1. 1 Welcome to the Jungle: Fixed Income Topics November 21, 2004 Zachary Emig MBA Class of 2005 Ross School of Business Finance Club

2. 2 Today’s Agenda I. What is fixed income? II. Duration III. Yield Curves and Credit Spreads IV. Swaps V. Securitized Products

3. 3 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 Foreign Exchange Corporate Bonds Mortgage Backed Securities Commodities Credit Derivatives Interest Rate Options And much, much, more!

4. 4 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).

5. 5 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: Agency MBS $3.9 T Agency Debt $1.5 T Treasuries $9.6 T Corporates$0.4TNYSENasdaq NYSE $0.8 T NASDAQ $0.6 T

6. 6 Market Capitalization It is very hard to find official capitalization, volume data on fixed income securities.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.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).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.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=296http://www.bondmarkets.com/story.asp?id=296, ?id=96, ?id=1209, ?id=304, ?id=323 http://www.bondmarkets.com/story.asp?id=296

7. 7 Today’s Agenda I. What is fixed income? II. Duration III. Yield Curves and Credit Spreads IV. Swaps V. Securitized Products

8. 8 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).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.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

9. 9 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:

10. 10 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 “2 nd derivative” is called convexity; for large swings in rates, it can play a factor in prices.

11. 11 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.

12. 12 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.

13. 13 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.

14. 14 Today’s Agenda I. What is fixed income? II. Duration III. Yield Curves and Credit Spreads IV. Swaps V. Securitized Products

15. 15 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

16. 16 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.

17. 17 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.

18. 18 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.

19. 19 Swap Spread Other interesting spreads to observe: Agency spread and swap spread.

20. 20 Today’s Agenda I. What is fixed income? II. Duration III. Yield Curves and Credit Spreads IV. Swaps V. Securitized Products

21. 21 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 swapsCurrency swaps Interest rate swapsInterest rate swaps Credit Default SwapsCredit Default Swaps Volatility SwapsVolatility Swaps Total Return SwapsTotal 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

22. 22 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 floatingBuying (going long) a swap = paying fixed rate, receiving floating Selling (going short) a swap = paying floating, receiving fixedSelling (going short) a swap = paying floating, receiving fixed

23. 23 Today’s Agenda I. What is fixed income? II. Duration III. Yield Curves and Credit Spreads IV. Swaps V. Securitized Products

24. 24 Securitization Securitization was one of the biggest financial innovations of the last 40 years.Securitization was one of the biggest financial innovations of the last 40 years. Definition: transforming illiquid/non-financial products into tradable financial securities.Definition: transforming illiquid/non-financial products into tradable financial securities. Two most common methods:Two most common methods: Pooling: using large pools of securities to diminish the illiquidity/risk of a single one.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.Tranching: dividing cash flows into separate “tranches” that have different risk levels, in order to target differing investor appetites for risk.

25. 25 Mortgage Backed Securities The history of MBS is an excellent example of both processes.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).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.In the late 70s and early 80s, Mortgage Pass-Thrus were popularized: securities whose coupons were supported by pools of [numerous] mortgage securities. Individual Mortgage MBS Pass-Thru Issuer (Fannie Mae, Freddie Mac, I-Banks) Pass- Thru Investors

26. 26 CMOs The next step in securitization was tranching.The next step in securitization was tranching. CMOs = Collateralized Mortgage Obligations.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.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.Commonly, the different tranches receive different timing of payments. Individual Mortgage Pass- Thru Individua l Mortgag e Pass-Thru CMOIssuer(I-Banks) First 18mos payments Tranche A Investors 18mos-36mos Tranche B Investors 36mos+ Tranche C Investors

27. 27 Today’s Agenda I. What is fixed income? II. Duration III. Yield Curves and Credit Spreads IV. Swaps V. Securitized Products ~ Fin ~