Welcome to the Jungle: Fixed Income Topics

Welcome to the Jungle: Fixed Income Topics November 21, 2004 Zachary Emig MBA Class of 2005 Ross School of Business Finance Club

II. Duration Today’s Agenda III. Yield Curves and Credit Spreads IV. Swaps I. What is fixed income? V. Securitized Products

What Is Fixed Income? Technically, the word “fixed income” means a security that has a set payment on a set sequence of days; i.e. straight debt. The way it is used today, it means “any financial security that is not related to equity (stocks).” This includes: Treasury Bonds Mortgage Backed Securities Commodities Corporate Bonds Credit Derivatives And much, much, more! Interest Rate Options Foreign Exchange

Fixed Income Covers a Lot! As you can see, there are many product areas that fall under the fixed income umbrella. Which makes sense, because …Fixed Income rules the world (or at least is where most of investor money is at).

Corporates $0.4T Market Capitalization The US is one of, if not the, most equity friendly country in the world. That said, compare market capitalizations: NYSE $11.7 Trn Nasdaq$3.1 Trn ABS $1.7 T Munis $1.9 T Agency $2.7 T Treasury* $3.7 T Corporate$4.6 T Mortgage$8.7 T What about monthly trading volume: Treasuries$9.6 T Agency MBS$3.9 T Agency Debt $1.5 T NYSE $0.8 T NYSE NASDAQ $0.6 T Nasdaq

Market Capitalization • It is very hard to find official capitalization, volume data on fixed income securities. • For trading volume, took average daily volumes and multiplied by 20 trading days in a month. • Didn’t include: derivative trading volumes (both equity and FI), foreign exchange, commodities (FI). • The point: Both domestically and globally, FI markets dwarf equity markets in capital and volume. http://www.nyse.com/pdfs/movolume0410.pdf http://www.nasdaq.com/newsroom/stats/Performance_Report.stm http://www.bondmarkets.com/collection.asp?colid=191 http://www.bondmarkets.com/story.asp?id=296, ?id=96, ?id=1209, ?id=304, ?id=323

Duration • One of the most important concepts to know is duration, which is basically the sensitivity of a bond’s price to interest rate movements. • There are several closely related versions of duration, but it’s usually defined as the % change in a bond’s value for a percentage change in yield (measured in basis points). • Duration also represents the weighted average of all payments of the bond. For zero coupon bonds, duration=time to maturity. For coupon paying bonds, duration will be less than the time to maturity. http://www.investorwords.com/1602/duration.html

Duration Example 5 year bond, non-callable, 4% annual coupons, $100 par. Using DCFs: Vary the interest rates a bit: Divide the % change in price by the bp change in rates:

Duration Example (cont.) Often, a graph of a bond’s price versus yield is helpful to understand duration. Duration is essentially the slope at a point on the P/Y line. Note that duration is different for different bonds. Also note that duration changes with interest rates; this “2nd derivative” is called convexity; for large swings in rates, it can play a factor in prices.

Real World Use: DV01 For convenience, most traders use DV01 (PVBP): the dollar change in the bond price for a 1bp move in yield (very similar to yield). This is the Bloomberg Yield Analysis (YA) for the 10yr Treasury Note.

DV01 in Action On Nov. 16, at 8:30, the government published the PPI numbers, which came in much hotter than expected. The yield on the 10yr benchmark Treasury immediately jumped 4.6bp DV01 x 4.6bp = Price 0.08103 x 4.6bp = $0.373 …=12/32nds.

DV01 in Action As expected, the price dropped by 37¢ ($12/32). …A trader long $50MM of 10 years just lost 27¢ x 50,000 = $18,637. Ouch.

Yield Curves Generically, a “yield curve”, is simply a plot of the current yields at different maturity points. When speaking of the yield curve, most traders mean the US Treasury yield curve, since Treasuries are the “riskfree” benchmark for all debt instruments. Bloomberg command: YCRV

Yield Question By the way, what is yield? I would answer that it is the periodic discount rate that, when applied to every payment in a bond’s cash flow, returns the exact same price as the current market price.

Credit Spread In the FI world, many products are traded on a “spread” off the Treasury yield curve. The credit spread is the difference in AAA corporate debt yields and Treasury yields; it is a real-time measurement of the credit risk tolerance of the market.

Breakeven Inflation Comparing the Treasury curve versus the TIPS (Treasury Inflation Protected Securities) yield curve reveals the breakeven inflation level expected by the market. A word of caution on TIPS: they are a fairly new product, and do have some liquidity issues that could lead to mispricing.

Swap Spread Other interesting spreads to observe: Agency spread and swap spread.

Swaps: At their most basic As their name implies, swaps are simply contractual agreements between two counterparties to exchange different cash flows. • The number of swaps are greatly expanding. A truncated list: • Currency swaps • Interest rate swaps • Credit Default Swaps • Volatility Swaps • Total Return Swaps ISDA: For interest rate swaps, rate options, and currency swaps, at mid-year 2004, the notional amount outstanding was: $164.49 Trillion http://www.isda.org/statistics/recent.html#2004mid

Interest Rate Swaps • Interest rate swaps (often called vanilla swaps) are simply exchanges of a fixed rate of interest for a floating rate, both paid on a fixed notional amount. • Things to remember: • Buying (going long) a swap = paying fixed rate, receiving floating • Selling (going short) a swap = paying floating, receiving fixed

Securitization • Securitization was one of the biggest financial innovations of the last 40 years. • Definition: transforming illiquid/non-financial products into tradable financial securities. • Two most common methods: • Pooling: using large pools of securities to diminish the illiquidity/risk of a single one. • Tranching: dividing cash flows into separate “tranches” that have different risk levels, in order to target differing investor appetites for risk.

Individual Mortgage Individual Mortgage Individual Mortgage Individual Mortgage Individual Mortgage Individual Mortgage Individual Mortgage Individual Mortgage Individual Mortgage Individual Mortgage Individual Mortgage Individual Mortgage Individual Mortgage Individual Mortgage Individual Mortgage Individual Mortgage Individual Mortgage Individual Mortgage Individual Mortgage Individual Mortgage Individual Mortgage Mortgage Backed Securities • The history of MBS is an excellent example of both processes. • Problems with investing in individual mortgages: small size (to an institutional investor) and prepayment risk (at the “whim” of the homeowner). • In the late 70s and early 80s, Mortgage Pass-Thrus were popularized: securities whose coupons were supported by pools of [numerous] mortgage securities. MBS Pass-Thru Issuer (Fannie Mae, Freddie Mac, I-Banks) Pass-Thru Investors

Individual Mortgage Individual Mortgage Individual Mortgage Individual Mortgage Individual Mortgage Individual Mortgage Individual Mortgage Individual Mortgage Individual Mortgage Individual Mortgage Individual Mortgage Pass-Thru Individual Mortgage Individual Mortgage Individual Mortgage Individual Mortgage Individual Mortgage Individual Mortgage Individual Mortgage Individual Mortgage Pass-Thru CMOs • The next step in securitization was tranching. • CMOs = Collateralized Mortgage Obligations. • Rather than divide all the pooled mortgage cash flows equally among investors, CMOs divide them into separate “tranches” of securities with different payment profiles. • Commonly, the different tranches receive different timing of payments. Tranche A Investors First 18mos payments CMO Issuer (I-Banks) 18mos-36mos Tranche B Investors 36mos+ Tranche C Investors

II. Duration Today’s Agenda III. Yield Curves and Credit Spreads IV. Swaps I. What is fixed income? V. Securitized Products ~ Fin ~

Welcome to the Jungle: Fixed Income Topics