured.
Bonds can also contain credit enhancements to help decrease the credit risk, such as insurance against default, overcollateralization, or even reserve accounts that can be drawn against to make payments. Bonds are subject to numerous legal and regulatory requirements, and one categorization that determines how they are regulated is the domicile of the issuer in relation to where the issue takes place. The most common structure for a bond involves periodic fixed interest payments and a lump sum of the principal at the maturity date.
These periodic interest payments are known as coupon payments. There are also bonds that are amortizing, which means that each periodic payment includes both interest and repayment of part of the principal amount. The coupon rates for bonds can be either fixed or floating, which means that the interest payments will either remain consistent over time or change in relation to a specified benchmark rate. One of these is a call option. This is useful for issuers when interest rates drop, and they are able to repay an older bond with higher interest with funds from a new issue at the lower rates.
Bondholders may want to exercise this option if rates have increased, and they want to sell that bond and purchase newer bonds with higher yields. These give the right to convert the bonds into equity shares in the company in certain situations. As mentioned in the previous section, floating rates bonds differ from their fixed rate counterparts in that the coupon rate changes over time-based on movements of a specified reference rate.
Similar to equity securities, there are both primary markets where new bonds are sold to investors for the first time and secondary markets where existing bonds are bought and sold between investors for bond securities. There are a number of mechanisms by which new bonds are issued in primary markets. The investment bank takes on the risk of this price guarantee because they are responsible for buying any remaining bonds that they are unable to sell at that price.
They retain the ability to issue new bonds as part of that offering in the near future without going through a new registration. Secondary trading for bonds can take place either on an exchange or over-the-counter OTC. On an exchange, trade orders are submitted to the exchange and matched with other orders based on exchange criteria, similar to what one sees on an electronic stock exchange.
In OTC trading, buyers and sellers contact each other directly to negotiate trades. The vast majority of bond trading is done via OTC. The difference between the bid and ask quotes in the market for a specific bond the bid-ask spread is an indicator of the liquidity for that security.
The larger the spread, the less liquid that bond likely is. Compared to equity securities, individual bonds trade much less frequently and tend to have commensurately larger spreads. US government bonds are denoted differently depending on their time to maturity. Issues made with less than 1 year to original maturity are known as T-bills, while T-notes and T-bonds have longer maturities. T-bills are issued as discount notes, meaning that they are issued at a price less than par.
T-notes and T-bonds are more typical bonds that are issued at par. In addition to traditional corporate or government bonds, there are also several categories of bonds issued in conjunction with governments but are not considered government bonds. Non-sovereign bonds are those issued to help fund public projects but are not guaranteed by national governments.
They typically have low default rates but have higher yields than guaranteed government bonds. There are also quasi-government bonds that are also not guaranteed but often have an implied government backing. Examples of issuers of these bonds are the semi-government organizations Fannie Mae and Freddie Mac.
There are even bonds issued by agencies that exist in multiple countries which are known as supranational bonds. Companies issue debt as a way to get funding for investments in their operations. When companies need short-term funding, they can issue Commercial Paper, which consists of debt with maturities generally less than 3 months and as short as overnight.
Banks have additional sources of short-term funding available to them, such as Interbank Lending and Central Banks, where they can borrow or loan money with other banks for terms of less than 1 year. One source of funding for banks are Certificates of Deposit, wherein they offer higher rates to depositors in exchange for having a fixed period before the deposits can be withdrawn.
These consist of the sale of a security usually financial market securities and an agreement to buy back the security at a specified future date at an agreed-upon price. These are naturally collateralized because the asset involved in the repo agreement serves as collateral for the loan.
Similar to equity securities, the price of a bond should be the present value of the expected future cash flows. Unlike equity securities, these cash flows tend to be finite and known in advance. Especially for plain vanilla coupon bonds, the buyer will know the exact amounts and dates of the cash flows they will receive. This means that it is relatively straightforward to calculate the present value of those cash flows, discounted using the current market interest rate.
Since the market rate serves as the discount rate, we expect the price of a bond to decrease as rates increase, since it means we are more heavily discounting the cash flows. Intuitively, this should also make sense because a bond whose coupon rate is below the new market rate should be worth less than it was before since the investor could now sell that bond and buy another one with a higher coupon.
You will use the time value of money functionality on your calculator to solve for this value the same way that you solved for IRR values in the Quantitative Methods section.
Be sure to keep track of what you have this value set to because you will definitely see questions involving bonds with varying numbers of payments per year. The curriculum refers to this annual frequency of payments as the Periodicity. It is also important to note that the price of a bond moves closer to the par value as the maturity of the bond nears. Also, the prices of longer-term bonds vary more than those of shorter-term bonds. In addition to finding the Yield to Maturity for a given bond, you can also find its current price using spot rates.
This is a similar calculation except that you will use different discount rates for each cash flow that you are discounting. Bond prices can be quoted in two different ways due to the nature of their interest accruals.
The accrued interest is calculated by taking the next coupon payment and multiplying it by the percentage of the coupon period that has passed since the last payment:. In the actual-actual method, the exact number of calendar days that are in each month and year are used. As mentioned earlier, bonds do not trade as frequently as equities so it is more often necessary to calculate the correct current price for them.
One method is to estimate the market discount rate and price based on the quoted or traded prices of similar securities that have recently traded.
This method is known as Matrix Pricing. It utilizes the market prices of securities with similar maturities, credit quality, and other characteristics to calculate a price for a given security that may not have traded. Since matrix pricing using many securities is computationally intensive, you will likely only be asked to use a few securities in a question on this topic. For example, with quantitative factors like maturity, you can find the appropriate yield to maturity for a bond by finding the average of the yields to maturity for securities with a longer and shorter maturity.
In order to compare the yields of bonds with different payment frequencies, bond yields are typically annualized. This is the same calculation principle from the Quantitative Methods section. When you use the time value of money functionality on your calculator to find the yield to maturity, that value is already annualized. You will likely be asked to compare the yields for bonds that have similar characteristics but different periodicities.
To convert rates between different periodicities, we use the general formula:. For money markets instruments, bond yields to maturity are annualized but not compounded, and are quoted using non-standard rates discount rates and add on rates.
To compare the yields of money market instruments on the same basis, we have to use the bond equivalent yield. The bond equivalent yield is quoted on a day add-on rate basis and is obtained by converting one rate to another. Yield curves are upward sloping because longer-maturity bonds have higher yields, but the slope flattens out at longer maturities because the yield differences become much smaller for each additional time to maturity at the long end.
Par curves are calculated based on spot curves and represent the difference in yields due to changes in maturity but holding every other bond characteristic the same. Bond rates can be quoted in terms of spot rates or forward rates, depending on whether the bond funding is being provided right now or at some point in the future.
A spot rate applies when the bond is to be issued now and the rate will apply immediately, while the forward rate is used when the bond will be issued in the future. Implied forward rates are calculated based on spot rates. The implied forward rate is the rate that sets the current spot rate and the spot rate for the period covering both the current spot and forward periods equal.
For example, the implied forward rate for a 3-year bond to be issued 2 years in the future would be calculated as follows:. You can also create a curve of these forward rates extending along the maturity dates and this would be known as the Forward Curve. Asset-Backed Fixed Income Securities ABS are different than the bonds already covered here because, rather than being based on an amount lent to an issuer that they pay back over time, they are based on pools of assets that are securitized and combined into one fixed income security.
These are very common for mortgages and other consumer lending products since it allows these relatively smaller loan amounts to be bundled together to create fixed income assets large enough to be purchased by institutional investors. The pools of assets that underly an asset-backed security are held in legal ownership by an entity created just for that purpose rather than owned by the issuer.
The SPEs can sometimes use another organization as the servicer, in which case that servicer is the one that receives and distributes the cash flows even though the SPE maintains the ownership of the assets. ABS can be divided up into multiple classes of bonds based on characteristics like credit and default risk.
The more subordinated lower in rank a class is, the higher the coupon payments but also the higher the default risk. These classes typically function in a waterfall structure, where the cash flow distributions are made in order of class, starting with the most senior, and the default losses are assessed in the reverse order. Investors can choose the level of risk and yield they wish to expose themselves to by purchasing at different class levels.
One common source of assets for ABS bonds are mortgage loans. These are categorized as either prime or sub-prime depending on how creditworthy the borrowers and how risky the loans are. An important risk to consider in mortgage ABS is that of prepayment risk. Since many mortgage borrowers are able to pay their mortgages off early or refinance when rates go down, there is an increased risk that the ABS will lose assets early and the investor will have to reinvest that money into newer, lower yielding securities.
A potentially more costly risk regarding mortgages is borrowers defaulting and the properties being foreclosed upon. The ABS investor is entitled to proceeds from foreclosure sales but there is often a shortfall between those proceeds and the original value of the mortgage loan.
Mortgages are categorized by whether they are Agency or non-Agency.
page 46 page Equity and Fixed Income, CFA Program Curriculum, Volume 5 (CFA Institute,. ). Introduction to the Valuation of Debt Securities.
A bond is a debt instrument that entitles the buyer to future cash flows from the issuing entity. Bonds can be issued by a variety of organizations, including companies, governments, and even supranational groups like the European Union. Bonds are categorized into three primary sectors based on issuer and structure: Government, Corporate, and Structured Finance.
Level I is comprised of ten topics which are shown below. Each topic is further divided into readings which cover a specific area of that topic.