Bond Basics

BOND BASICS - I Accrued Interest The amount which the buyer of a fixed-income security must pay the seller of the security to compensate the seller for holding the security between the last coupon payment date and settlement date. The accrued interest, added to the instrument's dollar price, constitutes the net amount, net proceeds or invoice amount. How this accrued interest is calculated varies from security to security. Depending on the type of bond, the accrued interest calculation uses one of several day count conventions for calculating the difference between two dates. The most common day count conventions are Actual/Actual, 30/360, and 30/360 European. Average Coupon The weighted average coupon of a bond. Average Life The weighted average time to receipt of principal payments (including scheduled paydowns and repayments). Average Maturity The market value weighted average maturity of the bonds in a portfolio, where maturity is defined as Stated Final for bullet maturity bonds and Average Life for amortizing instruments, including mortgage pass-throughs, CMOs, amortizing asset-backed securities and ARMs. Average Yield The market value weighted average Yield to Maturity/Option a bond. If the bond is trading to the call or put date, the yield to the option date is used. If the bond is trading to the maturity date, the YTM is used.Book Price The amortized carrying cost of the security as of the pricing date. For Treasuries, Agencies, Corporates, ABS and Municipals, the Scientific (Constant Yield) amortization method is used. Securities which are trading to call/(put) as of the Acquisition Date are amortized to the nearest call/(put) date and price. Bond Equivalent Yield Discount securities, like Treasury bills, are quoted on a bank discount basis. But the discount basis is not a yield, and so cannot be compared to yields of other instruments. The bond equivalent yield converts the price implied by the discount basis into a yield which is directly comparable to that of other investments. Call Price, Call Date, and Yield to Call Some bonds may be callable before maturity by the issuer, typically on coupon payment dates. Frequently, these issues pay par plus a premium over par on the call date for the right to call the bonds prior to maturity. This is referred to as a non-par call. Call provisions (i.e. the call premium and the applicable dates) in conjunction with current market conditions will affect the expected cash flow of the bond. Market participants frequently evaluate these securities by calculating yields to these call dates, especially if there is a strong likelihood that the issuer will exercise these rights. The lowest of the yields, under all scenarios, is called the "yield to worst" (we will leave aside the affects of sinking fund provisions on the "yield to worst", at this time). The yield to worst can become the effective yield measure used by the market to price the issue. It is a "Street" convention to price par-callable bonds using their next call date if they are trading above par, and to price them to maturity if trading at, or below, par. Commercial Paper Commercial paper is an unsecured promissory note issued for a specified amount. This security may carry a maturity of up to 270 days. However, the bulk of the issues mature within 30 days or shorter. Among the entities that issue commercial paper are industrial and manufacturing firms, most especially those with good credit ratings. While these firms can readily turn to banks to finance their short-term capital needs, they sometimes choose to sell paper, an alternative and cheaper source of funds. These firms together with finance companies, bank holding companies, municipalities, and municipal authorities have become the major issuers of commercial paper. Through the years, foreign entities such as sovereigns and corporations have joined this list as well. Typically, issuers cannot raise sufficient funds quick enough to pay back maturing paper. To get around this problem, they normally roll over the paper. They sell new paper to pay off the others. Convexity The convexity of a bond measures the curvature of the price/yield relationship of a bond's cash flows. The larger the convexity, the steeper the curvature of the price/yield curve. This behavior is more evident for large changes in yield. High convexity is frequently a desired characteristic because for a given percentage change in yield, up or down, the bond's percentage price gain will be greater than its percentage price loss. Another way of looking at this is to compare two bonds, one with high convexity and one with low convexity. The highly convex bond will become shorter faster than the low convexity bond for a given rise in rates, and will become longer faster than the low convexity bond for a given fall in rates.

In mathematical terms, convexity is related to the second derivative of price with respect to yield. Whereas modified duration may be used to calculate price changes for small changes in yield, duration and convexity together allow you to estimate price changes for large yield movements according to the following relationship: dP= Duration*Price*dY+0.5*Convexity*Price*dYsqrd. where dP = change in price ("delta P") dY = change in yield ("delta Y") Convexity, in conjunction with modified duration, is used to immunize portfolios for large movements in interest rates (see Immunization). Coupon The coupon rate is the annual rate of interest on the bond's face value that the issuer agrees to pay the holder until maturity. The term "coupon" comes from the manner by which bonds were redeemed historically. Attached to older bond certificates were a series of coupons, one for each coupon payment date stipulated in the bond's indenture. At each coupon payment date, the bondholder would clip the appropriate coupon, and present it for payment. Such issues were known as "coupon" or "bearer" bonds. Today, most issuers no longer issue bearer bonds. Instead, almost all bonds are now offered in book-entry registered form. Most U.S. bonds pay interest on a semi-annual basis. For example, the Treasury 8 1/8% due 5/15/2021 will pay coupons of 4.0625% of face value on 5/15 and 11/15 of each year until maturity. Most non-US domestic bond issues pay annual coupons. Exceptions are Japanese Government Bonds, UK Gilts, Canadian bonds, and Australian bonds, which pay coupons semiannually.

BOND BASICS - II Credit Risk Credit risk is the risk that an issuer of a debt security or a borrower may default on its obligations. In a slightly different context, it is also defined as the risk that payment may not be made on the sale of a negotiable instrument (i.e. counter-party risk). Current Yield The current yield of a bond is the annual coupon divided by the market price of the bond. It is an inadequate measure of yield because it takes into account neither the entire amount nor the timing of the cash flows of a bond. Day Count Basis In the capital markets, there are a number of ways that days between dates are computed for interest rate calculations. Many of these conventions were developed before the wide spread introduction of computers. The historical rationale for many of these calculations was to simplify the math involved in performing normally complex financial calculations. And as in most industries with a long history, many of these conventions have stayed with us despite considerable advances in computers and computational methods. The day count basis indicates the manner by which the days in a month and the days in a year are to be counted. The notation utilized to indicate the day count basis is (days in month)/(days in year). For example, 30/360 assumes that each of the twelve months in a year consists of exactly 30 days. On the other hand, Actual/Actual considers the actual number of days in a month and the actual number of days in a year. Other types of day count basis are Actual/360, Actual/365, and 30/360 European. The 30/360 European day count basis differs from 30/360 basis in the algorithm used to handle the end of the month. The five basic day count basis are the following: Actual/360 Actual/365 Actual/Actual 30/360 30/360 European Duration The common objective behind the different definitions of duration is to measure the price sensitivity (and, therefore market risk) of a fixed-income security to changes in its yield. In general, one can distinguish between the following duration or duration-related concepts: Macaulay's duration Modified duration Dollar duration, dPdY, or "risk" Price value of an 01 Yield value of a 32nd Macaulay's Duration If a bond is viewed as a series of cash flows, this concept measures sensitivity (in years) as the present value-weighted average of the cash flows of the bond. As such, it is a good measure for ranking different bonds as to their price sensitivity, and for constructing portfolios which will fully defease a future series of cash flows (see Immunization).

Modified Duration The exact measurement of the price sensitivity of a fixed-income security to a very small change in yield, expressed as a % change in price to a 1% change in yield. Since the price/yield relationship is not linear, the calculation is only exact for very small changes around the initial yield. Dollar Duration, dPdY, or Risk Essentially a tool for calculating the hedge ratio between different securities, this measurement of duration is defined to be the product of the modified duration of the bond and its full price (dollar price plus accrued interest). Price value of an 01, Yield value of a 32nd The concept of duration is frequently used by market participants to "immunize" portfolios (see Immunization). Since many institutional investors have liabilities that must be met on schedule with the proceeds of a bond portfolio, immunization attempts to ensure that regardless of what happens to interest rate levels between the present and the due date of one's liabilities, enough cash will be available to meet them. Duration and convexity are risk estimation tools which allow the manager to structure the portfolio so as to offset the two counterbalancing risks in the fixed-income world: market risk, whereby prices and yields move inversely in proportion to "longness"; and reinvestment risk, whereby as prices rally securities sold and new cash flows are reinvested at lower yield levels, and conversely. Duration (Macaulay's) If a bond is viewed as a series of cash flows, this concept of duration measures price sensitivity (in years) as the present value-weighted average of the cash flows of the bond, according to the formula: DurMac = ( Formula to be represented at a later date) where N = total number of compounding periods to maturity P$ = dollar price of the bond As such, it is a good measure for ranking different bonds as to their price sensitivity, and for constructing portfolios which will fully defease a future series of cash flows (see Immunization). Duration (Modified) The exact measurement of the price sensitivity of a fixed-income security to a very small change in yield, expressed as a % change in price to a 1% change in yield. Since the price/yield relationship is not linear, the calculation is only exact for very small changes around the initial yield. The main difference between modified duration and dollar duration, dPdY or risk lies in that modified duration is expressed as a percentage, whereas the modified duration is expressed in terms of actual dollar price values. Its relationship to Macaulay's duration (DurMac) can be stated as follows: DurMod=(-DurMac)/(1+(Yield/2)) Effective Margin The coupon rate for a floating-rate security periodically changes based on a predetermined index such as the prime rate or the three-month Treasury bill. Given this uncertainty, the true value of the cash flows cannot be determined, and hence, yield to maturity cannot be calculated. A security's effective margin measures the potential return for a floating-rate security. It measures the average spread or margin over the underlying index that an investor can earn over the life of the security. While this measure has its merits, it nevertheless overlooks two important aspects that may affect the potential return from investing in a floating-rate security. First, effective margin assumes that the index will remain constant. Second, this measure does not take into account the cap or floor on the security, if any exists. First Coupon Date The first coupon date is the date on which the first cash coupon payment will be made. Since most bond issues in the US pay semi-annually, normally their first coupons are paid exactly 6 months after they are issued. Such issues are said to have normal first coupons. Sometimes, however, the amount of the first coupon is not equal to 1/2 the issue's coupon rate, because for some reason the bonds were issued before or after the date 6 months prior to the first coupon date. Such issues are said to have "short" (first coupon < normal coupon) or "long" (first coupon > normal coupon) first coupon periods. For example, the U.S. Treasury 7 3/4% due 3/31/96 were originally 5-year notes with a short first coupon. The Federal Reserve would have normally issued the note on 3/31/91. But, since 3/31/91 was a Sunday, the actual issue date was 4/1/91. Therefore, the first coupon was less than the normal 3.875% since the first coupon period was one day less than a normal coupon period. In order to calculate the odd first coupon correctly, both the issue date and the first coupon date must be specified (the first coupon date may be deduced). However, if the settlement date (or valuation date) is beyond the first coupon date, both the issue date and the first coupon date become irrelevant for analytical purposes, since all remaining coupons will be normal.

IRR The "internal rate of return" is the discount rate which equates the present value of the future cash flows of an investment to the cost of the investment. Hence, the net present values of cash outflows and cash inflows equal zero when IRR is used as the discount rate. The yield to maturity in an IRR. Immunization Immunization is the structuring of a portfolio in such a way that any changes in the general level of interest rates will not negatively affect the total expected return from a bond or bond portfolio. There are some important assumptions underlying immunization through duration, chief among which are that when the general level of rates changes, all rates change in a parallel fashion, and that such changes will be "moderate". The latter assumption is necessary when convexity is not used, since duration is only accurate for relatively small changes around the status quo.

BOND BASICS - III Interest Rate Risk Risk associated with fluctuations of bond prices in response to the general movement of the interest rates and to changes in investor perceptions of government monetary policy and economic data. Invoice Price The invoice price of a security is its quoted price plus any accrued interest on the next coupon, where the interest is accrued to the valuation date. Issue Date The issue date is the first day a fixed income security begins accruing interest. Most issues have issue dates that occur on a six month anniversary date of maturity. But some bonds are issued on odd dates. These odd-first coupon bonds pay a different coupon amount during their first Market Risk Market risk is synonymous to the classic price/yield behavior of bonds. As yields fall, bond prices rise; as yields rise, bond prices fall. In some contexts, this phenomenon may be called "interest rate risk" or "price risk". Maturity The maturity of a security is the date the issuer makes the final payment to the security holder. After maturity, no further obligations or rights exist between the two parties. Typically, at maturity the issuer pays the redemption value to the holder, along with the final coupon payment Option Adjusted Spread (OAS) The spread over the Treasury spot curve which equates the present value of a bond's cashflows to its market price, incorporating the fact that the bond's cashflows may change under different interest rate environments. For corporate bonds with embedded options, the OAS is derived using a "finite difference grid" to examine the impact of option features on cashflows across interest rates and through time. For mortgage-backed securities (pass-throughs, CMOs and ARMs), OAS is derived using a Monte Carlo simulation which generates cashflows along various interest rate paths, using the appropriate prepayment model. The spread over the initial Treasury spot curve which equates the average present value of the cashflows across these various paths to the market price of the security is the OAS. Option Adjusted Yield (OAY) For corporate bonds, this is calculated by adding/(subtracting) the value of a call option/(put option) to the bond's market price to obtain the price of an otherwise equivalent but option-free bond. The yield which equates this new higher/(lower) price to the bond's cashflows to maturity is the Option Adjusted Yield. For mortgage-backed securities (pass-throughs and CMOs), this is calculated by first generating the cashflows produced by the vector of single monthly mortality rates (SMMs) based on today's forward curve. These cashflows, which may be thought of as the cashflows which exclude the time value of the prepayment option, are discounted by today's spot curve plus the bonds OAS to derive a theoretical option-adjusted price. The single IRR which equates the SMM cashflows to this theoretical price is the Option Adjusted Yield. Price The price of a security is typically quoted as a percentage of face value. It is also sometimes referred to as the "clean price". The actual payment that is exchanged between two parties may be different from the quoted price. For example, bonds between coupon payments accrue interest that is proportional to the coupon period. Therefore, the buyer has to pay the seller the quoted price of the security plus any accrued interest. This sum is known as the invoice price of the bond. Most securities are quoted as a percent in decimal. For example, a corporate bond quoted as 101.125 is equal to 101 and 1/8th percent. Almost all foreign-denominated securities are quoted in decimal. Treasury and federal agency securities are quoted in 32nds and halves of a 32nd. For example, a price of 101-12 is equal to 101 and 12/32nds percent. As a convention, many market participants use a "+" (plus sign) to denote 1/2 of 1/32nd or 1/64th percent. For example, a price of 101-12+ implies a price of 101 + 12/32nds + 1/64ths percent.

Recently, due to increased competitive pressures in the marketplace, another convention has been adopted for instruments trading in 32nds. The two places to the right of the decimal point remain in 32nds. A third decimal place was added to represent 1/8ths of a 32nd or 1/256th. For example, a price of 101.126 implies a price of 101 + 12/32nds + 6/256ths percent. Though these conventions seem confusing, most market participants are familiar with the quoting conventions of securities they frequently trade. Exercise caution when trading across market sectors. There is a big difference between 101.16 quoted in 32nds and 101.16 quoted in decimal. This warning holds true for day count conventions as well. As a general rule, verify the conventions in use when in doubt. Redemption Value Most securities pay 100% of face value (par) at maturity. Some may pay more or less at redemption, depending upon call and put terms for the issue. These amounts would be paid on corresponding call and/or put dates. Redemption value is that amount which is paid to redeem the securities. Reinvestment Rate The reinvestment rate is the rate at which intermediate income will be invested. Many securities like bonds make intermediate payments between the settlement date (or valuation date) and some horizon date. To analyze the return of all these cash flows, the intermediate payments are assumed to be reinvested at a user-defined reinvestment rate until the investment horizon date. Reinvestment Risk Reinvestment risk refers to the risk that a bondholder may only be able to reinvest his coupons at a lower rate than originally planned. If yields fall, his reinvestment income and consequently his total return from holding the bond will fall relative to the original yield. Conversely, if yields rise, total return will also rise. The time to maturity and the coupon rate determine the degree of reinvestment risk. For a given yield to maturity and a given coupon rate, the longer the maturity, the greater the reinvestment risk. A long maturity implies that the bond's total return is heavily dependent on interest earned on coupon payments in order to realize the yield to maturity at the time of purchase. Likewise, for a given maturity and a given yield to maturity, higher coupon payments translate to greater reinvestment risk. Risk-Free Rate This refers to the return on a risk-free investment, with risk taken to mean "credit risk". An example is the yield on the three-month Treasury bill. Given that this security carries the explicit backing of the U.S. Government and that its term is short enough to minimize the risks of inflation and market interest rate changes, the yield on this T-Bill may be considered risk-free.

BOND BASICS - IV Settlement Date Settlement date is the date when a security and the payment for it are actually exchanged between buyer and seller. It is also commonly known as the valuation date. Swap Hedge Ratios A swap hedge ratio answers the question: "If I sell Bond A, how much of Bond B should I buy to achieve my swap objectives?" While there have been various weighting schemes over the years, and while there may be good reasons for using such schemes as "$ for $ swap", the "dollar duration"-based approaches are the ones which answer the above question most appropriately for most investors. $ for $ Swap A bond swap in which the weighting is established by dividing the net proceeds of the "sell" security by the net proceeds of the "buy" security, rounding down to the nearest number of whole "buy" bonds. Note that you may purchase more or less of the second bond depending on the bonds' respective invoice prices. For example, when you sell 1,000M face value of the first bond at 110.00%, your proceeds amount to $1,100M (assuming no accrued interest is due). With this, you may purchase 1,100M of bonds trading at par. Par for Par Swap A bond swap in which the investor replaces the par value of the bonds sold with exactly the same par amount of bonds purchased. This only makes sense if the swap represents a trade between two bonds which are virtually substitutes for one another. Yield Value of a 32nd Swap A bond swap in which the weighting of the two bonds is made according to the respective values of the yield values of a 32nd. This weighting will be very close to weighting the trade according to a duration scheme. Dollar duration, dPdY, or "risk" Swap A bond swap in which the weighting of the two bonds is made according to their respective measures of $ duration, defined to be the product of the modified duration of the bond and its full price (dollar price plus accrued interest). Tom Next Tom next or "tomorrow next" refers to a transaction in the interbank market in Eurodollar deposits and the foreign exchange market with a next business day value or delivery date

Underwrite To assume the risk of buying a new security issue from a corporate or federal entity, and profiting or losing by reselling at a spread between a fluctuating public offering price and the purchase price. Volatility A relative measure of how rapidly the price of a security falls or rises within a short period of time. WAC (Weighted Average Coupon) An arithmetic mean of the coupon rate of the underlying mortgage loans or pools that serve as collateral for a security. WAC is calculated by (1) Multiplying the purchased unpaid principal balance of each mortgage by its coupon rate (resulting in a "product" for each mortgage) (2) Adding the products for all of the mortgages (3) Dividing the sum by the aggregate purchased unpaid principal balance of all the mortgages in the group. WALA (Weighted Average Loan Age) The weighted average number of months since the date of note origination of the mortgages in the Participation Certificate pool. WAM (Weighted Average Maturity) An arithmetic mean of the remaining term to maturity of the underlying mortgage loans that collateralize a security. WARM (Weighted Average Remaining Maturity) The WARM of any group of mortgages is calculated by (1) Multiplying the unpaid principal balance of each mortgage by the number of months remaining to maturity (resulting in a "product" for each mortgage), (2) Adding the products for all of the mortgages, (3) Dividing the sum by the aggregate unpaid principal balance of all the mortgages in the group. When Issued Term for a Treasury bond transaction conditionally made because the bond, although authorized, has not yet been issued. Yield Also known as "yield to maturity", yield is defined as the internal rate of return of a security's cash flows. It is that discount rate which equates a bond's invoice price (principal + accrued interest) with the present value of its coupon and principal payments. For most securities, this rate is quoted in terms of the compounding convention of the security. Money market instruments quote yield on a simple interest basis, whereas bonds are quoted on a semi-annual, compounded basis. Except in the case of zero-coupon instruments, "yield" is not an assured rate. In addition, it suffers from the inherent limitations of any internal rate of return (see IRR). This is one of the reasons why there exist other frameworks within which to compare securities. Yield to Call The yield to call is the interest rate that will make the present value of the cash flows equal to the price paid for the bond if it is held to its first call date. Yield to call is computed in the same manner as yield to maturity, except that the maturity date is replaced by the first call date and that the redemption value at maturity is replaced by the call price. Yield to Maturity Yield to maturity (YTM) is the internal rate of return of a bond. In calculating YTM, coupon income, redemption value, interest earned on interest, as well as the timing of each cash flow, are all taken into account from settlement to maturity. All intermediate cash flows are reinvested at the YTM itself. The YTM may only be realized when the bond is held to maturity and all cash flows are reinvested at exactly the YTM rate. Yield Value of a 32nd The yield value of an 32nd measures the amount by which the yield on a security would change if its price moved by 1/32. This is a price sensitivity measurement. Zero Coupon Bond A bond that pays no periodic interest and sold at a deep discount from the face value. Buyer's rate of return comes from the gradual appreciation of the bond.

Bond Ratings There are three main risks that investors face when investing in bonds: interest rate risk (the risk that interest rates could rise), purchasing power risk (the risk that inflation will rise and thereby erode the value of bonds), and credit risk (the risk that a bond issuer will become unable to meet its debt obligations). While assessing the first two risks demands that individual investors conduct a significant amount of research on their own, credit risks are arguably the easiest for investors to assess—thanks to credit ratings.

Credit ratings are essentially rankings of a company’s ability to repay their debts and to withstand various types of financial and economic stress compared to that of other companies. Ratings are intended to help provide forward-looking opinions on a company’s ability and willingness to pay interest and repay principle as scheduled. (For purposes of simplification, this article will discuss ratings as they apply to corporations. Keep in mind that the same general principles apply to government debt, municipal debt, agencies, and other fixed income securities). The Rating Agencies There are several private companies that issue credit ratings, the most prominent of which are: Moody’s Investor Services, Standard & Poors, Fitch IBCA, and Duff & Phelps. Each of these rating agencies follows a very thorough and rigorous methodology for determining a company’s creditworthiness. While the rating that each of these agencies assigns to a particular company can sometimes vary, for the most part their assessments are not usually far apart. The most prominent and oldest of the rating agencies is Moody’s. It all began in 1909 when founder John Moody introduced a simple grading system for railroad bonds. Soon enough, Moody’s methodology was being applied to other industries and the ratings system was underway. Moody’s current broad reach extends to roughly 1,500 issuers and some $2 trillion of bonds rated in the Aaa to Baa grades (more on these symbols later). Moody’s has ratings on 90% of public market bonds. For anyone that can cite the alphabet, the ratings system is actually quite simple to learn. All of the rating agencies use the letters A through D to signify a decreasing level of credit worthiness. There are two main categories of investments within the A through D grades—investment grade and below-investment-grade. Investment grade bonds are believed to have a low probability of default whereas below-investment-grade bonds are thought to have a relatively greater probability of default. Below is a simplified table detailing the ratings used by the major rating agencies: CREDIT RATINGS Credit Risk 1.Moody's* 2.Standard & Poor's* 3.Fitch IBCA** 4.Duff & Phelps** INVESTMENT GRADE Highest quality 1.Aaa 2.AAA 3.AAA 4.AAA High quality (very strong) 1.Aa 2.AA 3.AA A4.A Upper medium grade (strong) 1.A 2.A 3.A 4.A Medium grade 1.Baa 2.BBB 3.BBB 4.BBB NOT INVESTMENT GRADE Lower medium grade (somewhat speculative) 1.Ba 2.BB 3.BB 4.BB Low grade (speculative) 1.B 2.B 3.B 4.B Poor quality (may default) 1.Caa 2.CCC 3.CCC 4.CCC Most speculative 1.Ca 2.CC 3.CC 4.CC No interest being paid or bankruptcy petition filed 1.C 2.C 3.C 4.C In default 1.C 2.D 3.D 4.D Note that only Moody’s uses a lower case letter in their ratings system. In addition, they often attach a number to their letter ratings as well. They do this to give their ratings assignment greater specificity with regard to rank and to avoid generalizations within ratings categories. Here is how Moody’s describes the use of numbers within ratings grades: “Moody's applies numerical modifiers 1, 2, and 3 in each generic rating classification from Aa through Caa. The modifier 1 indicates that the obligation ranks in the higher end of its generic rating category; the modifier 2 indicates a mid-range ranking; and the modifier 3 indicates a ranking in the lower end of that generic rating category.” Basically, the numerical modifiers that Moody’s uses increases the number of ratings grades that they can assign. This gives investors still-more information to gauge the creditworthiness of the companies that they analyze. The Ratings Categories—Investment Grade The most familiar of the credit ratings is, of course, triple-A. Triple-A rated bonds are deemed to be of the highest credit quality. Companies that obtain a triple-A rating have the highest capacity to meet its financial commitments. Triple-A rated bonds are deemed protected by a “large and exceptionally stable margin and principal is secure,” according to Moody’s. While triple-A rated companies are, as with all companies, subject to potential changes in their outlook, the changes are felt “unlikely to impair the fundamentally strong position” of these companies. Examples of companies that carry the prestigious triple-A rating include companies with strong balance sheets in industries that are generally not subject to the extremes of the business cycle. Companies such as General Electric, Exxon, the United Parcel Service, Merck, and Johnson & Johnson carry a triple-A rating on their debt. Double-A rated bonds “differ from the highest-rated obligations only in small degree,” according to “Standard & Poor’s.” Companies that carry a double-A rating are believed to have a very strong capacity to meet its financial obligations. Here is how Moody’s characterizes double-A bonds: “Bonds which are rated Aa are judged to be of high quality by all standards. Together with the Aaa group they comprise what are generally known as high-grade bonds. They are rated lower than the best bonds because margins of protection may not be as large as in Aaa securities or fluctuation of protective elements may be of greater amplitude or there may be other elements present which make the long-term risk appear somewhat larger than the Aaa securities.”

The double-A rating is applied to a diverse group of elite companies from a broad array of industries. Companies that carry a double-A rating include AT & T, Proctor & Gamble, Kimberly Clark, Motorola, JP Morgan, Dupont, and Eli Lilly. Beyond the two high-grade ratings categories, triple-A and double-A, the creditworthiness of companies with lower ratings begins to deteriorate slowly but surely. Single-A rated bonds, for example, are considered “susceptible” to changing business and economic conditions and their ability to repay their debts is considered merely “adequate.” Thus, investment in single-A rated bonds carries a somewhat higher degree of risk than the highgrade categories do. Examples of bonds carrying the single-A designation include bonds of companies with somewhat greater sensitivity to cyclical economic conditions than companies rated triple- and double-A rated ratings. These include the consumer cyclical companies such as retailers and automobile companies. Financial companies are also often in this category because their profits and potential losses (from loan losses, bankruptcies, and the like) can vary sharply with the ups and downs of the business cycle. Below Investment-Grade The final ratings category considered investment-grade is triple-B. Bonds in this category are basically on the borderline between investment- and speculative-grade debt. As Moody’s puts it, they are “neither highly protected nor poorly secured.” Triple-B bonds are felt to have less protective elements than higher rated bonds and are considered vulnerable to potential changes in both an obligor’s company business fundamentals as well as the economic environment. Companies in this category are therefore likely to have a weakened capacity to repay its debts under changed circumstances. Beyond the triple-A to triple-B range, obligations rated BB, B, CCC, CC, and C are regarded as having significant speculative characteristics with BB indicating the least degree of speculation and C the highest. But companies carrying below investment-grade ratings are not necessarily outright speculative investments. Indeed, many of them have at least some quality and protective characteristics, even if they are outweighed by many uncertainties and vulnerabilities. How Credit Ratings Affect a Bond’s Yield The ratings designation on a bond has a significant bearing upon its yield-to maturity. Triple-A rated bonds for example, will have a much lower yield compared to that of triple-B bonds. In recent years triple-A bonds have averaged a yield of *** basis points over U.S. Treasuries. In contrast, triple-B bonds have averaged a yield of *** basis points over Treasuries. High-yield bonds, also known as junk bonds, have averaged a yield of roughly *** basis points over the same time period. But just because certain bonds with the same maturity share the same ratings designation doesn’t necessarily mean that their yields will be the same, too. Indeed, for a variety of reasons, two companies with identical ratings and maturity dates could have much different ratings. Factors that could cause similarly rated bonds to differ in yield include: industry fundamentals and characteristics such as the extent to which one company’s bonds are more or less vulnerable to the ups and downs of the business cycle; the total amount of debt that a company owes; an agencies opinion about a company’s management; cash flows; and exposure to various risks including regulations, and international conditions. Methodology The rating agencies conduct a very thorough review of the companies that they rate. There are numerous considerations that are weighed, the most important of which is a company’s cash flow. Basically, if a company is a cash cow, it is very likely to have a high credit rating. Rating companies look closely at the source of a company’s cash flow as well as its variety, availability, and source. Companies with high credit ratings have quick-turning, high quality accounts receivable, meaning that they are getting paid on time and getting all that they are due. Rating agencies also consider it important that a company have the ability to sustain their profitabaility.. Aside from cash flows, rating agencies scrutinize a company’s management for their competence, structure, strategic planning, and composition. Other considerations include scrutiny of a company’s appetite for risk and competition. Scrutiny of a company’s cash flows and their overall balance sheet requires a significant amount of mathematical homework. Rating agencies therefore deploy dozens of mathematical formulas and financial ratios to aid them in their rigorous examinations. The ratios are used for gaining an understanding of the financial characteristics of a firm. But rating agencies take pains to meld both quantitative and qualitative analyses in order to get the most complete picture of a company. Rating agencies must always consider external factors such as the economic cycle but the fundamentals of the companies that they rate always get first consideration and have a far greater bearing on a company’s overall rating. Nevertheless, rating agencies have increased their responsiveness to and consideration of the economic cycle in recent years given the large impact that the economic cycle has on many companies.

Credit Ratings: A Must-Have For Every Fixed Income Toolbox As you can see, rating agencies supply an enormous amount of information to help investors in the investment decision-making process. Investors are fortunate to have the complex and thorough research of the rating agencies summarized for them with a few simple ratings grades. Investors need simply gain an understanding of the various ratings grades to begin using ratings in their arsenal of research tools. Of course, investors should do a bit of research of their own, too, but it’s comforting to know the rating agencies have done a good deal of work for us.

Standard & Poor's : Credit Rating A Standard & Poor's issue credit rating is a current opinion of the creditworthiness of an obligor with respect to a specific financial obligation, a specific class of financial obligations, or a specific financial program (including ratings on medium term note programs and commercial paper programs). It takes into consideration the creditworthiness of guarantors, insurers, or other forms of credit enhancement on the obligation and takes into account the currency in which the obligation is denominated. The issue credit rating is not a recommendation to purchase, sell, or hold a financial obligation, inasmuch as it does not comment as to market price or suitability for a particular investor. Issue credit ratings are based on current information furnished by the obligors or obtained by Standard & Poor's from other sources it considers reliable. Standard & Poor's does not perform an audit in connection with any credit rating and may, on occasion, rely on unaudited financial information. Credit ratings may be changed, suspended, or withdrawn as a result of changes in, or unavailability of, such information, or based on other circumstances. Issue credit ratings can be either long-term or short-term. Short-term ratings are generally assigned to those obligations considered short-term in the relevant market. In the U.S., for example, that means obligations with an original maturity of no more than 365 days - including commercial paper. Short-term ratings are also used to indicate the creditworthiness of an obligor with respect to put features on long-term obligations. The result is a dual rating, in which the short-term rating addresses the put feature, in addition to the usual long-term rating. Medium-term notes are assigned long-term ratings. Long-term issue credit ratings Issue credit ratings are based, in varying degrees, on the following considerations: Likelihood of payment - capacity and willingness of the obligor to meet its financial commitment on an obligation in accordance with the terms of the obligation; Nature of and provisions of the obligation; Protection afforded by, and relative position of, the obligation in the event of bankruptcy, reorganization, or other arrangement under the laws of bankruptcy and other laws affecting creditors' rights. The issue rating definitions are expressed in terms of default risk. As such, they pertain to senior obligations of an entity. Junior obligations are typically rated lower than senior obligations, to reflect the lower priority in bankruptcy, as noted above. (Such differentiation applies when an entity has both senior and subordinated obligations, secured and unsecured obligations, or operating company and holding company obligations.) Accordingly, in the case of junior debt, the rating may not conform exactly with the category definition. AAA An obligation rated 'AAA' has the highest rating assigned by Standard & Poor's. The obligor's capacity to meet its financial commitment on the obligation is extremely strong. AA An obligation rated 'AA' differs from the highest rated obligations only in small degree. The obligor's capacity to meet its financial commitment on the obligation is very strong. A An obligation rated 'A' is somewhat more susceptible to the adverse effects of changes in circumstances and economic conditions than obligations in higher rated categories. However, the obligor's capacity to meet its financial commitment on the obligation is still strong.

BBB An obligation rated 'BBB' exhibits adequate protection parameters. However, adverse economic conditions or changing circumstances are more likely to lead to a weakened capacity of the obligor to meet its financial commitment on the obligation. Obligations rated 'BB', 'B', 'CCC', 'CC', and 'C' are regarded as having significant speculative characteristics. 'BB' indicates the least degree of speculation and 'C' the highest. While such obligations will likely have some quality and protective characteristics, these may be outweighed by large uncertainties or major exposures to adverse conditions. BB An obligation rated 'BB' is less vulnerable to nonpayment than other speculative issues. However, it faces major ongoing uncertainties or exposure to adverse business, financial, or economic conditions which could lead to the obligor's inadequate capacity to meet its financial commitment on the obligation. B An obligation rated 'B' is more vulnerable to nonpayment than obligations rated 'BB', but the obligor currently has the capacity to meet its financial commitment on the obligation. Adverse business, financial, or economic conditions will likely impair the obligor's capacity or willingness to meet its financial commitment on the obligation. CCC An obligation rated 'CCC' is currently vulnerable to nonpayment, and is dependent upon favorable business, financial, and economic conditions for the obligor to meet its financial commitment on the obligation. In the event of adverse business, financial, or economic conditions, the obligor is not likely to have the capacity to meet its financial commitment on the obligation. CC An obligation rated 'CC' is currently highly vulnerable to nonpayment. C A subordinated debt or preferred stock obligation rated 'C' is CURRENTLY HIGHLY VULNERABLE to nonpayment. The 'C' rating may be used to cover a situation where a bankruptcy petition has been filed or similar action taken, but payments on this obligation are being continued. A 'C' also will be assigned to a preferred stock issue in arrears on dividends or sinking fund payments, but that is currently paying. D An obligation rated 'D' is in payment default. The 'D' rating category is used when payments on an obligation are not made on the date due even if the applicable grace period has not expired, unless Standard & Poor's believes that such payments will be made during such grace period. The 'D' rating also will be used upon the filing of a bankruptcy petition or the taking of a similar action if payments on an obligation are jeopardized. Plus (+) or minus(-): The ratings from 'AA' to 'CCC' may be modified by the addition of a plus or minus sign to show relative standing within the major rating categories. r This symbol is attached to the ratings of instruments with significant noncredit risks. It highlights risks to principal or of expected returns which are not addressed in the credit rating. Examples include: obligations linked or indexed to equities, currencies, or commodities; obligations exposed to severe prepayment risk - such as interest-only or principal-only ; and obligations with unusually risky interest terms, such as inverse floaters. N.R. This indicates that no rating has been requested, that there is insufficient information on which to base a rating, or that Standard & Poor's does not rate a particular obligation as a matter of policy.

Hedge Funds Defined Considering the role that hedge funds have played in the current subprime mess in the U.S., it would seem prudent to first learn what they are. Hedge funds arrived on the markets with a bang in the early 1990s. Regardless of the enormous losses that this asset class had suffered in 1994, the industry managed to keep its allure. To illustrate, in 1988 there were 1,373 hedge funds. By the end of 2001, the industry grew to approximately 7,000 hedge funds. In terms of assets under management, the dollar size of the industry grew from $42.0 billion in 1988, to $311.0 billion in 1998, to over $600.0 billion in 2001. Today, the global hedge fund industry is estimated at $2.0 trillion and with approximately 10,000 active hedge funds. (Source: The Hedge Fund Association). Objectives and Characteristics Originally, hedge funds offered investors opportunities to play against the markets. Strategies used varied from short selling, to trading futures, to trading other types of forward commitments and contingent claims. Today, however, hedge funds are anything but a homogeneous class pursuing some goal common to all. As the subprime lending crisis unraveled, it became apparent that a number of hedge funds were highly leveraged. Of course, not all of them were or are, and the ability to use leverage is not the only characteristic unique to hedge funds. There are also funds that bet on commodity prices, on currencies, interest rates and other financial derivatives. And there are hedge funds that focus on exploiting violations of the law of one price. But the common denominator to all appears to be searching for absolute returns. Most money managers today labor under intense public scrutiny and pressure to beat some benchmark, usually a broader market index. In contrast, hedge funds are not “tied down” by a specific mandate, but rather they are “free” to search for absolute returns every which way. That being the case, the only “deities” hedge fund managers bow to are alphas and betas. Investors should be aware that since hedge funds’ profit extracting strategies are also extremely high risk activities, it is hardly surprising that hedge fund managers demand serious compensation for their efforts and why hedge funds have very high fee structures. Structure Hedge funds in the U.S. can be set up in one of two ways: limited partnerships; and, offshore corporations. In essence, both legal structures permit hedge fund managers to go long or short on a security, to employ any type of a derivative they like, and to borrow more or less without adhering to the usual regulatory minimum capital restrictions. Most hedge funds in the U.S. are structured as limited partnerships. Such structure allows them to be exempt from certain Securities and Exchange Commission (SEC) regulations under the Investment Company Act, especially if incorporated in the state of Delaware, the socalled “fund-friendly” state. Note that some rules still apply, such as, generally, having no more than a hundred accredited investors (individuals with a net worth of more than $1.0 million or annual income of more than $200,000). Hedge funds are also not allowed to advertise themselves to the general investing public. Offshore hedge funds have also been popular among North American investors. Incorporated in places such as the Cayman Islands or Bermuda, due to a number of legal and fiscal exemptions, offshore hedge funds appeal to a wide spectrum of investors worldwide, from ordinary people, to tax-free pension funds, to Japanese investors hedging their profits in yen, etc. In most cases, offshore hedge funds are merely a stopover on the paper trail that goes to a “parent fund,” usually a limited partnership incorporated in the Cayman Islands. Types of Hedge Funds Hedge funds are not as easy to classify as one might think. As their popularity grew, numerous types and sub-types of hedge funds emerged, catering to a truly diversified global client base.

Long/short funds—a traditional type that balances long and short positions depending on market forecasts; Market-neutral funds—a form of long/short funds whereby long and short positions are both dollar and market-neutral; note that other market-neutral strategies include fixed income hedging, pairs trading, various types of arbitrage, etc. Global macro funds—these funds bet against some macroeconomic variable, such as a currency, interest rates, direction of a market, etc.; in addition, global macro funds are often highly leveraged and their performance depends on extensive use of derivative instruments; Event-driven funds—these funds bet on certain developments to take place, usually with a company or a security; the idea is to earn profits as prices move from imbalance to new equilibrium. With some basic definitions out of the way, the next discussion concerns the issue of leverage and exposure to various risks that are unique to hedge funds. Source: International Investments, Fifth Edition, by Bruno Solnik and Dennis McLeavey, Copyright 2004.