Lecture Note 1 Handout

Finance 609: Fixed Income Securities Introduction and Course Overview Robert F. Dittmar Stephen M. Ross School of Business University of Michigan

October 27, 2008

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Outline 1

What’s Going on in Fixed Income Markets?

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Introduction to fixed income instruments Treasuries Corporate Bonds Mortgage- and Asset-Backed Securities

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Risks inherent in fixed income securities Interest Rate Risk Credit Risk Liquidity Risk Contractual Risk Other Risks

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What are Fixed Income Securities?

A fixed income security has Regular fixed payments Payment of principal at maturity

More generally refers to debt securities Floating rate notes CDOs/CMOs

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Fixed Income: The Current Environment Fixed income markets dwarf equity markets

Source: Federal Reserve Flow of Funds, Q2 2008

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Fixed Income: The Current Environment Huge growth in government, corporate, and mortgage borrowing

Source: Federal Reserve Flow of Funds, Q2 2008

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Fixed Income: The Current Environment The level of interest rates is falling 10-Year T-Note Yield

Source: Wall Street Journal

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Fixed Income: The Current Environment Perceived default risk is rising

Source: Datastream

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Fixed Income: The Current Environment Resulting in huge losses for investors Dow Jones Corporate Bond Index

Source: Wall Street Journal

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Fixed Income: The Current Environment Flight to safety One Month Bill Yield

Source: Wall Street Journal

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Fixed Income: The Current Environment And widening spreads in safe securities TED Spread

Source: Bloomberg.com F609 (001,002)

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Treasury Securities Treasury Bills Short-term claims on U.S. government Maturities 4 weeks, 13 weeks and 26 weeks, issued weekly 52 weeks, issued monthly (reintroduced 6/3/08)

Quoted at price per $100 face value Sold at discount No coupon payments The return arises because investor pays less than face value Nominal return assumed to be riskless

Source: Treasury Direct

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Treasury Securities Treasury notes, bonds, and TIPS Coupons paid semiannually Principal paid at maturity Notes: 2 - 10 year maturities Bonds: 30 year maturity TIPS: 10 & 20 year maturities, inflation protected

Source: Treasury Direct

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Treasury Securities STRIPS Created by private dealers Represent claims to part of a Treasury issue Coupon stripping $500 million, 10-Year note, 5% coupon 20 semiannual payments of $12.5 million One lump $500 million payment in 10 years

Why strip a bond? Sell the parts for more than the whole

Source: Zions Bank

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Treasury Securities Federal Agency Debt Issued by government agencies Issued in support of farm credit and home mortgages Major mortgage-related agencies Federal Home Loan Bank (FHLB) Federal National Mortgage Association (Fannie Mae) Government National Mortgage Association (Ginnie Mae) Federal Home Loan Mortgage Corporation (Freddie Mac)

Default risk of agency debts historically either zero or very low

Source: Wall Street Journal

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Corporate Debt Instruments Corporate bonds Issued by major corporations Frequently callable Semiannual coupons Rated according to their default risk Moody’s: Aaa, Aa, A, Baa, Ba, B, Caa, Ca, C, D[1,2,3] S&P: AAA, AA, A, BBB, BB, B, CCC, CC, C, D[+,-] Investment Grade (> BBB or Baa) and “Junk Bonds” or Speculative Grade

Historically illiquid Trade Reporting and Compliance Engine (TRACE) Requires all NASD broker/dealers to report transactions 500 issues in July, 2002 17,000 in by October, 2004

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Corporate Debt Instruments Trace quotes:

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Corporate Debt Instruments Trace quotes:

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Mortgage-Backed Securities Issued by government agencies Backed by a pool of mortgages Issuing steps: Originating bank sells pool of mortgages to U.S. agency (GNMA, FNMA, FHLMC) Agency guarantees mortgages against default and then sells pool Investment bank buys pool and sell slices to investors

Collateralized Mortgage Obligations (CMO’s): Principal Only (PO’s) and Interest Only (IO’s) securities Asset-backed Securities: Collateralized Automobile Receivables (CAR’s)

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Mortgage-Backed Securities

Source: Wall Street Journal

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Mortgage-Backed Securities

Source: Wall Street Journal

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Interest Rate Risk

Exposure of an investment’s value to interest rate fluctuations Price risk Bond prices are discounted cash flows If interest rates rise, bond prices fall If interest rates fall, bond prices rise

Reinvestment risk Changes in interest rates affect reinvestment opportunities 10-Year Note with 8% coupon At what rate can you invest the $40 coupon you receive in one year?

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Interest Rate Risk Robert Citron, Orange County, CA: Robert Citron ... had riskily invested the pool’s funds in a leveraged portfolio of mainly interest-linked securities. His strategy depended on short-term interest rates remaining relatively low when compared with medium-term interest rates. But from February 1994, the Federal Reserve Bank began to raise US interest rates, causing many securities in Orange County’s investment pool to fall in value. During much of 1994, Citron ignored the shift in the interest rate environment and the mounting paper losses in his portfolio. But by the end of 1994, demands for billions of dollars of collateral from Citrons Wall Street counterparties, and the threat of a run on deposits from spooked local government investors, created a liquidity trap that he could not escape. Source: erisk.com

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Credit Risk

Inability to service all or part of a debt obligation Causes: Financial distress Bankruptcy Reorganization

Two key concerns: Default probability Rate of recovery

Moody’s and S&P ratings reflect these concerns

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Credit Risk

Source: Datastream

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Credit Risk

Washington Mutual

Source: Bloomberg.com

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Liquidity Risk Liquidity: Ease with which a reasonable sized trade can be transacted in the market within a short notice Number of dealers Size of bid-offer spread Depth

Securities subject to liquidity risk Emerging market debt High-yield debt Municipal bonds Off-the-run Treasuries

Costs Fees and commissions Bid-offer spreads Market impact

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Liquidity Risk Long-Term Capital Management LTCM’s main strategy was to make convergence trades. These trades involved finding securities that were mispriced relative to one another, taking long positions in the cheap ones and short positions in the rich ones. [such as] [c]onvergence between on-the-run and off-the-run U.S. government bonds ... As Russia’s troubles became deeper and deeper, fixed-income portfolio managers began to shift their assets to more liquid assets. In particular, many investors shifted their investments into the U.S. Treasury market. In fact, so great was the panic that investors moved money not just into Treasurys, but into the most liquid part of the U.S. Treasury market – the most recently issued, or "on-the-run" Treasuries. While the U.S. Treasury market is relatively liquid in normal market conditions, this global flight to liquidity hit the on-the-run Treasuries like a freight train. The spread between the yields on on-the-run Treasuries and off-the-run Treasuries widened dramatically: even though the off-the-run bonds were theoretically cheap relative to the on-the-run bonds, they got much cheaper still (on a relative basis). What LTCM had failed to account for is that a substantial portion of its balance sheet was exposed to a general change in the "price" of liquidity.

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Contractual Risk Debt securities may be callable by the issuer at his option or puttable by the investor at his option. A call option introduces a timing risk to investors Interest rates fall Cost of issuing similar debt falls Probability of call increases

MBS have call risk Prepayment Refinancing In the early 90s, many MBS experienced high rates of prepayment Prepayment significantly shortens the securities’ effective life

Call risk must be priced before investing

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Inflation and Currency Risk

Inflation Risk Foreign Exchange Risk Event risk LBO (RJR rating fell from A1 to B3, spread from 100 to 350 bp) Natural accident or regulatory change

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Summary Fixed income markets are the largest source of capital Major types of primitive securities Treasuries Bills (≤ 6 months) Notes, Bonds (≥ 2 years) STRIPS (zero-coupon)

Corporate Debentures Mortgage (Asset)-backed

Unique risks to fixed income securities Interest rate risk Credit risk Liquidity risk

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