Fixed Income Markets and Their Derivatives

By Suresh Sundaresan

The third edition of this well-respected textbook continues the tradition of providing clear and concise explanations for fixed income securities, pricing, and markets. Fixed Income Markets and Their Derivatives matches well with fixed income securities courses. The book's organization emphasizes institutions in the first part, analytics in the second, selected segments of fixed income markets in the third, and fixed income derivatives in the fourth. This enables instructors to customize the material to suit their course structure and the mathematical ability of their students.

• New material on Credit Default Swaps, Collateralized Debt Obligations, and an intergrated discussion of the Credit Crisis have been added
• Online Resources for instructors on password protected website provides worked out examples for each chapter
• A detailed description of all key financial terms is provided in a glossary at the back of the book

• Language: English
• Publisher: Academic Press
• Release date: Mar 30, 2009
• ISBN: 9780080919331

Suresh Sundaresan

Suresh Sundaresan is the Chase Manhattan Bank Professor of Economics and Finance at Columbia University. He is currently the Chairman of the Finance subdivision. He has published in the areas of Treasury auctions, bidding, default risk, habit formation, term structure of interest rates, asset pricing, pension asset allocation, swaps, options, forwards, fixed-income securities markets and risk management. His research papers have appeared in major journals such as the Journal of Finance, Review of Financial Studies, Journal of Business, Journal of Financial and Quantitative Analysis, European Economics Review, Journal of Banking and Finance, Journal of Political Economy, etc. He has also contributed articles in Financial Times, and in World Bank conferences. He is an associate editor of Journal of Finance and Review of Derivatives Research. His current research focus is on default risk and how it affects asset pricing and sovereign debt securities. He has consulted for Morgan Stanley Asset management and Ernst and Young. His consulting work focuses on term structure models, swap pricing models, credit risk models, valuation, and risk management. He has conducted training programs for leading investment banks including Goldman Sachs, Morgan Stanley, CSFB and Lehman Brothers. He is the author of Fixed Income Markets and Their Derivatives. He has served on the Treasury Bond Markets Advisory Committee.

Book preview

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Part 1

Institutions and conventions

Chapter 1 Overview of fixed income markets

Chapter 2 Price-yield conventions

Chapter 3 Federal Reserve (central bank) and fixed income markets

Chapter 4 Organization and transparency of fixed income markets

Chapter 5 Financing debt securities: Repurchase (repo) agreements

Chapter 6 Auctions of Treasury debt securities

Chapter 1

Overview of fixed income markets

Chapter Summary

This chapter introduces debt securities and the markets in which they trade. Key players in debt markets and their objectives are described. A classification of debt securities is then provided. Various sources of risk (interest rate risk, credit risk, liquidity risk, call risk, event risk, and so on) that are present in debt securities are identified, with examples of how such risks could affect their prices and returns. Finally, the risk-return performance of the aggregate debt market is provided for a 10-year period and contrasted with other asset classes such as equity.

1.1 Overview of Debt Contracts

Debt securities are issued by borrowers to obtain liquidity (cash) or capital for either short-term or long-term needs. Such securities are contractual obligations of the issuers (borrowers) to make certain promised stream-of-cash flows in future. Promises made by borrowers may be secured by specific assets of the borrowers, or they can be unsecured. Markets in which debt securities trade are known as either debt markets or fixed-income markets. As of mid-2008, the Securities Industry and Financial Markets Association (SIFMA) estimated the market value of all outstanding debt securities at $30 trillion. In contrast, the market capitalization of the New York Stock Exchange was about $25 trillion as of 2006.

Debt securities have several defining characteristics, including (a) coupon rate, (b) maturity date, (c) issued amount, (d) outstanding amount, (e) issuer, (f) issue date, (g) market price, (h) market yield, (i) contractual features, and (j) credit-rating category. In the context of two real-life examples of debt securities, here we describe such defining features to better understand the sources of risks and returns of debt securities. The first example is a debt security issued by the United States Treasury. The second example pertains to a debt security issued by General Motors. These two examples will help us appreciate the significant diversity associated with debt securities and the way they contribute to cross-sectional variations in risk and return.

Take a look at Table 1.1, which features a 10-year Treasury note, a debt security issued by the U.S. Treasury with a maturity of 10 years.

Table 1.1 Contractual Features of Debt Securities Example: U.S. Treasury Debt

Source: Solomon Yield Book.

Several aspects of debt securities can be better understood in the context of this Treasury debt obligation: First, note that the issuer (or the borrower) is the United States Treasury; the obligations are backed by the federal government. The security has an annualized coupon of 4.125% and matures on May 15, 2015. The periodic compensation is referred to as the coupon, and the remaining life of the claim is referred to as the time to maturity.

The frequency of coupon is twice a year, or semiannual. The coupon is computed on the par value or the face value of debt security. Assuming a par value of 100, the semiannual coupon is 100×(4.125%/2)=2.0625. Typically debt securities tend to trade in million dollars of par value. On a million-dollar par value, the semiannual coupon (in this example) will be $20,625, which is fixed throughout the life of the debt contract. The security has a unique identifier known as Cusip, which is 912828DV9. The issued amount was about $24.27 billion, and the amount outstanding as of July 22, 2005, was approximately $22 billion. (The remaining $2.27 billion has been stripped—a practice that is described later in this book.) The first coupon date is November 15, 2005, and the coupon started to accrue from the dated date, which is May 15, 2005. The market price of the debt security is quoted at $99.213997 on a $100 par value. The yield is quoted at 4.223%.

The yield of a debt security is its internal rate of return (IRR): It is the discount rate at which the present value of all future promised cash flows is exactly equal to its market price.

The quotations are given by Solomon Smith Barney, one of the many dealers in debt markets. This debt security is denominated in U.S. dollars. The date on which the prices are quoted is July 22, 2005, but the transactions will settle on the settlement date, which is July 24, 2005. On the settlement date, the buyer and seller will exchange cash and security as per the terms agreed to on the pricing date. Therefore, the settlement date is the relevant date for valuation and computing prices. A Treasury note is not callable by the issuer, nor can it be put back to the issuer by investors. Debt securities such as the Treasury note in this example, which just pay coupons and mature on a specific date, are known as bullet securities.

The T-note described in Table 1.1 is an example of a default-free security, because there is no doubt that the promised payments will be made; thus, investors face no credit risk. This is not to say that such an instrument has no risk. Indeed, investors who take a position in this Treasury bond are exposed to a significant interest rate risk. This risk is due to the fact that the coupon is fixed: If interest rates in the market were to increase, the price of this bond would decline, reflecting the relatively low coupon of this T-note in a higher interest rate setting where similar debt securities will be issued with a higher coupon reflecting the current market conditions. Moreover, the security may have inflation risk: If inflation rates become unexpectedly high in the future, the market price of the security could fall.

The size of this specific T-note outstanding in the market is over $20 billion. This rather large size, coupled with the fact that there are dozens of dealers who stand ready to participate in a two-way market, is indicative that such a security is liquid. High liquidity means that investors can buy or sell large amounts easily at a narrow bid-offer spread without an adverse price reaction. (Bid is the price at which the market maker is prepared to buy the security; offer or ask is the price at which the market maker is prepared to sell the security.) This implies that the Treasury security has a low liquidity risk. The fact that this T-bond was not callable by the Treasury means that the investor has no uncertainty about the timing of the cash flows. Thus, the security has no timing risk. If the issuer can call the security, the investor will face timing risk because the issuer is likely to call the bonds when interest rates decline or when the credit quality of the issuer improves. Some securities are also subject to event risk. This risk arises if the issuer’s credit risk suddenly deteriorates or if a major recapitalization (such as a leveraged buyout) occurs, adversely affecting the risk of the bond. Note that the T-note has no such event risk, since it is the direct obligation of the U.S. Treasury.

Now let’s turn to the second example described in Table 1.2, which summarizes the features of a debt security that was issued by the General Motors Corporation. The GM corporate bond also has features such as coupon rate, maturity, and issue date that are very similar to the Treasury bond example in Table 1.1. But there are important ways in which the GM debt issue differs from the Treasury debt described in the first example. Note that the issue size is $1.25 billion, which is significantly smaller than the Treasury bond issue size. This small issue size is fairly typical of corporate debt issues. This size contributes to lower liquidity of corporate debt in the secondary markets. This lower liquidity may cause the investors to demand a higher return for holding GM debt.

Table 1.2 Contractual Features of Debt Securities Example: General Motors Debt

Source: Solomon Yield Book.

There is another important dimension on which GM debt is more risk; it has to do with GM’s credit quality. Rating agencies rate debt issued by companies and classify them into two broad categories: investment grade and noninvestment (junk) grade. There are currently three major rating agencies: Moody’s, Standard & Poor’s (S&P), and Fitch. The fact that GM debt is noninvestment grade implies that investors will perceive GM debt to have a high credit risk. This is in sharp contrast to Treasury debt in the first example: Treasury debt is viewed as being free from default risk and hence typically not even rated. When T-bills are rated, rating agencies accord them the highest rating, which is AAA. On the other hand, GM debt is rated and is classified as being below investment grade; this implies that investors will demand a higher coupon at issue to compensate them for being exposed to GM’s credit risk. Note also that the settlement conventions differ from Treasury and corporate debt securities.

GM has the right to call the bond back prior to maturity date; the company is likely to do this if its credit reputation improves and the ratings move to a higher level. This way, GM can refinance its existing debt with a new debt that can be issued with a lower coupon. This is an additional risk to investors because the bond may be called away from them, which will cause them to require a higher coupon at issue date or higher return at the time of purchase.

Our analysis of Treasury debt and GM debt clearly illustrates that investors will want a higher compensation to hold GM debt as opposed to Treasury debt due to increased credit risk, liquidity risk, and timing risk.

At-issue coupon of GM debt, which had 20 years to maturity on issue date, was 8.25%. On the same issue date, the Fed estimated the 20-year constant maturity Treasury yield at 4.60%. So, investors demanded an extra compensation of 8.25% – 4.60%=3.65% for holding GM debt instead of Treasury debt. In addition, GM debt was selling at 66.00 as of December 29, 2005 (see Table 1.2), which is a discount to the par value of 100, whereas a Treasury note with a coupon of 4.50% was selling close to par on the same date. This implies that investors want a higher compensation than the promised coupon in order to invest and hold GM debt. By purchasing GM debt at a discount, they can get this additional return.

1.1.1 Cash-flow rights of debt securities

Debt contracts typically have precedence over residual claims such as equity. When there are multiple issues of debt securities by the same issuing entity (as is typical), priorities and relative seniorities are clearly stated by the issuer in bond covenants. This leads to some important types of debt contracts: secured and unsecured debt. Secured debt, such as a mortgage bond, is backed by tangible assets of the issuing company. In the event of financial distress, such assets may be sold to satisfy the obligations of debt holders. Unsecured debt, known as debentures in the United States, is not secured by any assets. Debt securities sold by issuers such as banks and corporations are subject to a positive probability of default, and they typically contain two important contingency provisions.

First, debt contracts specify events that precipitate bankruptcy. An example of such an event is the nonpayment of promised coupon payments. Another example is the failure to make balloon payments. (The payment of principal at maturity is often referred to as a balloon payment.) Such events give the debt holders the right to take over the firm. Often, the debt holders might not exercise the right to take over the issuing firm if they feel they could do better by renegotiating with the managers of the issuing firm. When these contingencies arise, debt holders may decide whether to enter into a process of workouts and renegotiations or force the firm into formal liquidation. Alternatives such as Chapter 7 or Chapter 11 of the Federal Bankruptcy Act must be considered by the debt holders at this stage. A detailed treatment of these issues is provided in chapter 10 of this book on corporate debt securities.

Second, debt contracts also specify the rules by which debt holders will be compensated upon bankruptcy and transfer of control. Quite often, the actual payments upon bankruptcy may differ from the payments specified in the debt contract and implied by absolute priority. Naturally, the value of debt issues is affected in important ways by such provisions and deviations. Often, renegotiations and workouts lead to deviations from the absolute priority rules, whereby senior claimholders must be paid before any payments are made to junior claimholders. A fuller discussion of the empirical evidence is provided in chapter 10, on corporate debt securities.

Many corporate debt issues (especially those issues that are rated as noninvestment grade) are callable at predetermined prices, which gives the issuer the right to buy back the debt issue at prespecified future times. Most are issued with sinking fund provisions, which require that the debt issue be periodically retired in predetermined amounts. Some are puttable at the option of the buyer, and some are convertible into a prespecified number of shares of common stock of the issuing company. Many convertible debt securities are also callable by the issuers. These observations should make it clear that debt securities may have many contractual features, which make their valuation fairly sophisticated. Such contractual features introduce flexibilities to either issuers or investors but introduce uncertainty about future cash flows.

1.1.2 Primary and secondary markets

Markets in which borrowers issue debt securities to raise capital are known as primary debt markets. In primary markets, investors buy debt securities and thereby provide capital to borrowers. In large measure, both borrowers and investors in debt markets are institutions. Most debt securities are issued by institutions, including (a) governments (federal, state, and city), which borrow to finance their payroll, defense expenditures, construction of highways and bridges, and so on; (b) federal agencies, which borrow to buy mortgages or student loans; and (c) corporations and banks, which borrow for their operations and investments. In addition, special-purpose vehicles (SPV) are sometimes created to hold specific pools of assets. Such assets may be mortgage pools or portfolio of credit card loans. These SPVs, in turn, issue debt securities to finance the purchase of such assets. Investors in debt markets can be mutual funds, hedge funds, asset management firms, pension funds, insurance companies, foreign governments, or the like.

Investors who lend money to issuers are typically pension funds, insurance companies, mutual funds, asset management companies, and the like. In primary markets, debt securities are sold through intermediaries using auctions or underwriting procedures.

Once the debt securities are issued in the primary markets and capital has been raised, the investors who bought the debt securities might want to either increase or decrease their holdings. They can accomplish this in the secondary debt markets. Most of the secondary market trading occurs in the over-the-counter (OTC) markets or multidealer markets, although bonds are also traded in organized exchanges and through electronic platforms around the world.

1.2 Players and Their Objectives

Very broadly, the players in debt markets can be classified into three categories. First there are issuers, who issue debt securities to borrow money to fund their capital or liquidity needs. Second are investors, who invest their savings or capital by purchasing debt securities in primary and secondary markets. They may also change their holdings of debt securities by trading in the secondary markets. Finally there are intermediaries, who assist buyers and sellers by making markets, underwriting, and providing risk management services. In this section, we describe the role of these players and their objectives. In addition to these key players, there are two other important players: the Federal Reserve (central bank) and the U.S. Treasury, the functions of which we describe in detail in later chapters.

Table 1.3 shows a schematic representation of key players in fixed income markets.

Table 1.3 Players in Fixed Income Markets

The objectives of these players, however, can differ. Some of the key objectives of these players are shown in Table 1.4.

Table 1.4 Objectives of Players in Fixed Income Markets

Investors are sometimes referred to as representing the buy side, whereas investment banks, which intermediate in primary and secondary markets to help issuers issue securities and help investors to buy or sell debt securities, are referred to as the sell side. It is clear that investors would prefer to see a low bid-offer spread to lower the costs of portfolio rebalancing. On the other hand, intermediaries would like to earn more by charging a higher bid-offer spread to enhance revenues from market making. Investors on the buy side tend to hold securities over longer horizons, relative to intermediaries on the sell side. This implies that the buy-side investors care a good deal more about the risk premium that is priced into debt securities. Such investors would like to buy the securities when the risk premium is high (so that the security prices are low) and sell the securities when the risk premium is low, ceteris paribus. On the other hand, market makers on the sell side will typically hedge the price risk of their book of inventories of debt securities. They are interested in earning the bid-offer spreads by selling at the offer and buying at the bid. They are less interested in the risk premium because their horizon is short.

Next we provide a broad overview of the key players and some of their activities.

1.2.1 Governments

Governments issue securities and invest. Government issuance activities are dictated by the extent of deficit or surplus produced by the economy. A government with a deficit may issue debt securities to finance the deficit. On the other hand, a government with a surplus may choose to invest its surplus in other government securities. For example, in the recent past, the U.S. Treasury has issued a significant amount of debt. Japanese and Chinese central banks have invested their surplus in U.S. Treasury debt securities. Governments (through treasury departments) also set fiscal policies and regulate fixed income markets. We take up the activities of U.S. Treasury in debt markets in Chapter 6.

1.2.2 Central banks

Central banks set monetary policies, conduct open market operations, inject discretionary liquidity, and conduct auctions of government securities. The role of central banks in debt markets is extremely significant because they attempt to influence the level of interest rates to promote orderly growth of the economy and ensure price stability. In addition, they attempt to maintain the stability of the financial system. Chapter 3 undertakes a detailed treatment of the role played by central banks in debt markets.

1.2.3 Federal agencies and government-sponsored enterprises (GSEs)

In some countries (notably in the United States), government agencies represent a very important part of the debt markets. For example, the Federal Home Loan Bank (FHLB) in the United States is set up to provide credit to its members, who are mortgage lenders. In addition, institutions such as the Government National Mortgage Association (Ginnie Mae), the Federal National Mortgage Association (Fannie Mae), and the Federal Home Loan and Mortgage Corporation (Freddie Mac) help channel credit to the housing sector. Similar agencies exist to help channel credit to student loans, agriculture, and so on. Some of these agencies may have partial or full guarantees of the federal government. Debt securities issued by such agencies are known as agency debt securities, and they form the subject of Chapter 11 of this book.

1.2.4 Corporations and banks

Corporations and banks issue both short-term (under one year) and long-term debt securities. Short-term corporate debt issues are known as commercial paper, and long-term corporate debt issues are known as corporate bonds. These institutions also invest in debt securities through sponsored pension plans and liquidity accounts. (The corporate debt market is the focus of Chapter 10.) Banks lend and borrow in the interbank markets, especially in short maturities. The rates in the interbank markets are known as the London Interbank Offered Rates, or LIBOR, and they form the basis for setting the interest rates on many debt securities and for settling derivatives such as Eurodollar futures and swaps. These contracts are examined in Chapters 15 and 16.

1.2.5 Financial institutions and dealers

Financial institutions and dealers intermediate, invest, issue, and arbitrage in debt markets. They help securitize residential and commercial mortgage loans. They help securitize credit risk through loan sales and trading and by issuing collateralized debt obligations (CDOs), which are securities backed by pools of corporate bonds, bank loans, and the like. The role of dealers and the structure of dealer markets are the topic of Chapter 4.

1.2.6 Buy-side institutions

Asset management firms, university endowments, pension funds, and insurance companies make up the buy-side sector. They manage money and invest in assets under varying mandates. One of their goals is to minimize transaction costs, commissions, and bid-offer spreads and get the best possible execution. They invest on behalf of households. They manage assets to obtain superior returns for their clients and are often benchmarked against fixed income market indexes. One of the widely used indices in fixed income markets is the Lehman Brothers Aggregate Bond Index, known simply as the Lehman aggregate. We provide a brief description of the Lehman Aggregate later in this chapter.

1.2.7 Households

Households are the primitive units: They own homes, consumer durables, automobiles, and other assets, which they must finance. They have pensions and savings, which they must invest. They buy insurance policies for life and health. They send children to schools and colleges. Most of the fixed income markets are keyed off these basic needs of households:

• Banks and financial institutions provide households with mortgage loans, securitize them, and service them. In addition, they extend home equity loans. These activities have led to mortgage-backed securities (MBSs), Mortgage Servicing Rights (MSRs), and home equity loans. We discuss these issues in Chapter 12.

• Households own automobiles, and they finance them by taking out auto loans. This has led to the growth of the auto-receivables market, which is an asset-backed securities market, or ABS.

• Most households use credit cards, which are issued by banks and financial institutions. This has led to the growth of the credit-card receivables market, which is another example of an ABS.

• Households’ pensions are invested by asset management companies such as the Teachers Insurance and Annuity Association, College Retirement Equities Fund (TIAA-CREF) or Fidelity Investments, which have led to the growth of investment products. Likewise, households’ savings are invested in money market mutual funds, mutual funds, and other wealth management products.

• The development of student loans and their financing has led to another ABS segment.

We now examine the relative composition of various sectors of debt markets.

1.3 Classification of Debt Securities

The market capitalization of domestic debt market that is publicly traded grew from about $12.26 trillion in 1996 to an estimated $30.07 trillion by 2007, as shown in Table 1.5.

Table 1.5 Outstanding Debt Market Securities, 1996 and 2007

Source: SIFMA.

City and state governments issue municipal debt securities, which are exempt from federal taxes and state and city taxes for residents. The share of municipal debt securities has declined in the last decade, although the outstanding dollar value has increased. Treasury securities are coupon-bearing debt obligations of the United States and they constituted about 16% of the overall debt markets in 2007, with a market capitalization of $4.8 trillion. Mortgage-related debt securities are the biggest part of debt markets, accounting for nearly a quarter of the market in 2007. Debt securities issued by federal agencies accounted for about 10% of the market. Money markets represent short-term debt securities that typically mature within one year. A market that has been growing significantly in recent times is the asset-backed securities (ABS) market, in which SPVs issue debt securities backed by pools of assets such as credit-card receivables and auto receivables. ABS’s share has more than doubled in the last decade. Money markets, in which short-term debt is issued and traded, continues to be an important segment of fixed income markets.

The amount and composition of new debt issues in the United States are described in Table 1.6. Note that mortgage-related issues, closely followed by corporate issuers, ABSs, agencies, and treasuries, dominate new issue volumes.

Table 1.6 New Issue Volume, 2007

Source: SIFMA.

New issue volumes represent the capital raised in each segment to either refund old debt or raise new capital. Once the securities have been issued, they trade in secondary markets, where the ownership changes hands. No new capital is raised in the secondary markets; funds raised in the primary markets may be used to retire securities that trade in secondary markets. The trading volume of debt issues in the United States in the secondary markets is described in Table 1.7.

Table 1.7 Trading Volume in Secondary Markets, 2007

Source: SIFMA.

One interesting pattern is that Treasury and mortgage-related debt securities dominate the trading activity in the secondary markets. Note the limited trading activity in the secondary markets for municipal debt securities and corporate debt securities markets, despite the fact that there is a significant new issue volume in these sectors, as we noted in Table 1.6. Moreover, the trading volume in secondary markets for ABS is also rather limited. This suggests limited liquidity for municipal debt, corporate debt securities, and asset-backed securities in the secondary markets. In turn, this may imply higher bid-offer spreads and higher search costs in executing transactions in secondary markets for these classes of securities.

1.4 Risk of Debt Securities

As we have seen in the earlier sections of this chapter, fixed income securities carry a variety of risks. In this section, we examine each in turn and provide specific examples, helping to bring alive the magnitude of each risk.

1.4.1 Interest rate risk

Debt securities, which pay fixed coupon rates, suffer a price decline when interest rates go up unexpectedly, because the stated coupon is inadequate to compensate for the prevailing higher levels of interest rates. Likewise, reinvestment of fixed contractual coupons becomes risky when market interest rates decline. This interest rate risk is the most important source of risk for many debt securities. Consider the price of Treasury bonds over the period shown in Figure 1.1.

Figure 1.1 Interest Rate Risk of Fixed Income Securities (2007–2008)

Source: Solomon Yield Book.

The bond was issued near par value of 100 in the middle of January 2007. But the price of the bond started to decline and reached a low of 92 in July 2007. Such a decline may be due to (a) an increase in interest rates in the market, (b) an increase in unanticipated inflation rate, and (c) a fall in risk premium that causes investors to prefer riskier securities than Treasury debt.

Subsequently, the price of this bond dramatically increased, reaching a peak of nearly 110. Since the T-note carried a fixed dollar coupon of 4.75%, its price must respond to changes in the interest rates to compensate potential buyers for the prevailing market conditions. This example shows that in a span of a little over one year, the price of this bond fluctuated from a low of about 91 to a high of 110, subjecting the investor to a significant amount of price risk. On $1 million par value, the market value fluctuated from a low of $910,000 to a high of $1.1 million.

1.4.2 Credit risk

Treasury securities do not carry credit risk, since we do not expect the U.S. Government to default on its promised payments of coupons and the principal amount. However, there are corporate bonds that carry a significant amount of credit risk: Corporate debt securities carry a risk that the issuer may be unable to service all or some of the promised obligations due to financial distress, reorganization, workouts, or bankruptcy. Since Treasury bonds have no credit risk, it is convenient to examine the spread between the yields (IRR) on GM debt and the yields on a Treasury benchmark to gauge the extra compensation that investors demand for holding GM debt instead of Treasury debt. Moody’s, a credit-rating agency, accorded GM an investment grade rating of A3 in early 2001. During the period 2003 to 2005, GM’s rating fell from A3 to lower and lower levels until, in May 2005, it was downgraded from investment grade to noninvestment grade and its rating fell to B2. The spreads on GM debt dramatically increased during this period in response to the company’s deteriorating credit quality, as shown in Figure 1.2.