STUDY SESSION 15 Fixed Income Investments

STUDY SESSION 15 Fixed Income Investments Basic Concepts

This study session presents the foundation for fixed income investments, one of
the largest and fastest growing segments of global financial markets. It begins
with an introduction to the basic features and characteristics of fixed income securities
and the associated risks. The session then builds by describing the primary
issuers, sectors, and types of bonds. Finally, the study session concludes with an
introduction to yields and spreads and the effect of monetary policy on financial
markets. These readings combined are the primary building blocks for mastering
the analysis, valuation, and management of fixed income securities.

LEARNING OUTCOMES
Reading 62: Features of Debt Securities
The candidate should be able to:
a. explain the purposes of a bond’s indenture, and describe affirmative and negative
covenants;
b. describe the basic features of a bond, the various coupon rate structures, and the
structure of floating-rate securities;
c. define accrued interest, full price, and clean price;
d. explain the provisions for redemption and retirement of bonds;
e. identify the common options embedded in a bond issue, explain the importance
of embedded options, and state whether such options benefit the issuer or the
bondholder;
f. describe methods used by institutional investors in the bond market to finance
the purchase of a security (i.e., margin buying and repurchase agreements).

Reading 63: Risks Associated with Investing in Bonds
The candidate should be able to:
a. explain the risks associated with investing in bonds;
b. identify the relations among a bond’s coupon rate, the yield required by the market,
and the bond’s price relative to par value (i.e., discount, premium, or equal
to par);
c. explain how features of a bond (e.g., maturity, coupon, and embedded options)
and the level of a bond’s yield affect the bond’s interest rate risk;
d. identify the relationship among the price of a callable bond, the price of an
option-free bond, and the price of the embedded call option;
e. explain the interest rate risk of a floating-rate security and why such a security’s
price may differ from par value;
f. compute and interpret the duration and dollar duration of a bond;
g. describe yield curve risk and explain why duration does not account for yield
curve risk for a portfolio of bonds;
h. explain the disadvantages of a callable or prepayable security to an investor;
i. identify the factors that affect the reinvestment risk of a security and explain why
prepayable amortizing securities expose investors to greater reinvestment risk
than nonamortizing securities;
j. describe the various forms of credit risk and describe the meaning and role of
credit ratings;
k. explain liquidity risk and why it might be important to investors even if they
expect to hold a security to the maturity date;
l. describe the exchange rate risk an investor faces when a bond makes payments
in a foreign currency;
m. explain inflation risk;
n. explain how yield volatility affects the price of a bond with an embedded
option and how changes in volatility affect the value of a callable bond and a
putable bond;
o. describe the various forms of event risk.

Reading 64: Overview of Bond Sectors and Instruments
The candidate should be able to:
a. describe the features, credit risk characteristics, and distribution methods for
government securities;
b. describe the types of securities issued by the U.S. Department of the Treasury
(e.g., bills, notes, bonds, and inflation protection securities), and differentiate
between on-the-run and off-the-run Treasury securities;
c. describe how stripped Treasury securities are created and distinguish between
coupon strips and principal strips;
d. describe the types and characteristics of securities issued by U.S. federal agencies;
e. describe the types and characteristics of mortgage-backed securities and explain
the cash flow, prepayments, and prepayment risk for each type;
f. state the motivation for creating a collateralized mortgage obligation;
g. describe the types of securities issued by municipalities in the United States, and
distinguish between tax-backed debt and revenue bonds;
h. describe the characteristics and motivation for the various types of debt issued by
corporations (including corporate bonds, medium-term notes, structured notes,
commercial paper, negotiable CDs, and bankers acceptances);

i. define an asset-backed security, describe the role of a special purpose vehicle in
an asset-backed security’s transaction, state the motivation for a corporation to
issue an asset-backed security, and describe the types of external credit enhancements
for asset-backed securities;
j. describe collateralized debt obligations;
k. describe the mechanisms available for placing bonds in the primary market and
differentiate the primary and secondary markets in bonds.

Reading 65: Understanding Yield Spreads
The candidate should be able to:
a. identify the interest rate policy tools available to a central bank (e.g., the U.S.
Federal Reserve);
b. describe a yield curve and the various shapes of the yield curve;
c. explain the basic theories of the term structure of interest rates and describe the
implications of each theory for the shape of the yield curve;
d. define a spot rate;
e. compute, compare, and contrast the various yield spread measures;
f. describe a credit spread and discuss the suggested relation between credit
spreads and the well-being of the economy;
g. identify how embedded options affect yield spreads;
h. explain how the liquidity or issue-size of a bond affects its yield spread relative to
risk-free securities and relative to other securities;
i. compute the after-tax yield of a taxable security and the tax-equivalent yield of a
tax-exempt security;
j. define LIBOR and explain its importance to funded investors who borrow
short term.

Reading 66: Monetary Policy in an Environment
of Global Financial Markets
The candidate should be able to:
a. identify how central bank behavior affects short-term interest rates, systemic liquidity,
and market expectations, thereby affecting financial markets;
b. describe the importance of communication between a central bank and the
financial markets;
c. discuss the problem of information asymmetry and the importance of predictability,
credibility, and transparency of monetary policy.