An Introduction to Bond Markets

Foreword xvii Preface xix Preface to the First Edition xxiii About the author xxv 1 Introduction to Bonds 1 Description 4 Outline of market participants 6 Bond analysis 8 Financial arithmetic: the time value of money 8 Present value and discounting 9 Discount factors and boot-strapping the discount function 15 Bond pricing and yield: the traditional approach 18 Bond pricing 18 Bond yield 23 Accrued interest 30 Clean and dirty bond prices 30 Day-count conventions 32 Illustrating bond yield using Excel spreadsheets 33 Bibliography 38 2 The Yield Curve, Spot and Forward Yields 41 The yield curve 42 Yield-to-maturity yield curve 42 The par yield curve 44 The zero-coupon (or spot) yield curve 45 The forward yield curve 49 Theories of the yield curve 50 Spot rates 54 Discount factors and the discount function 55 The boot-strapping method: deriving the theoretical zero-coupon (spot) rate curve 56 Mathematical relationship 60 Implied forward rates 62 Understanding forward rates 69 The term structure of interest rates 70 Bibliography 73 3 Bond Instruments and Interest-rate Risk 75 Duration, modified duration and convexity 76 Duration 77 Properties of Macaulay duration 81 Modified duration 81 Convexity 87 Bibliography 91 4 Floating-rate Notes and other Bond Instruments 93 Floating-rate notes 94 Synthetic convertible note 98 Description 98 Investor benefits 99 Interest differential notes 99 Example of IDN 99 Benefits to investors 100 Convertible quanto note 101 Example of Japanese equity note 102 Bibliography 105 5 The Money Markets 107 Introduction 109 Securities quoted on a yield basis 111 Money market deposits 111 Certificates of deposit 113 cd yields 114 Securities quoted on a discount basis 118 Treasury bills 120 Banker’s acceptances 121 Eligible banker’s acceptance 122 Commercial paper 123 Commercial paper programmes 124 Commercial paper yields 126 Asset-backed commercial paper 127 Repo 132 Definition 133 The classic repo 134 Examples of classic repo 136 The sell/buy-back 141 Examples of sell/buy-back 142 Repo collateral 144 Legal treatment 146 Margin 146 Variation margin 148 5.A Currencies using money market year base of 365 days 148 6 the Eurobond Market 151 Eurobonds 152 Foreign bonds 155 Eurobond instruments 155 Conventional bonds 155 Floating rate notes 156 Zero-coupon bonds 157 Convertible bonds 157 The issue process: market participants 159 The borrowing parties 160 The underwriting lead manager 162 The co-lead manager 163 Investors 164 Fees, expenses and pricing 164 Fees 164 Expenses 165 Pricing 165 Issuing the bond 166 The grey market 168 Alternative issue procedures 168 Covenants 169 Trust services 170 Depositary 170 Paying agent 171 Registrar 172 Trustee 172 Custodian 173 Form of the bond 173 Temporary global form 173 Permanent global bond 174 Definitive form 174 Registered bonds 175 Fiscal agent 176 Listing agent 176 Clearing systems 176 Market associations 178 International Capital Market Association 178 Bloomberg screens 178 Secondary market 180 Settlement 180 Bibliography 181 7 CONVERTIBLE BONDS, MTNs AND WARRANTS 183 Description 184 Analysis 184 Value and premium issues 187 Zero-coupon convertibles 188 Warrants 189 Medium-term notes 190 MTN programme 191 Shelf registration 192 Credit rating 192 Secondary market 192 Issuers and investors 193 MTNs and corporate bonds 193 8 Credit Ratings 197 Credit ratings 199 Purpose of credit ratings 199 Formal credit ratings 200 Credit rating agencies and the 2007–2008 financial market crash 201 9 Inflation-linked Bonds 209 Basic concepts 210 Choice of index 210 Indexation lag 211 Coupon frequency 213 Type of indexation 213 Index-linked bond cash flows and yields 215 TIPS cash flow calculations 216 TIPS price and yield calculations 217 Assessing yields on index-linked bonds 220 Which to hold: indexed or conventional bonds? 221 Inflation-indexed derivatives 222 Market instruments 223 Applications 227 Bibliography 228 10 An Introduction to Asset-backed Securities 229 The concept of securitisation 232 Reasons for undertaking securitisation 233 Benefits of securitisation to investors 236 The process of securitisation 237 Securitisation process 237 SPV structures 239 Credit enhancement 240 Impact on balance sheet 242 Credit rating 243 Redemption mechanism 245 Average life 245 Illustrating the process of securitisation 246 Securitisation post-credit crunch 250 Bloomberg screens 253 Bibliography 259 11 Introduction to Derivative Instruments 261 Interest-rate swaps 262 Characteristics of IR swaps 264 Swap spreads and the swap yield curve 267 Swap duration 270 Summary of IR swap 271 Non-standard swaps 271 Using swaps 273 Cancelling a swap 276 Zero-coupon swap pricing 276 Hedging using bonds and swaps 278 Swaptions 282 Cross-currency swaps 283 Bloomberg screens 284 Futures contracts 288 Description 288 Bond futures contracts 290 Futures pricing 293 Arbitrage-free futures pricing 297 Hedging using futures 299 The hedge ratio 301 Interest-rate options 302 Introduction 302 Definition 303 Option terminology 305 Option premium 306 Pricing options 307 Behaviour of option prices 311 Using options in bond markets 312 Hedging using bond options 314 Exotic options 315 Bibliography 317 12 Introduction to Credit Derivatives 319 Introduction 321 Why use credit derivatives? 323 Classification of credit derivative instruments 325 Definition of a credit event 326 Asset swaps 327 Credit default swaps 330 Impact of the 2007–2008 credit crunch: new CDS contracts and the CDS ‘Big Bang’ 334 Credit-linked notes 338 Total return swaps 341 Synthetic repo 345 Reduction in credit risk 346 Capital structure arbitrage 347 The TRS as a funding instrument 347 Credit options 349 The CDS iTraxx index 350 General applications of credit derivatives 355 Use of credit derivatives by portfolio managers 355 The credit default swap basis 358 A negative basis 358 The basis as market indicator 361 Bibliography 364 13 Approaches to Government Bond Trading And Yield Analysis 365 Introduction 366 The determinants of yield 366 Spread trade risk weighting 367 Identifying yield spread trades 373 Coupon spreads 374 Butterfly trades 376 Basic concepts 376 Putting on the trade 377 Yield gain 379 Convexity gain 380 Bloomberg screens 384 Bond spreads and relative value 386 Bond spreads 388 Summary of a fund manager’s approach to value creation 393 Bibliography 396 14 Risk Management and Value-at-risk 397 Characterising risk 398 Risk management 400 The risk management function 401 Interest-rate risk 402 Value-at-Risk 403 Definition 403 Calculation methods 404 Validity of the variance–covariance (correlation) VaR estimate 406 Assessment of VaR tool 407 VaR methodology for credit risk 408 Modelling VaR for credit risk 409 Time horizon 411 Applications of credit VaR 412 Bibliography 412 Glossary 413 List of abbreviations 421 Index 425