1_rsm430 _ Overview of FI Market
Transcript of 1_rsm430 _ Overview of FI Market
Session 1: Overview of Fixed Income Markets & Securities
Instructor: Fotini Tolias
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RSM 430H1F Course Overview
Instructor: Fotini Tolias
Email Address:
Office: RSM 432
Office Hours: TBD
Assignment #1: 10% due October 16th
Midterm 30% on October 25th
Assignment #2: 10% due December 2nd
Final exam: 50% TBD
Assignments may be done in groups of 2 to 4 students
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Session/Date Topic
1: Sept. 9 Overview of Fixed Income Markets: overview of the markets and
participants, the yield curve and interpolation Chapters 1,2
2: Sept. 16 Building the Yield Curve: Government Bond Auctions - single vs. multiple
price and inflation protected securities (RRBs, TIPS)- begin bond features
Chapters 1,2/Class
Notes
3: Sept. 23 Overview of Securities (fixed rate, floating rate and convertible bonds) and
Bond valuation
Chapters 3, 19
(selected pages)
4: Sept. 30 Other yield measures and bonds with embedded options Chapter 3, Class
Notes
5: Oct. 7
Understanding the Yield Curve
Spot Rates, Forward Rates, Bootstrapping and bond stripping Chapters 5
Oct. 14 THANKSGIVING MONDAY - NO CLASSES
Wed. October 16th - Assignment #1 due by 4:00 p.m. at Rotman Commerce Office
Week of Oct. 21 Friday, October 25th - Mid Term Exam
6: Oct. 28 Measuring Interest Rate Risk
Duration, Convexity, PV of a basis point, basic yield curve trades Chapter 4
7: Nov. 4
Corporate Bond Market : Bond payment structures (bullet, amortizing and
defeasance), rating agencies, shadow rating a company and bond
covenant analysis
Chapters 7, 20
Nov. 11/12 STUDY BREAK - NO CLASSES FOR MONDAY SECTIONS
8: Nov. 18 Corporate Bond Market: Documentation and Offering methods Chapters 7, 20
9: Nov. 25 Corporate Credit Spreads and Interest Rate Models
(KMV, Merton)
Chapter 16/Class
Notes
Mon. December 2nd - Assignment #2 due by 4:00 p.m. at Rotman Commerce Office
10: Dec. 2 Securitization – Structuring Basics (incl. CDO’s) , Asset Backed
Securities
Chapter 15/ Class
Notes
11: Dec. 4 Securitization - Mortgage Backed Securities/Covered Bonds
Chapter 13/ Class
Notes
Who Am I? Fotini Tolias, B.Comm., MBA
• 20 years of experience on a fixed income trading floor
• Spent over 10 years working for 2 major Canadian dealers
• Covered corporate clients to issue bonds into the capital
markets
• Helped Canadian companies raise money for their financial
requirements
– Sectors covered included financial institutions, media & telecom
and special situations
– Deal size ranged from $50 million to $1 billion
– Full time instructor at Rotman since 2009 teaching primarily
fixed income in undergraduate, MBA and Master of Finance
programs
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Linking bond theories with practice - use of 'mini' cases
in class to demonstrate/apply theory to real issuers
Understanding of bond mathematics, bond pricing and
relative value of product across the credit spectrum
Building knowledge of current fixed income markets and
issues
Structuring deals - ability to understand and analyze a
prospectus and bond trust indenture
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Major asset classes for investing ◦ Equities
◦ Fixed income Securities
◦ Other asset classes
Real Estate, Private Equity, Hedge Funds, Commodities a.k.a
“Alternative Asset Classes”
What distinguishes a fixed income security from equity or stock?
◦ A fixed income security is a financial (and contractual) obligation of an
entity that entitle the holder to receive a pre-determined stream of
future cash flows
The entity that promises to make the payments is called the issuer
◦ Failure to pay may result in ‘default’
The investor in the fixed income security is a creditor (or lender)
The instrument has a ‘maturity date’ where afterwards it is retired
and ceases to exist
Equity/Preferred Shares
Cannot force bankruptcy if no dividend paid
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Who Issues Bonds?
1. Governments and their agencies – sovereign bonds
2. States, provinces and municipalities
3. Companies (senior secured debt, senior unsecured debt,
subordinated debt)
4. Commercial Banks (senior unsecured debentures as deposit
liabilities, subordinated debt for capital purposes)
5. Special-purpose vehicles or trusts (ABS, MBS)
6. Foreign institutions (Maple or global bonds)
Purpose?
Raise capital..i.e. $$$$
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Who Buys Bonds?
1. Governments, foreign institutions, Sovereign wealth funds
2. Pensions funds
3. Insurance companies
4. Mutual funds , hedge funds and asset management companies
5. Commercial banks
6. Retail investors
Purpose?
Objectives differ depending on the risk profile and risk appetite of the buyer
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Overview of Issuers and some characteristics Federal or Provincial Government (s) Treasury Bills
◦ Pure discount securities placed through auction ◦ Maturity 13, 26 and 52 weeks
Treasury Notes and Bonds
◦ Semi-annual pay coupons (North American convention) ◦ Maturity 2, 3, 5, 7, 10 (notes) and 30 years (bonds) ◦ Sold in denominations of $1,000
Agency Securities - Issued by different organizations
In the US:
◦ Federal National Mortgage Association (Fannie Mae)
◦ Federal Home Loan Mortgage Corporation (Freddie Mac)
◦ Student Loan Marketing association (Sallie Mae)
Agencies have at least two common features:
1. were created to fulfill a public (social) purpose
2. the debt of most agencies is not guaranteed by the government (until
recently at least) i.e. Canadian government borrows on behalf of Crown
corporations (CMHC)
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Overview of Issuers and some characteristics Municipal Bonds
Issued by state and local governments
◦ Exempt from federal income tax
◦ Exempt from (issuing) state local tax
Market is virtually non-existent in Canada because of no preferential tax
treatment for the coupon
Types of “munis”
◦ General obligation bonds: backed by the “full faith & credit” of the issuer
(taxing power)
◦ Revenue bonds (riskier): issued to finance specific projects (airports,
hospital, etc.)
Corporate Bonds
◦ Typically pays semi-annual coupons (North American convention)
◦ Subject to default risk
◦ Bond trust indenture stipulates collateral and specific terms
◦ Different “seniority” classes - Secured Bonds; Subordinated debentures
Who is the
target investor?
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Overall Bond Market
Generally speaking, the bond market can be divided into 6 sectors
(in both the US and Canada):
Government bond sector
Agency Sector
Municipal Sector
Corporate Sector
Asset-backed securities sector - ‘ABS’
Mortgage Sector - ‘ MBS’
The bond market is the total outstanding issuance from these sectors of
these instruments
Muni’s, Govi’s, T-bonds, MBS’, Provi’s, Corporates in market ‘lingo’
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Overall Bond Market
• Global bond market estimated to be USD $95 trillion 1 of outstanding
bonds
– US bond market is approximately USD $37 trillion 2
– Canadian Bond market is approximately CAD $2 trillion 3
Note the increased issuance of treasuries as a result of the financial crisis
1 source: Bank for International Settlements, quarterly review, June 2011. 2 source: Securities Industry and Financial Markets Association (SIFMA), April 2012. 3 source: PC Bond, February 2013. 4 source: SIFMA, February 2013.
312.4 380.7 571.6
745.2 853.3
746.2 788.5 752.3
1,037.3
2,074.9
2,304.0 2,103.1
2,308.8
0.0
500.0
1,000.0
1,500.0
2,000.0
2,500.0
2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012
4 Treasury Issuance - USD$ billions
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Overall Bond Market
The landscape of the Canadian bond market has changed significantly
over the last decade
The primary driver of this shift has been the rush by all levels of
government in Canada to join the global trend toward fiscal discipline
‘Balanced budgets’ have resulted in less borrowing by the federal
and provincial governments
Outstanding Government of Canada Bonds (all maturities)
Note: issuance of treasury bills increased 57%
and issuance of bonds increased 40% during the
financial crisis
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Overall Bond Market
With declining supply of government bonds, non-government borrowers
such as traditional corporate issuers to the more recently created "alphabet
soup" of fixed income securities (MBS, CMBS, ABS and so on) have been
quick to fill the bond supply pipeline
◦ Note the shift from government bond issuance to corporate
issuance
Government of
Canada
57%
Corporate
19%
Municipals
2%
Provincial
22%
Canadian Bond Sector Weight - 1999
Provincial
24%
Corporate
28%
Municipals
1%
Government of
Canada
47%
Canadian Bond Sector Weight - 2011
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Historical 10 year Canadian Government of Canada Bond Yields – 1998 - 2013
Second key driver for the shift away from government bonds… Interest Rates..
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NIM12 ‘Go’ Bloomberg = New Issue Monitor Canada
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NIM1 ‘Go’ Bloomberg = New Issue Monitor US
Bond call option – determined by dividing the new
issue credit spread by 4 (1/4 of the new issue
spread) = bond market convention
140bps/4=35 bps 17
Coupon is determined by
adding the yield of the
benchmark Government bond
to the credit (or default) spread
of 140 bps or 1.40%
(1 basis point = 1/100 of 1%)
‘Benchmark or Pricing Bond’
CAN = Gvt of Canada Bond
S/A = semi-annual
coupon payments
‘Bullet Structure’ =
entire principal
amount is repaid at
the maturity date
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Pepsico issued $1.25 billion of
bonds with a 10 year term to
maturity – all companies must
state a ‘use of proceeds’ i.e.
what will they do with the
money!
Pepsico is extending the
maturity of their debt (CP) and
‘fixing’ their rate of interest
‘Benchmark or Pricing Bond’
T is US Treasury Bond
About the Yield Curve
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The Nominal Yield Curve The nominal yield curve is defined by treasury bills or bonds issued by the
Federal government
Nominal = real interest rate + inflation
Each yield associated with a specific term to maturity is called the risk
free rate
Both Canada and the U.S. have a sovereign credit rating of ‘AAA’
◦ US government bonds downgraded to AA+ by S&P in August 2011
◦ US debt at $16 trillion (Globe – Sep 2012)
The bonds are backed by the “full faith and credit” of these governments
◦ Generally accepted by investors that the Canadian and US governments
will never default on their loan obligations = full powers of taxation
◦ The full faith and credit of these governments essentially confers risk-free
status to securities such as Government of Canada bonds and US
Treasuries
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Gov’t Yield Curve = min. rate of interest accepted by investors Short-end of the yield curve (up to 2 years) – monetary policy
Mid area of the yield curve (3-10 years)
Long end of the yield curve (over 10 years)
(YCRV Go Bloomberg)
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U.S. Canada
Divergent
monetary policy
Cda vs. US
reflected in the
short end of the
yield curve
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What do we observe and why do we care?
• We should notice that the yield curves indicate that the longer the term to maturity the higher the yield = a ‘normal yield curve’
• The ‘shape and steepness’ of the yield curve has implications for investors, economists, traders etc
– An ‘inverted’ yield curve indicates that the longer the maturity the lower
the yield
– A ‘flat’ yield curve is approximately the same for any maturity
Inversion typically to
the 5 year term to
maturity 22
Yield Curve Inversions
A classic yield curve inversion is precipitated by a major event
• In 2000/2001, the major event was the bursting of the dot-com bubble
• The yield curve inverts because it implies the market is expecting that the
economy will slow down
– Central banks will have to cut rates (likely aggressively) to stimulate growth
– Funds flow to the ‘mid’ area of the yield curve (safe haven)
• Central banks can only affect the “overnight rate”. The move of funds into the
long end is not typical because investors usually require that the higher risks
of borrowing long term should be compensated by higher returns
• Generally speaking the market predicts the state of the economy 6 months
forward
• The peak of the dot.com bubble was roughly March 2000 when the NASDAQ
composite reached its all time high
– In May of 2000, the Fed funds rate was at a high of 6.50% and was kept there until
year end. In January of 2001, the Fed cut rates by 50 bps to 6.00% and by another
50 bps by the end of January to 5.50%. By December 2001, the
overnight rate had been cut 10 times and stood at 1.75%
– http://www.federalreserve.gov/fomc/fundsrate.htm.
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Yield Curve Steepness – how to measure…
◦ A steep yield curve implies the beginning of an economic expansion -
inflationary
This type of curve can be seen at the beginning of an economic expansion (or
after the end of a recession)
In this case, economic stagnation will have depressed short-term interest rates;
the central banks will have aggressively lowered the overnight rates
Rates begin to rise once the demand for capital is re-established by growing
economic activity
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4
(50)
(25)
0
25
50
75
100
125
Jan-97 Dec-97 Nov-98 Oct-99 Sep-00 Aug-01 Jul-02 Jun-03 May-04
Spr
ead
(in b
ps)
(50)
(25)
0
25
50
75
100
1255 vs. 10 Yr. GOCs
10 vs. 30 Yr GOCs
5/10 & 10/30 YEAR YIELD CURVE DIFFERENTIALS
5 vs. 10 Year GOCs
10 vs. 30 Year GOCs
Maximum 106.5 bps 73.4 bps
Minimum -17.6 bps -59.9 bps
Average 43.7 bps 30.2 bps
Current 73.80 bps 46.4 bps
These bonds are the most recently auctioned government bonds
and are used as a pricing benchmark by the financial markets
◦ They are the most traded in the secondary market and therefore the most liquid
Coupon rate
on the bond
Price where
you can buy
or sell the
bond
Yield to Maturity
associated with the
market price of the bond
On-the-run Government of Canada bonds
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Off-the-run Government of Canada bonds
‘Off the run
bonds can
be identified
by their
coupons
• Once the bonds are no longer used as a pricing benchmark by the market they
are considered ‘off-the-run’
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In practice, interpolation usually occurs between two bonds that are
usually considered ‘liquid’ to arrive at a yield for a particular date
◦ Note that GoC bonds all have a Mar 1, Jun 1, Sep 1 or Dec 1 coupon
date
The concept of interpolation also exists in the ‘swap’ or derivatives
market
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Interpolation - Interpolation is often used for pricing of primary
bonds when no government benchmark bond exists
Example of interpolation:
◦ What would be the benchmark yield on a bond to be issued September 1,
2010 and maturing September 1, 2016?
Step 1: find two close ‘on-the-run’/liquid government bonds
4.0% due June 1, 2016 and 4% due June 1, 2017
Yields of 2.97% and 3.17% respectively
Step 2: Calculate the number of days between the two bonds =365 days
Step 3: Yield difference between the two bonds is: 3.17%-2.97% = 20 bps
Step 4: this equates to 20 bps/36 5 days = 0.000005479 bps per day or
0.0005479%
Step 5: Find the number of days between the Jun 1 and Sep 1 = 92 days
Step 6: Calculate the basis points to be added to the lower yielding bond (4.00%
due Jun 1, 2016) = 92 days x 0.0005479 bps per day= 0.050410 % or 5 bps
◦ Yield on new Sep 1, 2016 bond = 2.97% + 0.05 % =3.02%
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Interpolation - Interpolation is often used for pricing of primary
bonds when no government benchmark bond exists
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Interpolated yield curve
Used to calculate a
Government yield to a specific
calendar date
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Interpolation – Not as common in the US given the supply of
US T-bonds issued
UST bond prices are quoted in dollars and fractions of a dollar. By market
convention, the normal fraction used for Treasury security prices is 1/32
Price on #63: 1.375% due Sep 2018 has a bid price of 97.625
A key function of the yield curve (the government curve) is to serve as a
benchmark for pricing all other bonds
◦ The coupon on any other bond will be composed of:
The benchmark yield + a credit spread
‘Credit spread’ or ‘Default risk premium’ is equal to the premium
necessary to compensate the investor for the risks associated with
investing in the bond
It is the difference between the coupon offered on the bond and the yield on the
Government reference bond
◦ Market convention for quoting yield spreads is in basis points (or bps)
1 bps is equal to 1/100 of 1% or 0.0001
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Importance of the Yield Curve
Moody’s S&P DBRS Summary Description
Aaa AAA AAA
highest credit quality, with exceptionally strong
protection for the timely repayment of principal
and interest
Aa1 AA+ AA(high) Superior credit quality, and protection of
interest and principal is considered high Aa2 AA AA
Aa3 AA- AA(low)
A1 A+ A(high) Good credit quality, and protection of interest
and principal is considered high A2 A A
A3 A- A(low)
Baa1 BBB+ BBB(high) Long-term debt rated BBB is of adequate
credit quality. Protection of interest and
principal is considered acceptable,
Baa2 BBB BBB
Baa3 BBB- BBB(low)
Ba1-Ba3 BB+/BB/BB- BBh/BB/BBl Considered low grade, speculative
B1-B3 B+/B/B- Bh/B/Bl Considered highly speculative
Caa CCC CCC May be in default, very speculative
D D D Default
Investment
Grade
High Yield
A large determinant of the credit spread will be the credit rating of the issuer
Credit ratings are provided by Moody’s, Standard & Poor’s, Dominion Bond
Rating Service or Fitch
◦ These rating agencies score “the probability of continued & uninterrupted
streams of interest & principal payments to investors”
Default
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Note the credit spread and the
credit rating on the Sprint 10
year bond offering