An Introduction to Bond Markets, 4th Edition

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