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BU 449 Fixed Income Analysis

Table of Contents

Introduction to the Fixed Income Environment

  • US: bloomberg real yield
  • CA: BNN bloomberg

goldilocks report (happy equilibrium)

Inflation @ 2.8% wanted to bring it down to 2% but not really possible anymore. Jobs report are strong so can’t really do any cuts yet.

Job report and interest rate cuts are very highly connected. 2-yr treasury rate fell to 4.79 when it was over 5 a few months ago.

Fed funds rates (US interbank borrowing rate), 2yr treasury

Dual mandate

Things causing inflation: monetary (demand), non-monetary (supply)

How does the policy discussion reflect the yield curve is market driven

Yield curve: yield vs maturity

Suppose 2-year yield has dropped in anticipation of interest rate cuts.

What is refunding regarding bond auctions:

  • government borrowing through issuance of bonds
  • refund: refinancing of existing debt
    • issuing debt to buy back older debt that was probably issued at higher rates
  • probably higher if investors think that the yield will decrease

Bank of Canada mandate is to promote economic and financial welfare, unlike the Federal Reservers mandate which is both price level and unemployment

ECB: European Central Bank

When there is high inflation, coupons are worth less and the higher interest keeps bond prices lower.

Where to invest in? Treasury 2-4yr, Corporate, Provinces.

Federal Agency Securities: debt taken by government corporations

Secularization: Using loans as collateral to sell something

Money Markets: short-term borrowing using commercial paper…

Fixed Income Outstanding

  • Treasury: 22.5
  • Treasury + Federal Agency: ~24T
  • Municipalties: $4T
  • Corporate Bonds: $10T

Trifecta Framework

  • analytics
  • intuition
  • communication

Chapter 1

Market Players

  • Issuers
  • Intermediaries
    • Investment banks
    • Commercial banks
    • Dealers
    • Primary Dealers
    • Inter-dealer brokers
    • Credit rating agencies
  • Investors


  • Senior secured
  • Senior unsecured
  • Senior subordinated
  • Subordinated
  • Junior subordinated

Moodys credit report for recovery rates shows difference between senior secured and senior unsecured and all tranches

Default Risk

default risk = prob of default * loss given default = prob of default * (1 - recovery rate)


Seniority & Capital Structure

Model AA Toyota Bond Value

Structured instruments

  • unlisted for 5 years
  • voting rights
  • 120% of ordinary shares
  • can be bought back at par value
  • eligible for set defined dividends

Dealer Bid Ask Spreads

  • Quotes from dealers are dollar plus 1/32nds
  • To calculate the bid-ask spread, take all asks and all bids and calculate the difference between the lowest ask and the highest bid
  • So if there is an ask of 95 plus 22 and a bid of 95 plus 17, the bid-ask spread is 5/32
  • Can infer that there is an implicit ask yield that is lower than the bid yield
  • the bid-ask spread is a proxy for (lack of) liquidity


  • Full price
    • Dirty Price
    • Invoice price = quoted Price plus the interest accrued since the last coupon payment
  • Actual price
    • Clean price
    • Quoted price (US bond prices quoted on a Bloomberg Terminal)
  • Invoice needs to include the interest accrued

To calculate returns, make sure to consistently use the same price. Don’t mix up clean and dirty.

Call Protection Period

  • Callability is the ability for the issuer to call the bond back
    • usually when interest rates drop, or the firms rating improves
  • although the callability itself leads to a premium, call protections is typical for the first half of the bond’s life which reduces the flexibility of the firm

Calling Back a Bond

  • Single call date (called in whole)
  • Declining call schedule for future years for what price to pay
  • Discretely callable schedule (10 days notice)

Callable versus Refundable

  • Refundable bond
    • only refinanced by issuing new debt at lower yields
  • Callable bonds can be refinanced by
    • capital injection
    • call option more costly to bond-holders than refundable option

Callable Make Whole Provision

Special callable bond because it can be exercised at any time, call price is based on the treasury yield at the time the call occurs. The make whole price can go above par value unlike callable which has a ceiling.

Make-whole versus Fixed Call

Embedded Bond Options

  • Favourable to issuers
    • accelerated sinking fund provision:
      • sets a reserve aside to retire parts of the debt (further than callable)
    • cap on a floater: max amount of variable rate to pay
    • callable option
      • the entire bond is called back, not just a part of it
    • prepayment option
    • higher yields and lower prices
  • Favourable to investors
    • put-table option: investor can force the issuer to make the investor whole
    • extendible option: maturity date can be extended
    • conversion option: converted to equity
    • floor on a floater: variable rate but with a guaranteed yield
    • lower yields and higher prices

Overview of the fixed income market

Primary vs Secondary

Issuance vs trading

underwriter has firm commitment

Process of Issuing Corporate Debt

corporate → prospectus → dealer (underwriter) → investors → buy side (pension funds, insurance companies, mutual funds, trusts)

Dealers (syndicate)

  • assesses demand for the debt issue (ratings)
  • pricing the issue
  • hedging inventory positions
  • distributing securities to ultimate investors


  • ensures legal requirements are met
  • monitors the issuing firm’s performance
  • takes action


  • enforced by trustee
  • financial covenants
  • restrictive covenants
  • underwriter helps

Why covenants

  • lowers cost of debt
  • shareholders restrict managers
  • bond holders restrict shareholders and managers
  • credit sights covenant review
  • violation of covenant can lead to penalties and trustee control

Medium Term Note

Five to ten year maturity

Corporate Debt Primary Debt

Secondary Corporate Bond Market

  • Trading of corporate bonds
  • Over $10T in bonds
  • 99% goes through Dealer Markets
    • Reuters
    • Bloomberg
    • ICAP (ECN)

Regulation History

  • 80s
    • LBO defaults
  • Fixed Income Pricing System introduced introduced in 1994
  • 2003
    • TRACE system introduced. Trade Reporting and Compliance Engine
  • 144A Issue does not have to register with SEC
    • Promote foreign/emerging market companies to come to the US
    • Go to dealers who sell only to Qualified Institutional Buyers (QIBs)
    • Speed of issuance
    • Private lenders tend to have significant advantages over public lenders in handling credit risk and information asymmetry (Lender specialization)
    • Favourable for higher yields (B rating) issuances
    • International corporations favour 144A way more than US companies although it is going up slowly with the business cycle
  • Private debt is issued significantly more than public debt
    • Most of it is through bank loans


  • IIROC working with CSA to enhance transparency
  • Before November 2015, debt market was opaque

Optimal Debt Issue

  • debt or equity
  • market timing
  • debt composition
  • maturity structure
  • issuance markets?
  • currency composition

Primary Dealers

Federal Reserve Bank of New York…

Cantor Fitzgerald & Co.: iconic / ubiquitous company

Why do Foreign Countries own US Treasuries

When countries export to US, they get USD currency. To get pay workers, these corporations need to acquire RMB, so they increase the currency exchange rate, which would make exports less attractive. Therefore, the foreign central banks want to facilitate the exchange rate themselves. With all the extra USD, they want to earn a rate of return. So therefore, they invest in the safest security; treasuries.

Why are they abandoning treasuries?

When US overnight lending rates go higher, the bond prices go down too. QE: federal reserve buys the bonds. Foreign demand (China and Japan) has been lower coincidentally further once rates started going up. Japanese and Chinese cost to buy debt has gone up due to a higher currency exchange rate. US domestic buyers (mutual funds, households, pension funds, insurance companies) are filling in the gap.

Uniform Price Dutch auction

$20B where 16B is competitive tender and 4B is non-competitive tender.

  1. Treasury announces $16B 2 year note
  2. Demand schedule for quantity and yields
  3. Coupon rate set to 1/8th rounded down from highest aggregate demand yield that satisfies the tender. Therefore, the price is usually at a discount.
  4. Stop-out yield: all yields lower than the stop-out yield are met

Bid Cover Ratio

Higher the bid-cover ratio, higher the interest in the issue. Measures the excess demand.

Sum the $ demanded (competitive + non-competitive) at the stop-out yield and divide by the total $ issued.

The BoC only has 2 people working at running these auctions since most of the process has been automated.

Secondary Market for Treasury Debt

  • trading amongst dealers (90%)
  • 10% external sources
  • IDB: interdealer broker
    • 6 of them
    • anonymous trading

Algorithmic Trading: GovPX

  • Improves public’s access to US Treasury prices by disseminating all trades, best bids, offers in the market
  • consolidates data from 5-6 brokers

Federal Fund Market

  • Member banks borrow and lend within each other
  • Surplus bank lends to deficit bank
  • In the US, banks borrow to keep reserve requirements
  • In Canada, deficit banks borrow to maintain their internal Basel III requirements
  • The central bank can keep selling treasuries to remove liquidity
  • The central bank can also keep buying treasuries to provide liquidity
  • during great financial recession, banks were unwilling to lend to each other so there were spikes in the effective rate

Federal Funds Rate and Monetary Policy

Decrease in overnight lending rate → dollar goes down, interest rate goes down → increase in demand → higher costs/prices → higher rate of inflation

Increase in overnight lending rate → dollar goes up, interest rate goes up → decrease in demand → lower costs/prices → lower rate of inflation

  • dollar changes due to foreign investment
  • demand: household, corporate, government, and exports

Bond Buyback at Deutsche Bank

  • February 2016
  • Falling stock price and CoCo bond price
    • CoCo’s pay higher interest than traditional bonds
  • Under-performing euro stock index
  • Decision is whether to buy back $5.5B CoCo bonds
  • Deutsche Bank: financial services
    • investment banking (majority)
    • commercial banking
    • asset management
  • Global bank headquartered in Frankfurt, Germany
  • 31.1B EUR market cap
  • SWOT
    • Strategy 2020
    • Established Brand
  • When the dividend was suspended, the price declined
  • Higher Credit Default Swap spread
  • Maturity Transformation
    • Difference between short term rates and long-term rates matters to banks
    • Banks borrow at short-term rates and lend at long-term rates

Contingent Convertible Bonds

Compared to a convertible, the contingent holder has no say and the bond can convert when share price decreases.

Core Equity Tier 1 (CET1)

  • Common Shares
  • Retained Earnings

Additional Tier 1 (AT1)

  • preferred shares
  • high-trigger CoCos
    • low triggers means lower loss absorbing capacity
    • usually not AT1
    • Boost T2 capital in cost-efficient manner
    • Regulators and markets pressured banks to boost T1 capital
    • CoCos with higher triggers are more expensive
    • Basel III and Dodd-Frank regulations

Tier 2 (T2)

  • non-coco subordinated debt
  • low-trigger cocos

Structure of CoCos

  • Triggers
    • Mechnical (book value or market value)
    • Discretionary
  • Loss absorption mechanism
    • Conversion to equity
    • Principal write down (cash for forgoing the principal)
  • Capital Requirements
    • Buffer against a shock
    • 4.5% for T1
    • Add-on by adding T2
    • Tier 1 vs Tier 2
      • Tier 1 is equity
      • Tier 2 is subordinated debt that could be kept as debt forever*

Hedge Fund Strategies

  • Bearish on the Firm
    • Short stock, buy CDS
    • Solvency perception goes down as stock goes down
    • Short unsecured bons + long CDS
    • Short CoCo bonds + long CDS
    • Combination of above
  • Bullish
    • Long stock + short CDS
    • Long unsecured bonds + short CDS
    • Long CoCo bonds + short CDS
    • Combination of above

LIBOR-Scandal and SOFR

  • london interbank offer rate
  • rate banks charge each other in London
  • want a low LIBOR rate not a high rate
  • banks even in USA use LIBOR as a going rate for risk free
  • Lower than it should’ve been to avoid regulation
  • Cannot trust self-regulation

Fed Funds Rate is AAA whereas LIBOR is AA.

ICE took control of LIBOR.

LIBOR-ICE turned to Overnight interest swaps

Interest Rate Swap

One side pays fixed rate, the other pays LIBOR on the principal, therefore there is a net cash flow.

Teva Pharmaceuticals

Pricing the 2016 bond offering.

  • Cross border acquisition
  • Israeli pharmaceutical company founded in 1901
  • Merged with Orphahell in 1982 to become Teva
  • Allergan acquisition, a division of ($40B from cash, shares and $19.5B bond financing)
  • Copaxone patent expiring: 20% revenue, 50% profits
  • Generic medicine is 54% of revenue
    • Cost savings, no clinical trials, lower prices
    • Largest producer in the US?
    • 5 big producers (Teva - Israel, Novantis - Belgium, Sun Pharma - India, Mylan - Switzerland, Allergan - Ireland)
  • Consolidation?
    • Probably just economies of scale
    • Less patents coming out
  • Regulations
    • US Hatch Waxman ACt
      • No need for repetitive preclinical and clinical trials for generic drugs, only need prove equivalency
    • Europe
      • Centralized procedure
      • Applications submitted to a group of countries, only one member evaluation needed
  • Macro-economic conditions
    • China, Japan, Breixt
  • Bond yields
    • Decreasing yields
  • Allergen: botox
  • M&A Synergies
    • Newer markets
    • Cost synergies: stream
    • Offsetting Copaxone patent expiration
  • Bond Plan
    • USD (six tranches, multiple maturities), EUR (three tranches), CHF
    • Exchange rate frozen to July 16, 2016
    • Looked at competitors’ coupon rates to benchmark scenario analysis

Momentum and Contrarian

  • Momentum would be applicable only to an industry


  • Bloomberg originally located in Israel
  • Operations research company
    • Optimization


  • Stick entire yield curve


  • GE Euro issue (GBP)
  • Teva did some Euro issue in dollars

Global Bond

  • IBM global issue: luxembourg

Eurobond Market

  • collared bond (cap and a floor)
    • cap: a cap on the floating coupon being paid
    • floor: a floor on the floating coupon being paid
  • drop-lock: change floating into fixed once a trigger occurs
  • perpetual/undated floating issue
  • dual currency issues (pay coupon in one currency and principal in another)
  • option currency bonds: investor or issuer chooses the currency

Brady Bonds

  • Emerging market debt blowing up
  • Non-performing loans to emerging market governments that were restructured into marketable securities
  • Interest rate bonds: interest due on the loans
  • Principal bonds: principal amount owed on the bank loans