Fixed Income Investing : A Classic in a Time of Increased Uncertainty

Fixed income investments have been a topic of broad interest, in particular for institutional investors such as insurance companies and pensions schemes. They were considered safe heavens in turbulent times by almost all other institutional and individual investors and are used for strategies such as portfolio immunization and asset liability matching (ALM). The latest crisis, however, revealed some of the weaknesses of fixed income instruments. They proved to be not as safe as originally thought with both credit and interest rate risks emerging. Consequently, fixed income investments have been in the spotlight once more. This book presents all aspects pertaining to fixed income investments, starting from the basics―i.e. the types of bonds, their valuation, the interest rate term structure―then moving to fixed income portfolio management and the interest rate and credit derivatives and their relevant markets, funds, risks and risk management. Finally, the book addresses contemporary issues such as their behavior in times of crisis, their relation to debt, their coexistence with equity and the current regulatory environment. This book, providing a look at the broader environment of fixed income alongside the current market structure, will be of interest to students, academics, researchers and practitioners in fixed income and investing strategies.​ Preface References Acknowledgements Contents List of Figures List of Tables 1 Introduction 1.1 Introductory Notions 1.1.1 Basic Steps in the Investment Process 1.1.2 Return 1.1.3 Risk 1.1.4 Risk-Return Ratio 1.1.5 Benchmark 1.1.6 Differentiation 1.1.7 Types of Assets 1.1.8 Participants of the Financial System 1.2 Bonds 1.2.1 What Is a Bond? 1.2.2 Bond Indenture 1.2.3 Bond Categories 1.2.4 History of Bonds 1.3 Stock 1.3.1 Common Stock 1.3.2 Preferred Stock 1.4 Markets 1.4.1 Money Markets 1.4.2 Fixed Income Capital Market (or Bond Market) 1.4.3 Equity Markets 1.4.4 Derivative Markets 1.4.4.1 Futures Markets 1.4.4.2 Options Markets 1.5 Primary and Secondary Markets 1.5.1 Primary Market 1.5.2 Secondary Market 1.6 Issuers 1.7 Intermediaries 1.8 The Role of Central Banks 1.8.1 FED 1.8.1.1 Structure of the Fed 1.8.1.2 Functions of the FED 1.8.1.3 Monetary Policy Objectives 1.8.1.4 Conducting Monetary Policy 1.8.1.5 Quantitative Easing (QE) 1.8.2 ECB 1.8.2.1 Objective of the European System of Central Banks 1.8.2.2 The Eurosystem Monetary Policy Strategy 1.8.2.3 The Operational Framework of the Eurosystem 1.8.2.4 Monetary Policy Instruments and Procedures 1.8.2.5 Open Market Operations 1.8.2.6 Standing Facilities 1.8.2.7 Minimum Reserves 1.8.2.8 Asset Purchase Programs 1.8.2.9 Pandemic Emergency Purchase Program 1.8.2.10 Counterparties 1.8.2.11 Eligible Assets 1.8.2.12 Organization of the European System of Central Banks (ESCB) Exercises Exercise 1 Exercise 2 Exercise 3 Exercise 4 Exercise 5 Exercise 6 Exercise 7 Exercise 8 Exercise 9 Exercise 10 References 2 Bonds 2.1 Basic Bond Characteristics, Concepts and Notions 2.1.1 Basic Bond Characteristics 2.1.2 Basic Bond Concepts and Notions 2.2 Bond-Related Risks 2.2.1 Ratings and Rating Agencies 2.2.2 Factors Affecting the Credit Rating 2.3 Bond Valuation 2.3.1 The Relation Between Price and Present Value 2.3.2 Bid Price and Ask Price 2.3.3 The Relation Between Quoted Price and Cash Price 2.3.4 The Relation Between Price and Face Value 2.4 Bond Yields 2.4.1 Yield to Maturity (YTM) 2.4.2 Effective Yield (EY) 2.4.3 Current Yield (CY) 2.4.4 Realized Compound Yield (RCY) 2.4.5 Simple Yield to Maturity (SY) 2.4.6 Yield to Call 2.4.7 Yield to Put 2.4.8 Yield to Worst 2.5 Holding Period Return 2.5.1 The Relation Between Price and Present Value—Revisited 2.6 Bond Price Movements 2.7 Government Bonds 2.8 Corporate Bonds 2.9 Other Bond Types 2.9.1 Municipal Bonds 2.9.2 Mortgage-Backed Securities 2.9.3 Money Market Instruments Exercises Exercise 1 Exercise 2 Exercise 3 Exercise 4 Exercise 5 Exercise 6 Exercise 7 Exercise 8 Exercise 9 Exercise 10 Exercise 11 Exercise 12 Exercise 13 Exercise 14 Exercise 15 References 3 Term Structure of Interest Rates 3.1 Definition 3.2 Relation Between Spot and Forward Rates 3.2.1 Annual Compounding 3.2.2 Multi-Period Compounding Per Year 3.2.3 Continuous Compounding 3.3 Relation of the Term Structure with the Bond Yields 3.3.1 Types of Yield Curves 3.4 Bond Valuation, Pricing and Return 3.4.1 Bond Valuation 3.4.1.1 Annual Compounding 3.4.1.2 Multi-Period Compounding Per Year 3.4.1.3 Continuous Compounding 3.4.2 Bond Pricing and Yield to Maturity 3.4.3 Bond Return 3.5 Construction of the Term Structure 3.6 The Moves and the Uncertainty of (the Term Structure of) Interest Rates 3.7 Approaches and Theories of the Term Structure Evolution Over Time 3.7.1 The Expectation Hypothesis Theory 3.7.2 The Liquidity Preference Theory 3.7.3 The Market Segmentation Theory 3.7.4 The Preferred Habitat Theory 3.8 Formation of the Term Structure 3.9 Determinants of the Interest Rates 3.10 Stochastic Interest Rate Models 3.10.1 Continuous-Time Term Structure Models 3.10.1.1 Equilibrium Models 3.10.1.2 No-arbitrage Models 3.10.2 Discrete-Time Term-Structure Models 3.10.2.1 Standard or Basic Trinomial Tree 3.10.2.2 General Trinomial Tree—The Model of Hull and White Exercises Exercise 1 Exercise 2 Exercise 3 Exercise 4 Exercise 5 Exercise 6 Exercise 7 Exercise 8 Exercise 9 Exercise 10 References 4 Fixed Income Portfolio Management 4.1 Interest Rate Risk 4.1.1 Price Sensitivity to Interest Rate Moves 4.1.2 Duration 4.1.3 Properties of Duration 4.1.4 Uses of Duration 4.1.5 Interpretation of Duration 4.1.6 Duration Between Coupon Payment Dates 4.1.7 Impact of Coupon Payment and Time Lapse on Duration 4.1.8 Portfolio Duration 4.1.9 Duration for Multi-Period Compounding 4.1.10 Duration for Continuous Compounding 4.1.11 Convexity 4.1.12 Uses of Convexity 4.1.13 Convexity Between Coupon Payment Dates 4.1.14 Portfolio Convexity 4.1.15 Duration for Non-Horizontal Yield Curve 4.1.15.1 Quasi-Modified Duration 4.1.15.2 Fisher-Weil Duration 4.1.16 Other Measures 4.1.16.1 Time to Maturity 4.1.16.2 Weighted Average Maturity 4.1.16.3 Weighted Average Cash Flow 4.1.16.4 Price Value of a Basis Point 4.1.16.5 Yield Value of a Price Change 4.2 Passive Bond Portfolio Management 4.2.1 Bond Indexing 4.2.1.1 Potential Problems of Bond Indexing 4.2.1.2 Potential Solutions to Bond-Indexing Problems 4.2.2 Immunization 4.2.3 Net Worth Immunization 4.2.4 Target Date Immunization 4.2.5 Cash Flow Matching 4.2.5.1 Potential Problems of Cash Flow Matching 4.2.6 Concerns Relevant to Immunization 4.3 Active Bond Portfolio Management 4.3.1 Interest Rate Forecasting 4.3.2 Identification of Mispriced Bonds 4.3.3 Taxonomy of Active Bond Portfolio Management Strategies 4.3.3.1 Substitution Swap 4.3.3.2 Intermarket Spread Swap 4.3.3.3 Rate Anticipation Swap 4.3.3.4 Pure Yield Pickup Swap 4.3.4 Horizon Analysis 4.4 Combination of Active and Passive Bond Portfolio Management Exercises Exercise 1 Exercise 2 Exercise 3 Exercise 4 Exercise 5 Exercise 6 Exercise 7 Exercise 8 Exercise 9 Exercise 10 Exercise 11 Exercise 12 Exercise 13 Exercise 14 Exercise 15 References 5 Interest Rate Derivatives 5.1 Repos 5.1.1 Reverse Repo 5.2 Interest Rate Forward Contracts 5.2.1 Forward Rate Agreements 5.2.2 Forward Contract on a Bond 5.3 Interest Rate Futures 5.3.1 Futures Contract on a Single Bond Issue 5.3.2 Bond Futures 5.3.3 T-Bill Futures 5.3.4 Eurodollar Futures 5.3.5 Duration Hedging 5.4 Interest Rate Swaps 5.4.1 Main Reasons for Entering a Swap 5.4.2 Swap Financial Intermediation 5.4.3 Interest Rate Swap Valuation 5.4.4 Currency Swaps 5.5 Interest Rate Options 5.5.1 Interest Rate Option Pricing with the Use of Black’s Model 5.5.2 Bond Option Pricing with Continuous-Time Models 5.5.2.1 Zero-Coupon Bond Options 5.5.2.2 Coupon-Bearing Bond Options 5.5.3 Bond Option Pricing with Discrete-Time Models 5.5.3.1 Pricing Interest Rate Options with a Trinomial Tree 5.5.3.2 Pricing Bond Options with the Hull & White Trinomial Tree 5.6 Bonds with Embedded Options 5.6.1 Callable Bonds 5.6.2 Puttable Bonds 5.6.3 Option-Adjusted Spread 5.7 Mortgage Backed Securities 5.7.1 Interest Only and Principal Only MBS 5.7.2 MBS Cash Flows and Valuation 5.8 Collateralized Mortgage Obligations 5.9 Asset Backed Securities 5.9.1 Collateralized Debt Obligations 5.9.2 Collateralized Bond Obligations 5.9.3 Collateralized Loan Obligations 5.10 Swaptions 5.10.1 Valuation of Swaptions 5.11 Caps and Floors 5.11.1 Caps 5.11.1.1 Valuation of Caps 5.11.2 Floors 5.11.2.1 Valuation of Floors 5.11.3 Collars Exercises Exercise 1 Exercise 2 Exercise 3 Exercise 4 Exercise 5 Exercise 6 Exercise 7 Exercise 8 Exercise 9 Exercise 10 Exercise 11 Exercise 12 Exercise 13 Exercise 14 Exercise 15 Exercise 16 Exercise 17 Exercise 18 Exercise19 Exercise 20 Exercise 21 Exercise 22 Exercise 23 Exercise 24 Exercise 25 References 6 Credit Derivatives 6.1 Credit Default Swaps 6.1.1 CDS Valuation 6.1.2 Binary CDS 6.1.3 Basket CDS 6.1.4 CDS Risks 6.2 Total Return Swaps 6.3 Collateralized Debt Obligations 6.4 Credit Spread Options 6.4.1 Credit Spread Options Written on the Spread 6.4.2 Credit Spread Options Written on the Credit Asset 6.4.3 Credit Spread Options Strategy Exercises Exercise 1 Exercise 2 Exercise 3 Exercise 4 Exercise 5 References 7 Bond Markets 7.1 Contemporary Trends in the Bond Markets 7.1.1 The Size of the Bond Markets 7.1.2 The Modernization of the Bond Markets 7.1.3 The Drivers of the Bond Market Growth 7.1.3.1 The Low Interest Rates and the Increase of Corporate Bond Issues 7.1.3.2 The Role of Regulation 7.1.3.3 The Importance of New Products 7.1.3.4 The Contribution of ITC Advances 7.2 Traditional Notions of the Bond Markets 7.2.1 Government Bond Market 7.2.2 Corporate Bond Market 7.2.3 Municipal Bond Market 7.2.4 Mortgage-Backed Security Market 7.2.5 Money Market 7.2.5.1 Treasury Bills 7.2.5.2 Certificates of Deposit 7.2.5.3 Commercial Paper 7.2.5.4 Bankers’ Acceptances 7.2.5.5 Eurodollars 7.2.5.6 Repurchase and Reverse Repurchase Agreements 7.2.5.7 Tax Anticipation Notes 7.2.6 Bond Indices Exercises Exercise 1 Exercise 2 Exercise 3 Exercise 4 Exercise 5 References 8 Bond Funds 8.1 Bond Mutual Funds 8.1.1 Bond Mutual Fund Definition 8.1.2 Types of Bond Mutual Funds 8.1.2.1 Money Market Funds 8.1.2.2 Investment-Grade Bond Funds 8.1.2.3 High-Yield Bond Funds 8.1.2.4 Multi-Sector Bond Funds 8.1.2.5 Municipal Bond Funds 8.1.2.6 International Bond Funds 8.1.2.7 Other Types of Bond Funds 8.1.3 The Mechanics of Bond Mutual Funds 8.1.3.1 Pricing 8.1.3.2 Shareholder Fees 8.1.3.3 Operating Expenses 8.1.4 The Bond Mutual Fund Market 8.1.5 Comparison of Bond Mutual Funds with Bonds 8.1.6 Concerns About Bond Mutual Funds 8.2 Bond ETFs (Exchange Traded Funds) 8.2.1 Bond ETF Definition 8.2.2 Types of Bond ETFs 8.2.3 The Mechanics of ETFs 8.2.4 Bond ETF Market 8.2.5 Comparison of Bond ETFs with Bond Mutual Funds 8.2.6 Concerns About Bond ETFs 8.3 Private Debt Funds 8.3.1 Private Debt Definition 8.3.2 Positioning Private Debt Among Other Asset Categories 8.3.3 Private Debt Types 8.3.3.1 Senior Debt 8.3.3.2 Mezzanine Debt (Intermediate Debt) 8.3.3.3 Credit Opportunities 8.3.3.4 Distressed Debt 8.3.3.5 Infrastructure Debt 8.3.3.6 Real Estate Debt 8.3.3.7 Special Situations 8.3.3.8 Venture Debt (Business Debt) 8.3.4 Reasons to Invest in Private Debt (Funds) 8.3.5 The Private Debt Market 8.3.6 Comparison of Private Debt with Private Equity 8.3.7 Concerns About Private Debt Exercises Exercise 1 Exercise 2 Exercise 3 Exercise 4 Exercise 5 References 9 Risks and Risk Management 9.1 Interest Rate Risk 9.1.1 Sensitivity Analysis 9.1.2 Stress Testing 9.1.2.1 Stress Testing Steps 9.1.2.2 Stress Testing Limitations 9.1.3 Scenario Testing 9.1.3.1 Scenario Testing Steps 9.1.3.2 Scenario Testing Limitations 9.1.4 Value at Risk 9.1.4.1 VaR Limitations 9.1.5 VaR Calculation 9.1.5.1 Parametric VaR 9.1.5.2 Historical VaR 9.1.5.3 Monte Carlo VaR 9.2 Foreign Exchange Risk 9.2.1 Parametric VaR 9.2.2 Monte Carlo VaR 9.3 Economic Capital 9.4 VaR Generalization 9.4.1 Parametric VaR 9.4.1.1 More Than Two Factors 9.4.1.2 More Positions 9.4.2 Monte Carlo VaR with More Than Two Factors 9.5 VaR Contribution 9.5.1 Parametric VaR Contribution 9.5.2 Historical and Monte Carlo VaR Contribution 9.5.3 Economic Capital Revisited 9.6 Liquidity Risk 9.6.1 Forced Sale 9.6.2 Close-Out Time 9.6.3 Bid-Ask Spread 9.7 Credit Risk 9.7.1 Expected Losses in Case of Default 9.7.2 Probability of Default 9.7.2.1 Zero-Coupon Bonds Without Recovery 9.7.2.2 Zero-Coupon Bonds with Recovery 9.7.3 Coupon-Bearing Bonds 9.7.4 Alternative Approaches for Calculating the Probability of Default 9.7.5 Loss Given Default 9.7.6 Protection from Credit Risk 9.7.6.1 Credit Risk Reduction 9.7.6.2 Netting 9.7.6.3 Guarantees—Collaterals 9.7.6.4 Activating/ Triggering Downgrades 9.7.6.5 Credit Derivatives 9.7.7 Credit Ratings Revisited 9.8 Other Risks 9.8.1 ALM Risk 9.8.2 Concentration Risk 9.8.3 Operating Risk 9.9 Risk Management Exercises Exercise 1 Exercise 2 Exercise 3 Exercise 4 Exercise 5 References 10 Bonds and Crises 10.1 The Impact of Crisis on the Bond Yield 10.2 The Impact of QE on the Bond Yield 10.3 Impact on Stakeholders 10.4 The Relationship Between Sovereign Bonds’ Holders and Crises Exercises Exercise 1 Exercise 2 Exercise 3 Exercise 4 Exercise 5 References 11 Bonds and Debt 11.1 The Impact of Public and Private Debt to Bond Yields 11.2 Policymaking Implications 11.3 The Composition of Debt and its Sustainability Exercises Exercise 1 Exercise 2 Exercise 3 Exercise 4 Exercise 5 References 12 Bonds versus Stocks 12.1 Stocks 12.1.1 Preferred Stock 12.1.2 Common Stock 12.2 Stock Valuation 12.2.1 Stock Valuation Based on Dividends—Discounted Dividend Model (DDM) 12.2.2 Stock Valuation with the Use of Gordon’s Formula 12.2.2.1 Estimating g 12.2.3 Stock Valuation Based on Market/ Equity Financial Ratios/ Multiples 12.2.3.1 P/E 12.2.3.2 Company/ Equity Valuation with the Use of P/E 12.2.3.3 P/BV 12.2.3.4 Company/ Equity Valuation with the Use of P/BV 12.2.3.5 Other Ratios 12.2.3.6 Combination of Ratios 12.3 Stock Returns 12.3.1 Holding Period Return 12.3.2 Capital Asset Pricing Model - CAPM 12.3.3 Dividend Yield 12.4 Comparison of Bonds and Stocks 12.4.1 Selecting Between a Stock and a Bond with the Use of HPR 12.4.2 Selecting Between a Stock and a Bond with the Use of Current Yield and Dividend Yield 12.4.3 Selecting Between a Stock and a Bond with the Use of Utility Functions 12.5 Company Financing Exercises Exercise 1 Exercise 2 Exercise 3 Exercise 4 Exercise 5 Exercise 6 Exercise 7 Exercise 8 Exercise 9 Exercise 10 References 13 Hedging, Speculation and Arbitrage 13.1 Hedging 13.1.1 Using Futures or Forward Contracts to Hedge 13.1.1.1 Optimal Hedge Ratio 13.1.1.2 Duration-Based Hedging 13.1.2 Using Options to Hedge 13.2 Speculation 13.2.1 Using Forward or Futures Contracts to Speculate 13.2.2 Using Options to Speculate 13.3 Arbitrage 13.3.1 Using Forward or Futures Contracts to Exploit Arbitrage Opportunities 13.3.2 Using Options to Exploit Arbitrage Opportunities Exercises Exercise 1 Exercise 2 Exercise 3 Exercise 4 Exercise 5 Exercise 6 Exercise 7 Exercise 8 Exercise 9 Exercise 10 Reference 14 Bonds and Regulation 14.1 Capital Markets Union 14.1.1 The History of CMU 14.1.2 The Benefits of the CMU 14.1.3 What Has Been Done so Far Towards the Establishment of the CMU? 14.1.4 Challenges and the New CMU Action Plan 14.1.5 CMU and Bonds 14.1.5.1 Covered Bonds 14.1.5.2 SME Financing 14.2 Green Bonds 14.2.1 The EU Green Deal 14.2.1.1 Other Initiatives 14.2.2 What Are Green Bonds? 14.2.3 Why Are Green Bonds Becoming Popular? 14.2.4 What Are the Green Bond Principles? 14.2.4.1 Use of Proceeds 14.2.4.2 Process for Project Evaluation and Selection 14.2.4.3 Management of Proceeds 14.2.4.4 Reporting 14.2.5 What Are the Eligible Green Projects? 14.2.6 What Is the External Review Process? 14.2.6.1 Second Party Opinion 14.2.6.2 Verification 14.2.6.3 Certification 14.2.6.4 Green Bond Scoring/Rating 14.2.7 The Green Bond Market 14.2.8 Green Bonds Versus Plain Vanilla Bonds 14.2.9 Concerns Around Green Bonds 14.3 MifID, MifID II/MiFIR and Bond Markets 14.3.1 MiFID 14.3.2 MiFID II/MiFIR 14.3.3 Impact on Bond Markets 14.3.4 Market Structure 14.3.5 Transparency 14.3.6 Best Execution Data Provision 14.3.7 Third Country Trading Venues 14.3.8 Costs and Charges Disclosure 14.3.9 Research Unbundling Rules 14.3.10 Securities Financing Transactions Exercises Exercise 1 Exercise 2 Exercise 3 Exercise 4 Exercise 5 References Index Fixed income investments have been a topic of broad interest, in particular for institutional investors such as insurance companies and pensions schemes. They were considered safe heavens in trbulent times by almost all other institutional and individual investors and are used for strategies such as portfolio immunization and asset liability matching (ALM). The latest crisis, however, revealed some of the weaknesses of fixed income instruments. They proved to be not as safe as originally thought with both credit and interest rate risks emerging. Consequently, fixed income investments have been in the spotlight once more. This book presents all aspects pertaining to fixed income investments, starting from the basicsi.e. the types of bonds, their valuation, the interest rate term structurethen moving to fixed income portfolio management and the interest rate and credit derivatives and their relevant markets, funds, risks and risk management. Finally, the book addresses contemporary issues such as their behavior in times of crisis, their relation to debt, their coexistence with equity and the current regulatory environment. This book, providing a look at the broader environment of fixed income alongside the current market structure, will be of interest to students, academics, researchers and practitioners in fixed income and investing strategies. Thomas Poufinas is Assistant Professor in the Department of Economics of the Democritus University of Thrace. He holds a Ph.D. in Financial Mathematics from the Ohio State University and a Bachelors Degree in Mathematics from the University of Athens. His research focuses on finance, investments, risk management and actuarial science