CFA Level 1 (2009) - 5

Study Session 15

Cross-Reft:rence to CFA Institute Assigned Reading #61 - Risks Associated With Investing in Bonds

9.	A straight 5% coupon bond has two years remaining to maturity and is priced at
	$981.67 ($1,000 par' value). A putable bond, which is the same in every respect

as the straight bond except for the put provision. is priced at 101.76 (percent of par value). With the yield curve Hat at 6%, what is the value of the embedded pUt option?

A.$17.60.

B.$26.77.

C.$:3'5.93.

10.Which of the following is least likely to Lillunder the heading of event risk with respect to fixed-income securities?

A.A change in rate regulation.

B.One firm's acq uisi tion by another.

C.A Federal Reserve decrease in money supply.

11.Which of the following 5-year bonds has the highest il1lerest rate risk'

A.A floating-rate bond.

B.A zero-coupon bond.

C. A ')UA)fixed-coupon hondo

12.An investor is concerned about interest rate risk. Which of the following three bonds (similar except for yield and maturity) has the least interest rate risk? The bond with:

A.5% yield and 1O-year maturity.

B.5% yield and 20-year maturity. e. 6% yield and IO-year maturity.

13.Which of the following statements about the risks of bond investing is mmt

accurate?

A.A bond rated AAA has no credit risk.

B.A bond with call protection has volatility risk.

e.A U.S. Treasury bond has no reinvestment risk.

14.Which of the following securities will have the least reinvestment risk for a long-term investor?

A.A lO-year, zero-coupon bond.

B.A 6-month T-bill.

e.A 3D-year, prepayable amortizing bond.

15.A 2-year, zero-coupon U.S. Treasury note is least likely to have:

A.inflation risk.

B.currency risk. e. volatility risk.

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©2008 Kaplan Schweser

5mdy Session I 5

Cross-Reference to CFA Institute Assigned Reading #61 - Risks Associated With Investing in Bonds

ANSWERS - CONCEPT CHECKERS

I.B The percentage price change, based on duration is equal to -5.4 x (-0.2%) ~ 1.08%.

The ncw price is 1.0108 x 985 = $995.64.

2. A An increase in volatility will increase the value or the call option and d<:<.:rease the valuc of a callable bond. A putable bond will increasc in value. The valuc 01'option-frcc bonds will be unaffeered.

3.B A z.ero-coupon bonel, as a security, has no reinvestment risk because there are no cash flows prior to maturity that must be reinvested. A double-A bond has some (small) default risk. Zero-coupon honds have the most interest rate risk for a given maturity.

IJ. C The duration is computed as (()!lows:

.	'	percclIlage change in pricc
dUralllll1		---------- . -------
		change j n yield as a decimal

2.50	')	21J Ij 'x,
102.
-- _ .. _.... _--		4.88
O. no ':i		n.5%1

':i. C Embedded options reduce duration/interl'st rate risk.

6.B The duration of a Aoating-rate bond is higher the greater the time lag until the next coupon paymcntlreset date. The greatest duration/interest rate risk is, thererore. immediately after the coupon has been reset.

7.B The approximate dolbr change in price is compured as rollows:

dollar price change = --5.47 x 0.02 x 986.30 = -$107.90

8.B The option value is the differencc between the value of an option-free bond and the corresponding price of the callable bond. Its value is computed as:

call option value = $981.67 - $917.60 = $64.07

9.C The value of the embedded put option is the difference between the price of the putable bond and the price of the straight bond. So it is computed as:

option value = $1,017.60 - $9RI.()7 = $35.93

10. C Event risk refers to events that can impact a firm's ability to pay its debt obligations that are separate from market risks. The Fed's actions can impact interest rates, but this is a market risk faeror, not event risk.

1 J. B The zero-coupon bond will have the greatest duration of any of the three bonds and, as such, will be subject ro the greatest interest ratc risk.

12.C Interest rate risk is inversely related to the yield and directly relatcd to maturity. All else equal, the lower the yield, the greater the interest rate risk. All else equal, the longer the maturity, the greater the interest rate risk. This bond has the highcr yield and the sharrer maturity, and thus has the lowest interest rare risk.

13. B A Treasury bond pays semiannual coupon interest and, therefore, has reinvestment risk. A triple-A rated bond can lose its AAA rating, so ir has downgrade risk, a component of credit risk. A bond with a call feature has volatility risk even when the call cannot be

©2008 Kaplan 5chweser

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Srudy Session 15

Cross-Reference to CFA Institute Assigned Reading #61 - Risks Associated With Investing in Bonds

exercised immediarely. The call feature srill has value (to the issuer), and its value will be affected by volatility changes.

14.A A I O-year, zero-coupon bond has no cash flows prior 10 maturity 10 reinvest while rhe entire amount invested in 6-month bills must be reinvested twice each year.

15.C It will have inflation (purchasing power) risk. It will have currency risk to non-U.S. dollar investors. Volatiliry risk only applies to bonds with embedded oprions.

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©2008 Kaplan Schweser

The following is a review of rhe Analysis of fixed Income Investments principles designed to address the

learning outcome statements set forth by CFA Institute®. This topic is also covered in:

OVERVIEW OF BOND SECTORS AND

INSTRUMENTS

Study Session I 5

EXAM Focus

This review introduces the various types of fixed income securities and a fair amount of terminology relating to fixed Income securities. Pay special attention to the mechanics of these securities; that is, how they pay, when they pay, and what they pay. The additional information is nice, but likely not crucial. Try to gain enough understanding of the terms listed in the karning outcome statements so that you will understand them when they are used in

a question. Much of this material is unlikely to be tested by itself; however, knowing the basics about Treasury securities, mortgagebacked securities, and municipal securities is important as a foundation for much of

the material on debt securities that		follows,
as well as for the	more detailed	material
on fixed income	valuation and risk that
is contained in the Level 2 and		Level 3
curricul urn.

LOS 62.a: Describe the features, credit risk characteristics, and distribution methods for government securities.

Bonds issued by a country's central government are referred to as sovereign bonds or sovereign debt. The sovereign debt of the U.S. government consists of U.S. Treasury securities, which are considered to be essentially free of default risk. The sovereign debt of other countries is considered to have varying degrees of credit risk. Sovereign debt can be issued in a country's own domestic market, another country's foreign bond market, or in the Eurobond market.

Sovereign debt is typically issued in the currency of the issuing country, bur can be issued in other currencies as well. Bond rating agencies, such as Standard and Poor's, rate sovereign debt based on its perceived credit risk, often giving different ratings to sovereign debt denominated in the home currency (local currency) and to the sovereign debt of the same country denominated in foreign currency.

Professor's Note: Remember that it is often easier for a country to print currency (expand the money supply) in order to meet obligations denominated in the home currency than it is to exchange the local currency fOr a fixed amount offoreign currency. Thus, local currency sovereign debt often receives a higher rating than the foreign currency denominated debt ofthe same country.

©2008 Kaplan .Schweser

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Scudy Session 15

Cross-Reference to CFA Institute Assigned Reading #62 - Overview of Bond Sectors and Instruments

There arc four prim;]ry methods used by central governments to issue sovereign deb!.

I.Regular cycle auction-single price. Under this method the debt is auctioned periodically according 10 a cycle and the highest price (lowest yield) at which the entire issue to be auctioned can be sold is awarded to all bidders. This is the system used by the U.S. Treasury.

2.Regular cycle auction-multiple price. Under this mcrhod, winning bidders receive the bonds at the price(s) that they bid.

3.An ad hoc auction system refers to a method where the central governmenr auctions new securities when it determines market conditions are advantageous.

4.A tap system refers to the issuance and aucrion of bonds identical to previously issued bonds. Under this system, bonds are sold periodically, not according ro a

regular cycle.

. _ -------------- _ . ---

l.OS 62.b: Describe the types of securities issued by the U.S. Department or the 'Treasury (e.g., bills, notes, bonds, and inflation protection securities), and differentiate between on-the-run and off-the-run Treasury securities.

Treasury securities (Treasuries) are issued by the U.S. Treasury. Because they are backed by the full faith and credit of the U.S. government, they are considered to be free

from credit risk (though they're still subject to interest rate/price risk). The Treasury issues three distiner types of securities: bills, notes and bonds, and inflation-protected secun ties.

Treasury bills (T-bills) have maturities of less than one year and do not make explicit interest paymenrs, paying only the face (par) value at the maturity date. T-bills are sold at a discount to par value and interest is received when the par value is paid at maturity (like zero-coupon bonds). The interest on T-bills is sometimes called implicit interest since the interest (difference between the purchase price and the par value) is not made in a separate "explicit" payment, as it is on bonds and notes. Securities of this type are known as pure discount securities.

•There are three maturity cycles: 28, 91, and 182 days, adjustable by one day (up or down) due to holidays. They are also known as 4-week, 3-month, and 6-month T-bills, respectively.

•Periodically, the Treasury also issues cash management bi11s with maturities ranging from a few days to six months to help overcome temporary cash shortages prior to the quarterly receipt of tax payments.

Treasury notes and Treasury bonds pay semiannual coupon interest at a rate that is fixed at issuance. Notes have original maturities of 2, 3, 5, and 10 years. Bonds have origi nal maturities of 20 or 30 years.

Prior to 1984, some Treasury bonds were issued that are callable at par five years prior to maturity. The Treasury has not issued ca11able bonds since 1984.

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Study Session 15

Cross-Reference to CfA Institute Assigned Reading #62 - Overview of Bond Sectors and Instruments

Treasury bond and note prices in the secondary market arc quoted in percenr apJ 32nds

		5
or I % of face value. A quote of 102-5 (sometimes 102:5) is 102% plus - % of par,
which for a $100,000 bce value T-bond, translates to a price of:		32
1102	+ -~-]%)X $100,000 = 1.0215G25 X $1 00,000 = $102,156.25
L	:n

Since 1997, the U.S. Treasury has issued Treasury Inflation-Protected Securities (TI PS).

Currently, inflation-protected 5- and 10-year notes and 20-year bonds arc offered by the Treasury. The details of how TIPS work arc:

•TIPS make semiannual coupon inrcrest paymenrs at a rate fixed at issuance, just like

notes and bonds.

The par value of TIPS begins at $1,000 and is adjusted semiannually for changes in the Consumer Price Index (CPl). If rhere is deflation (falling price levels),

rhe adjusred par value is reduced for lhal period. The fixed coupon rale is paid semiannually as a percenrage of the illflatio/l (/(lju.,tcd pal" /1fI/1I1'.

Any increase in the par value from the inflation adjustment is taxed as income in the yeu of the adjustmenr;

__	stated coupon rate
lIPS coupon payment =	inflation-adjusted par value X ---~'------­
	2

1:01' example, consider a $100,000 par value TIPS with a 3% coupon rate, set at issuance. Six monrhs later the annual rate of inflation (CPI) is 4%. The par value will be increased by one-half of the 4% (i.e., 2%) and will be 1.02 x 100,000 = $102,000.

'1"he first semiannual coupon will be one-half of the 3% coupon rate times the inflation adjusted par value: 1.5% x 102,000 = $1,530. Any percentage change in the CPI over rhe next 6-monlh period will be used to adjust the par value from $102,000 to a new inflation-adjusted value, which will be multiplied by 1.5% to compute the next coupon payment.

If the adjusted par value (per bond) is greater than $1,000 at maturity, the holder receives the adjusted par value as the maturity payment. If the adjusted par value is less than $ 1,000 (due to deflation), holders receive $1,000 at maturity as this is the minimum repayment amount.

On-the-Run and Off-the-Run Treasury Securities

Treasury issues are divided into two categories based on their vintage:

•On-the-run issues are the most recently auctioned Treasury issues.

•Off-the-run issues are older issues that have been replaced (as the most traded issue) by a more recently auctioned issue. Issues replaced by several more recent issues are known as well offthe-run issues.

©2008 Kaplan Schweser

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Study Session 15

Cross-Reference £0 CFA Institute Assigned Reading #62 - Overview of Bond Sectors and Instruments

The distinction is that the on-the-run issues are more actively traded and therefore more liquid than off-the-run issu~s. Market prices of on-the-run issues provide better

information about curren t market yields.

LOS 62.c: Describe how strippcd Trcasury securities arc created. and d.istinguish betwecn coupon strips and principal sHips.

---- ._--~-------_._--_._-----

Since the Us. Treasury does not issue zero-coupon notes and bonds, investment bankers began stripping the coupons from Treasuries to create zero-coupon securities of various maturities to meet investor demand. These securities are termed stripped Treasuries or Treasury strips. In 1985, the Treasury introduced the Separate Trading of Registered Interest and Principal Securities (STRIPS) program. Under this program. the Treasury issues coupon-bearing notes and bonds as it normally does, but then it allows certai n government securities dealers to buy large amounts of these issues, strip the coupons from the principal, repackage the clsh Haws, and sell them separately as zero-coupon bonds, at discounts to par value.

1-'or example, a 1O-year T-note has 20 coupons and one principal payment; these 21 cash Haws can be repackaged and sold as 21 different zero-coupon securities. The stripped securities (Treasury strips) are divided into two groups:

•Coupon strips (denotecl as ci) refers to strips created from coupon payments stripped from the original security.

•Principal strips refers to bond and note principal payments with the coupons stripped off. Those derived from stripped bonds arc denoted bp and those from stripped notes np.

Professor's Note: While the payments on coupon strips and principal strips with the same maturity date are identical, certain countries treat them differently for tax purposes, and the)1 often trade at slightly different prices.

STRIPS are taxed by the IRS on their implicit interest (movement roward par value), which, for fully taxable investors, results in negative cash Haws in years prior to matUrity. The Treasury STRIPS program also created a procedure for reconstituting Treasury notes and bonds from the individual pieces.

LOS 62.d: Describe the types and characteristics of securities issued by U.S. federal agencies.

Agency bonds are debt securities issued by various agencies and organizations of the U.S. government, such as the Federal Home Loan Bank (FHLB). Most agency issues are not obligations of the U.S. Treasury and technically should not be considered the same as Treasury securities.

Even so, they are very high quality securities that have almost no risk of default.

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Study Session 15 Cross-Reference to CFA Institute Assigned Reading #62 - Overview of Bond Sectors and Instruments

There are two lypes of federal agencies:

I

1.Feriemffy related institutions, such as the Governmenr National Morrgage Association (Ginnie Mac) and the Tennessee Valley Authority (TVA), which are owned by the U.S. governmenr and arc exempt from Securities and Exchange Commission (SEC)

registration. In general, these securities are b3cked by the full faith and credit of' the U.S. government, except in the case of the TVA and Private Export Funding Corporation. Essen tjally, these securities are free from credi t risk.

2.Government sponsored enterprises (GSEs) include the Federal Farm Credit System, the Federal Home Loan Bank System, the Federal National Mortgage Association (Fannie Mae), the Federal Home Loan Bank Corpor3tion (heddie Mac), and the Student Loan Marketing Association (Sallie Mae). These arc privately owned, but publicly charrered organizations, 3nd were created by the U.S. Congress. They issue their securities directly in the marketplace and expose investors to some (albeit very little) credit risk.

Debentures are securities that 3re not backed by collateral (i.e., they arc unsecured).

CSEs commonly issue debentures. These are of nun)' maturity structures and can be

COUPOJl interest paying securities or Jiscounr secmilies (referred to as bills).

LOS 62.e: Describe the types and characteristics of I1lortgage-bac\,cd securities and explain the cash flow, prcp,lyments, and prepayment risk for cach lYl'C.

Mortgage-backed securities (MBSs) are backed (secured) by pools of mortgage loans, which not only provide coffateral but also the cash flows to service the debt. A mortgagebacked security is any security where the collateral for the issued security is a pool of mortgages.

The cash Rows from a mortgage are differenr from the cash flows of a coupon bond. Mortgage loans are amortizing loans in that they make a series of equal payments consisting of the periodic interest on the outstanding principal and a partial repayment of the principal amount. Residential real estate mortgages arc typically for 30 years and consist of 360 equal monthly payments. In the early years, the greater portion of the payment is interest, and the final payment, after 30 years, is almost all principal.

~~ Professor's Note: Amortizing loans and amortization schedules are covered in the \~,~ Study Session on Quantitative Methods.

The Government National Mortgage Association (GNMA), the Federal National Mortgage Association (FNMA), and the federal Home Loan Mortgage Corporation (FHLMC) all issue mortgage-backed securities. All three are sponsored by the U.S. government and they are known now by the names Ginnie Mae, Fannie Mae, and Freddie Mac. Each purchases mortgages from lenders to provide funds for mortgage loans. The agencies issue three types of mortgage-backed securities: mortgage passthrough securities, collateralized mortgage obligations, and stripped mortgagebacked securities. This process of combining many similar debt obligations as the collateral for issuing securities is called securitization. The primary reason for mortgage

©2008 Kaplan Schweser

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StuJy Session 15

Cross-Reference to eFA Institute Assigned Reading #62 - Overview of Bond Sectors and Instruments

securirization is ro increase rhe debt's arrraetiveness to investors and to decrease invesror required rares of return, increasing the availability of funds for home mortgages.

There are three types of cash /lows from a mortgage: (l) periodic interest, (2) schdubl repayments of principal, and (3) principal repayments in excess of scheduled principal payments. Borrowers (issuers of mortgages) rypically have the right to pay additional principal amounts withour penalty, reducing rhe outstanding principal amount and rhereby reducing futme interesr cash Hows. [I'the borrower sells the property backing the mortgage, rhe entire principal amount is repaid at one time. Because lhe borrower can accelerate principal repayment, the owner of a mortgage has prepayment risl,.

Prepaymenr risk is similar to call risk excepr that prepayments may be part of or all of the outsranding principal amount. This, in turn, subjects rhe mortgage holder to reinvesrment risk, as principal may be repaid when yields for reinvestment are low.

Ginnie Mal', Fannie Mae, and Freddie Mac all guaraIHCl' rhe timely payment of scheduled inreresr and principal paymenrs from rheir mortgage-backed securities. They are able to do this because rhey only purchase or underwritc loans that conform [0 certain srandards regarding borrow('f credir ratings, loan size, and rhe rario of each loan to lhe value of thc propnty secming it.

A mortgage passthrough security passes the payments made on a pool of mortgages through proportionally to each securiry holder. A holder of a mortgage passthrough security rhar owns a ] % portion of the issue will receive a 1% share of all rhe monthly cash flows from all rhe mortgages, afrer a small percentage fee for adminisrration is deducred. Each monthly payment consisrs of interesr, scheduled principal payments, and prepayments of principal in excess of rhe scheduled amount. Since each holder receives

a percentage of all cash flows, a mortgage passthrough securiry has prepaymenr risk as a single mortgage would, bur there is S0111e diversihGltion benefir from rhe pooling of

hundreds or thousands of mortgages. Since prepayments tend to accelerate when interest rares fall, due to the refinancing and early payoff of exisring mortgage loans, security holders can expect to receive grearer principal paymenrs when mortgage rates have decreased since the mortgages in the pool were issued.

Collateralized mortgage obligations (CMOs) are created from mortgage passthrough certificares and referred to as derivative mortgage-backed securities, since they are derived from a simpler MBS strucrure. CMOs have a more complex strucrure than mortgage passthroughs. A CMO issue has differenr "tranches," each of which has a different type of claim to the cash flows from the pool of mortgages (i.e., their claims are nor just a proportional claim on rhe total cash flows from the pool).

Professor's Note: Tranche is from the French word for "slice. " In finance, when o a security issue consists ofdifferent classes ofsecurities with differing claims

and especially with differing risks, the different classes ofsecurities are called tranches. You will likely run into this term only in r~ference to the different classes ofsecurities that make up a eM0.

An example of a simple sequential CMO structure with rhree tranches will help to illusu·ate a CMO structure. Assume rhat three tranches are created out of a passthrough security. Ler's call them Tranches 1, II, and III. They receive interest on the basis of their

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Study Session ] 5

Cross-Reference to CFA Institute Assigned Reading #62 - Overview of Bond Sectors and Instruments

outstanding par values. The foJlowing al"(: the details of the payments to each of the three

traflches.

1.Tranche I (the short-term segment of the issue) receives net interest on outstanding principal and all of the principal payments from the mortgage pooluI1lil it is completely paid off

2.Tranche II (the intermediate-tcrm) receives its share of net interest and starts receiving all of the principal paymenrs after Tranche 1 has been completely paid off. Prior ro thar, it only receives inrerest payments.

3.Tranche III (thc long-term) receives monthly net inrerest and starts receiving all principal repaymcnts after Tranches I and II have been completely paid off. Prior to that it only receives iI1lerest payments.

Ti·anche I has the shortest expected maturity and may appeal to an investor with a prefcrence for securities with a shorrer time horizon, who previously could

not particip:lte in the mortgage-backed sccurities marker. Other structures, with prepaymenrs primarily alleering only sOllle of the tranches, are L1sed to redisrribure prepaymen t risk. The tranches wi th less prepaymen t risk wil I become more attraerive to some investors. Investors berrcr able ro bear prepayment risk will find the tranches with higher prepayment risk anractive.

Stripped mortgage-backed securities are either the principal or interest portions of a mortgage passthrough security. Prepayments affect the values of interest-only (10)

strips and principal-only (PO) strips differently. The holder of a principal-only strip will gain from prepayments because the face value of the security is received sooner rather than later. The holder of an interest-only strip will receive less rural payments when prepayment rates arc higher since interest is only paid on the outstanding principal amount, which is decreased by prepayments.

LOS 62.f: State the motivation for creating a collateralized mortgage obligation.

The motivation for creating collateralized mortgage obligations (CMOs) is to redistribute the prepayment risl? inherent in mortgage passthrough securities and/or create securities with various maturity ranges. The CMO structure takes the cash flows from

the mortgage pool and, in a simple structure, allocates any principal payments (both scheduled payments and prepayments) sequentially over time to holders of different CMO rranches, rather than equally to all security holders. Creating a CMO does not alter the overall risk of prepayment, it redistributes prepayment risk.

As a general rule, CMOs are created to satisfy a broader range of investor risk/rerum preferences-making investing in mortgage-backed securities more appealing to a wider audience and decreasing overall borrowing COSts.

©2008 Kaplan Schweser

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