Fixed-Income Instruments and Markets: Comprehensive Notes

Reading 49: Fixed-Income Instrument Features

  • Major types of fixed-income instruments
    • Loans: private, non-tradable agreements between borrower and lender.
    • Bonds (fixed-income securities): standardized, tradable debt investments representing a loan to the issuer.
    • Investors in bonds are lending capital (principal, par, face value) to the issuer.
    • Issuer promises to repay principal plus interest, typically via regular coupon payments stated as a percentage of par.
    • Capital raised funds long-term investments of the issuer; for corporates, loans and bonds are long-term liabilities.
  • Key features specified in a fixed-income security
    • Issuer: types include sovereign national governments, corporations; other issuers include local governments, supranational entities (e.g., IMF), quasi-government entities, and special purpose entities issuing asset-backed securities (ABS).
    • Maturity: date of final cash flow.
    • Tenor refers to time remaining until maturity after issue.
    • Money market securities: original maturities ≤ 1 year.
    • Capital market securities: original maturities > 1 year.
    • Perpetual bonds: no stated maturity date.
    • Principal (par/face value): amount repaid at maturity; some debt instruments repay gradually (e.g., mortgages).
    • Coupon rate and frequency: annual percentage of par paid as interest; payments can be annual, semiannual, quarterly, or monthly.
    • Example: $1,000 par, 5% coupon paid semiannually → $25 every six months.
    • Floating-rate notes (FRNs): coupon based on a market reference rate (MRR) plus a fixed margin; margin expressed in basis points (bp).
    • 1 bp = 0.01%
    • Zero-coupon (pure discount) bonds: no periodic coupon; sold at a discount to par and pay par at maturity.
    • Example: 10-year, $1,000 zero-coupon, yield 7%; price ≈ $500 (exact price computed via valuation).
    • Seniority: debt claims rank above equity; among debt, senior debt ranks above junior/subordinated debt.
    • Contingency provisions (embedded options): call options, put options, or conversion rights (to equity).
  • Yield measures and price/yield relationship
    • Yield is the return from the bond given price and expected cash flows; for fixed-coupon bonds, price and yield are inversely related: when price rises, yield falls; when price falls, yield rises.
    • Graphical yield curves plot yields against maturities; shape provides signals about risk and expectations.
    • Yield curve shapes:
    • Normal (upward-sloping): longer maturities offer higher yields due to greater uncertainty/risk over time.
    • Inverted (downward-sloping): longer maturities offer lower yields; less common, signals unusual conditions.
    • Government yield curves are often used as benchmarks; spreads above government yields measure extra return for credit/risk.
    • Example: if 5-year corporate yield = 6% and 5-year government yield = 5%, corporate spread = 1%.
  • Indentures, repayment sources, and covenants (LOS 49.b)
    • Bond indenture: legal contract between issuer and bondholders defining obligations, sources of repayment, collateral, credit enhancements, and covenants.
    • Sources of repayment by issuer depend on issuer type:
    • Sovereign bonds: taxes on economic activity and, in some cases, currency creation.
    • Local government bonds: local taxes or revenue from infrastructure.
    • Corporate bonds: secured bonds are repaid from operating cash flow plus a lien/pledge on specific assets (collateral); unsecured bonds rely on operating cash flow.
    • ABS: cash flows come from the collateral pool (pool of assets) if the SPE issued the ABS.
    • Bond covenants
    • Affirmative covenants: requirements issuer must fulfill (e.g., timely financial reporting, use of proceeds, rights to redeem at a premium in acquisitions).
      • Examples: cross-default (default on other debt triggers default on this bond); pari passu (equal seniority with other senior debt).
    • Negative covenants: restrictions on actions by issuer (e.g., asset sales, pledges of collateral, incurrence of new debt above ratios, dividends, share repurchases).
    • Purpose: protect bondholders; must balance restriction with operational flexibility.
  • Key concept recaps (LOS 49.a and 49.b)
    • Features of fixed-income securities include issuer, maturity, par value, coupon rate, coupon frequency, seniority, and contingency provisions.
    • Par value is the principal repaid at maturity; coupon structure determines periodic interest; zero-coupon pays no coupons.
    • Senior debt ranks above junior debt; covenants (affirmative/negative) regulate issuer behavior and protect bondholders.
    • Yield is the expected return, inversely related to price for fixed coupons; yield curves summarize term structure of interest rates.

Reading 50: Fixed-Income Cash Flows and Types

  • Cash-flow structures in fixed-income securities
    • Bullet structure
    • Principal repaid in a single payment at maturity; coupons are periodic interest payments.
    • Example: 5-year, 5% 1,000 par, par-issued bond, annual payments: 5 yearly coupons of 50 and final payment of 1,050 at year 5; principal repaid at maturity.
    • Amortizing loan/bond
    • Periodic payments include both interest and principal repayment.
    • Fully amortizing schedule results in equal payments until maturity; principal fully repaid by final payment.
    • Example: 5-year, 5% bond with fully amortizing payments would have linearly decreasing balance and level PMT around 230.97 (calculated via standard amortization formula).
    • Balloon payment (paradox/par liability structure)
    • Final payment includes remaining principal (not full par) at maturity; example shows final payment larger due to remaining balance.
    • Sinking fund provisions
    • Issuer retires a portion of principal over time (e.g., redeem $20m each year from year 6 for a 20-year $300m issue).
    • Pros: reduces credit risk; cons: reinvestment risk when rates fall.
    • Waterfall structures (ABS/MBS related)
    • Principal repayments distributed to tranches by seniority; senior tranches get paid first until they’re fully repaid; juniors receive residual principals later.
  • Other coupon structures
    • Floating-rate notes (FRNs)
    • Coupon = MRR + fixed margin; most pay quarterly on a 90-day reference rate.
    • Example: MRR 2.3% + 0.75% margin; payment = (2.3% + 0.75%)/4 of par per quarter.
    • Step-up coupon bonds
    • Coupon grows over time on a predetermined schedule, protecting investors against rising rates.
    • Credit-linked / leveraged loan-linked coupons
    • Coupons can increase with deteriorating credit quality (e.g., MRR + 2.5%, rising to MRR + 3% if debt/EBITDA crosses a threshold).
    • Payment-in-kind (PIK) bonds
    • Interest is paid by increasing principal rather than cash; usually higher yields due to higher credit risk or leverage.
    • Green bonds, inflation-indexed bonds (linkers)
    • Green bonds: coupon may rise if environmental goals not met; ESG-linked features.
    • Inflation-linked bonds: coupon or principal adjusted with inflation; common structures include:
      • Interest-indexed: coupon adjusts with inflation; principal remains fixed.
      • Capital-indexed (e.g., TIPS): coupon fixed, principal adjusts with inflation; deflation caps at par or adjusted principal at maturity.
      • Example (capital-indexed): par $1,000, 3% coupon semiannual; inflation 1% after 6 months; new principal $1,010; six-month coupon = 1.5% × 1,010 = $15.15.
    • Zero-coupon and deferred coupon bonds
    • Zero-coupon: single payment at maturity; minimal reinvestment risk; trade below par to yield positive return.
    • Deferred coupon: coupons begin after a delay; useful for issuers with delayed revenue streams.
    • Contingent features and embedded options (embedded in contract)
    • Callable bonds: issuer can redeem early at a fixed call price; creates call risk for bondholders; higher yield demanded for callable features.
    • Putable bonds: bondholder can sell back to issuer at prespecified price; price rises (lower yield) due to option value for bondholder.
    • Convertible bonds: bondholder can convert to a predetermined number of shares; conversion price, conversion ratio, conversion value defined; typically allows issuer to price higher by embedding option value.
    • Contingent convertible bonds (CoCos): convert to equity automatically if regulatory capital thresholds are breached; used by banks to meet capital requirements.
    • Warrants attached to bonds: give holder right to buy shares at a fixed price; detach and trade separately.
  • Original issue discount (OID) and premium tax treatment
    • OID bonds issue at a discount; gains over tenor as price moves toward par count as interest income for tax purposes in many jurisdictions.
    • Premium bonds: some jurisdictions treat part of premium as tax-deductible against coupon income.
  • Taxation basics
    • Interest income on most bonds taxed as ordinary income.
    • Municipal bonds often exempt from federal (and sometimes state) income tax in the issue state.
    • Capital gains from sale of bonds are taxed as capital gains; long-term capital gains may receive preferential rates.
  • Summary key concepts (LOS 50.auto)
    • Bullet vs amortizing vs balloon vs sinking fund vs time-tranche structures affect cash flows, risk, and reinvestment considerations.
    • Different coupon structures (FRN, step-up, PIK, inflation-linked, zero-coupon) tailor to issuer needs and investor preferences.
    • Embedded options shift risk between issuer and investor; call/put/convertible options create different payoff profiles and values.
    • OID and premium considerations have tax implications; the tax treatment of cash flows vs accreted value matters for investors.

Reading 51: Fixed-Income Issuance and Trading

  • Market structure and segments (LOS 51.a)
    • Global bond markets segmented by:
    • Type of issuer: governments (sovereign and non-sovereign), corporates, special purpose entities issuing ABSs.
    • Credit quality: investment-grade (e.g., S&P AAA to BBB-) vs non-investment grade/high-yield.
    • Original maturity: money market (
    • Other factors: currency, geography, ESG features.
    • Aggregate indexes: broad exposure to many bonds; examples include Bloomberg Barclays Aggregate Index; excludes high-yield and unrated issues.
    • Narrower indexes focus on geography, credit quality, sector, or maturity; ESG considerations are increasingly used (e.g., Bloomberg Barclays MSCI Euro Corporate Sustainable/SRI Index).
  • Issuance and market structure (LOS 51.a, 51.c)
    • Primary markets: new bond issues; sold via public offerings or private placements; usually through financial intermediaries (underwriters/banks).
    • Debut issuers vs repeat issues; shelf registrations allow issues to be drawn down over time; roadshows for debut issuers.
    • Public auctions for government debt: competitive and noncompetitive bids; single-price vs multiple-price auctions; primary dealers participate.
    • Secondary markets: primarily OTC dealer markets; electronic trading platforms exist but most trading is dealer/OTC; bid-ask spreads reflect liquidity.
    • Distressed debt: bonds of issuers in or near bankruptcy; investors may trade these bonds seeking restructuring outcomes or recovery.
  • Primary market mechanics and issues (LOS 51.c)
    • Underwritten offering: price guaranteed by intermediaries; best-efforts offering: no guarantee, placement on commission basis.
    • Public auctions vs private placements: government debt usually issued via auctions; debut issues costly and time-consuming; repeat issues smoother.
    • Auction theory concepts: single-price vs multiple-price; noncompetitive bids guarantee allocation at auction price.
  • Investor positioning and market participants (LOS 51.a, 51.c)
    • Pension funds and insurance companies: long-term investment-grade securities to match liabilities.
    • Central banks: use intermediate-term Treasuries for monetary policy operations.
    • Bond funds/ETFs: position according to mandate (often investment-grade intermediate securities, excluding Treasuries).
    • Asset managers: seek higher returns; may invest in high-yield, distressed debt, etc.
    • Financial intermediaries (banks): use Treasuries to manage risk and liquidity across maturities.
  • Key concepts and takeaways (LOS 51.a, 51.b, 51.c)
    • Fixed-income indexes include a large number of constituents and exhibit higher turnover than equity indices due to maturity and new issues.
    • Aggregate indexes broad in scope; narrower indexes focus on sector, credit quality, geography, or ESG.
    • Primary market actions and secondary market trading patterns differ from equity markets; auctions are a key feature for sovereign debt.

Reading 52: Fixed-Income Markets for Corporate Issuers

  • Short-term funding for non-financial corporations (LOS 52.a)
    • External loan financing via bank lines of credit:
    • Uncommitted lines: flexible, may be drawn at floating rate (MRR + spread); less reliability; may be unsecured.
    • Committed lines: bank commits to lending for a period; incur a commitment fee; regulators require reserves; may be syndicated to reduce risk.
    • Revolving (operating) lines: highly reliable, longer-term; often include restrictive covenants.
    • Asset-backed and secured funding options
    • Secured/asset-backed loans backed by collateral; secured lines reduce risk and borrowing costs.
    • Factoring: transferring receivables to a lender at a discount; used when cash flow is tight.
    • External security-based financing
    • Commercial paper (CP): short-term unsecured debt; typical maturity < 3 months; used for working capital; under favorable conditions CPs can be rolled over.
    • Bridge financing: temporary funding until longer-term financing is secured.
    • Credit support and liquidity management
    • Backup lines of credit with banks to manage rollover risk; liquidity enhancement.
  • Short-term funding for financial institutions
    • Deposits: core funding (checking, savings, CDs); negotiable CDs can be sold in markets; wholesale deposits are a major funding source for banks.
    • Interbank funding: banks lend to each other (overnight to 1 year) at MRR; secured (repos) or unsecured; central bank facilities and discount windows for liquidity support.
    • Asset-backed commercial paper (ABCP): CP backed by assets; typically funded by a SPE; ABCP is often used by banks to securitize short-term assets.
  • Repurchase agreements (repos) (LOS 52.b)
    • Definition: a sale of a security with an agreement to repurchase at a higher price; effectively a collateralized loan from buyer to seller.
    • Repo rate: implied interest; initial margin (haircut) protects lender against collateral decline; example with $1,000,000 collateral and 103% initial margin yields a loan of $970,874; repo price after 90 days calculated with de-annualized repo rate.
    • Haircut: the difference between market value and loan amount as a percentage of market value; management of margin via variation margin if collateral value falls.
    • Overnight vs term repos; tri-party repos; bilateral repo arrangements.
    • Uses of repos:
    • Financing positions in securities; banks and funds lend cash against collateral; central banks use repos for monetary policy; short sellers borrow securities via repos (reverse repo).
    • Repo risks: default risk, collateral risk, margining risk, legal risk, netting and settlement risk; tri-party arrangements mitigate some operational risk.
  • Long-term funding: investment-grade vs high-yield (LOS 52.c)
    • Differences arise in default risk, credit spreads, covenants, standardization, maturity flexibility, and collateral requirements.
    • Investment-grade issuers typically offer fewer restrictive covenants and rely more on benchmark rates for pricing; high-yield issuers may post more covenants, more security, and tailored terms; higher expected default risk.
  • Summary key concepts (LOS 52.a, 52.b, 52.c)
    • Short-term corporate funding uses bank lines, CP, ABCP, and securitization; liquidity management and rollover risk are central concerns.
    • Interbank and central bank funding are crucial for liquidity management; repos are central tool for short-term secured financing.
    • Long-term corporate funding choices reflect issuer quality and capital structure needs; investment-grade vs high-yield have distinct risk profiles and financing strategies.

Reading 53: Fixed-Income Markets for Government Issuers

  • Sovereign debt basics (LOS 53.a)
    • Governments issue bonds to fund public goods, services, and infrastructure; debt service backed by tax revenue and, for some, currency-issuing ability.
    • Distinguish between developed-market and emerging-market sovereign issuers:
    • Developed-market: stable, diversified economies; debt denominated in major reserve currencies.
    • Emerging-market: faster growth but less stable revenues; debt can be domestic or external.
    • Domestic debt: issued in home currency; held by domestic investors; may face capital-flow restrictions or illiquidity in some cases.
    • External debt: owed to foreign creditors; denominated in home or reserve currency; external currency risk for investors due to macro conditions.
    • Debt management policy: governments issue across maturities to balance rollover risk and financing flexibility; Ricardian equivalence suggests taxes/timing considerations for debt issuance, but practical deviations lead to diverse maturity structures.
    • Benefits of broad maturity range: benchmark yield curves, hedging, collateral for repos, monetary policy implementation.
  • Sovereign issuers and auctions (LOS 53.a, 53.b)
    • Sovereign debt issued mainly via regular public auctions; bids can be competitive or noncompetitive.
    • Auctions: single-price vs multiple-price; competitive bids determine cut-off yield; noncompetitive bids guarantee allocation at auction price.
    • Primary dealers: banks required to bid and broker; act as counterparties to the central bank.
    • After issue, sovereign debt trades mainly in OTC dealer markets; on-the-run bonds are most active and informative for yields.
    • Why government bonds are used by various investors (central banks, reserves, regulatory holdings) and how this affects yields and liquidity.
  • Non-sovereign government debt and supranational entities (LOS 53.a, 53.b)
    • Non-sovereign government debt: states, provinces, GO bonds (general obligation backed by tax power), revenue bonds (payments from project revenues).
    • Agencies/quasi-government entities: government-sponsored entities (GSEs) or government-created agencies (e.g., Ginnie Mae) that back debt with implied government support.
    • Supranational bonds: issued by international organizations (World Bank, IMF, regional development banks) to promote growth; credit quality often high due to implicit support.
  • Global vs domestic vs international bonds; currency considerations (LOS 53.a, 53.b)
    • Domestic bonds: issued in home market and currency; may have capital controls.
    • External debt: denominated in reserve currencies; reduced direct currency risk, but indirect currency risk remains via external revenue streams.
    • Eurobonds: issued outside any single country jurisdiction and denominated in any currency; often bearer instruments historically, now mostly registered.
    • Global bonds: traded in both Eurobond markets and at least one domestic market.
  • Taxation and other considerations (LOS 53.a)
    • Taxation varies; government yields generally impacted by fiscal policy, inflation expectations, and external financing needs.
  • Summary key concepts (LOS 53.a, 53.b)
    • Sovereign debt is influenced by fiscal policy, monetary policy, and external stability; debt management aims to balance yield, liquidity, and rollover risk.
    • Sovereign auctions set benchmark yields; primary dealers facilitate issuance; on-the-run sovereigns provide the benchmark for credit-free risk-free yields.
    • Non-sovereign and supranational debt carry implicit support; agency debt often mirrors sovereign risk; currency and international factors affect cross-border investment decisions.

Reading 62: Credit Risk

  • What is credit risk? (LOS 62.a)
    • The risk of losses to fixed-income investors from a borrower's failure to make payments of interest or principal (default).
  • Bottom-up vs top-down drivers (the Cs of credit analysis)
    • Bottom-up (issuer-specific): Capacity, Capital, Collateral, Covenants, Character.
    • Top-down (macro-level): Conditions, Country, Currency.
  • Probability of Default (POD) and Loss Given Default (LGD) (LOS 62.a)
    • Expected loss = POD × LGD (as a percentage).
    • LGD% is the loss given default; often LGD = Expected Exposure × (1 − Recovery Rate).
    • Recovery rate is the proportion recovered; Loss severity = 1 − Recovery Rate.
    • Expected exposure is the difference between owed amount and collateral value if a default occurs.
  • Credit risk measurement and spreads
    • The credit spread can be viewed as the market price premium for credit risk; a rough estimate is:
      extCreditspread ≈ POD×LGD%ext{Credit spread} \,\approx\, POD \times LGD\%
    • If actual spreads exceed the estimated fair spread, investors may be adequately compensated; if not, they may be undercompensated.
  • Factors affecting default probability and LGD
    • Strong profitability, high cash flow, and able to service debt reduces POD.
    • Secured vs unsecured debt affects LGD: secured debt has lower LGD due to pledged collateral; secured debt reduces loss given default for senior claims.
    • Higher seniority reduces expected losses; hierarchical debt structure affects recovery opportunities.
  • Ratings and credit analysis (LOS 62.b, 62.c)
    • Credit rating agencies provide forward-looking assessments to compare credit risk and to assess migration risk.
    • Ratings capture expected loss but lag market pricing; ratings may not reflect market pricing for distressed debt or prepayment risks.
    • Notching: differences between issuer CFR and issue-specific CCR due to seniority and collateral; cross-default and pari passu provisions influence recovery and default risk.
    • Key caveats: ratings are not perfect predictors; due diligence remains essential; ratings lag or miss events such as litigation or systemic risk.
  • Practical example: expected loss and credit spreads
    • Example: POD = 3%, Recovery Rate = 75% (LGD = 25%), bond coupon = 4%, government benchmark yield = 2.5%
    • Actual credit spread = 4% − 2.5% = 1.5%
    • Estimated credit spread = POD × (1 − Recovery) = 0.03 × (1 − 0.75) = 0.75%
    • Conclusion: actual spread > estimated fair spread; bond provides extra compensation for credit risk.
  • Key ratios and risk indicators (qualitative and quantitative)
    • Qualitative indicators: business model stability, competitive landscape, governance quality, covenants.
    • Quantitative indicators: profitability (e.g., EBITDA margins), leverage (Debt/EBITDA), coverage (EBIT/Interest), liquidity and cash flow strength (CFO, FFO, FCF, RCF).
  • Summary key concepts (LOS 62.a, 62.b, 62.c)
    • Credit risk arises from default probability and loss given default; POD and LGD multiplicatively determine expected loss.
    • A higher likelihood of default or higher potential losses increases credit spreads; secured debt lowers LGD relative to unsecured debt.
    • Ratings are useful but imperfect; investors should perform independent credit analysis and consider market liquidity, spreads, and macro conditions.

Reading 64: Credit Analysis for Corporate Issuers

  • Qualitative factors (LOS 64.a)
    • Business model: stable, predictable cash flows; long-term strategic changes may raise risk.
    • Industry competition: less competition → higher credit quality; assess long-term competitive dynamics.
    • Business risk: lower risk of revenue/margin deviations.
    • Corporate governance: governance quality, debt covenants, and accounting policies.
    • Covenants: unsecured IG issuers typically have affirmative covenants; high-yield issuers likely have negative covenants restricting dividends, new debt, etc.
    • Accounting policies: aggressive accounting or off-balance-sheet financing signals risk; CFO and governance quality matter.
  • Quantitative factors (LOS 64.a, 64.b)
    • Profitability: higher EBIT margin indicates stronger profitability and creditworthiness.
    • Coverage: higher EBIT/Interest (or EBITDA/Interest) indicates stronger ability to service debt.
    • Leverage: lower Debt/EBITDA or Debt/Capital indicates lower leverage and risk.
    • Cash flow metrics: Free cash flow to debt or net debt; retained cash flow against debt levels; liquidity strength.
    • Sample illustration (York vs. Zale): profitability (EBIT margin) and leverage (Debt/EBITDA) can point in different directions; overall credit quality is a balance of multiple ratios.
  • Seniority, collateral, and covenants in corporate debt (LOS 64.c)
    • Debt seniority: secured debt priority (first lien/mortgage, senior secured) vs unsecured debt (senior unsecured, subordinated).
    • Seniority ranking: 1) First lien/mortgage, 2) Senior secured (second lien), 3) Junior secured, 4) Senior unsecured, 5) Senior subordinated, 6) Subordinated, 7) Junior subordinated.
    • In default, higher-priority debt gets paid first; pari passu within the same category means equal treatment; secured claims have priority over unsecured.
    • Notching: differences between issuer ratings and issue-specific ratings based on collateral and covenants; structural subordination arises when a parent’s debt ranks behind a subsidiary’s debt in the cash-flow waterfall.
  • Application and examples (LOS 64.a, 64.b, 64.c)
    • Use EBIT margin, EBIT/Interest, Debt/EBITDA, RCF/Net Debt to compare firms; higher profitability with manageable leverage and strong coverage suggests higher credit quality.
  • Summary key concepts (LOS 64.a, 64.b, 64.c)
    • Corporate creditworthiness depends on qualitative governance and business factors and quantitative metrics of profitability, coverage, and leverage.
    • Seniority and collateral affect loss given default; covenants influence risk control and potential future debt capacity.
    • Notching and structural subordination can cause issuer ratings to differ from individual issue ratings.

Reading 65–67: Fixed-Income Securitization, ABS, MBS, and CDOs

  • Overview of securitization (LOS 65.a, 65.b)
    • Securitization process steps:
    • Step 1: Originator (bank/firm) creates a pool of debt-based assets (collateral).
    • Step 2: Pool is sold to a special purpose entity (SPE) or SPV.
    • Step 3: SPE issues fixed-income securities (asset-backed securities, ABS) backed by cash flows from the collateral; ABS are purchased by investors.
    • Key players and roles:
    • Seller/Depositor: originator of loans/assets.
    • SPE/Trust/Issuer: buys assets and issues ABS.
    • Servicer: collects payments, manages delinquencies, and administers loan servicing; can be the same as the seller.
    • Trustee: ensures integrity of cash-flow distribution and info to ABS holders; acts as a watchdog.
    • Benefits of securitization (to issuers, investors, economies, markets)
    • Issuers: increased business activity, fee generation for originations; reduced capital reserves; improved liquidity.
    • ABS investors: tailored risk/return; access to collateral; greater liquidity; liquidity and price discovery.
    • Economies/markets: decreased liquidity risk in securitized assets, improved market efficiency, lower financing costs, and reduced leverage for originators.
    • Risks for ABS investors: uncertain cash flows, credit risk of collateral; potential systemic risk if securitization concentrates credit risk.
  • Internal credit enhancements (LOS 66.a, 66.b)
    • Overcollateralization: collateral value exceeds ABS face value; acts as cushion against losses.
    • Excess spread: excess income from collateral over promised ABS coupons; can absorb losses.
    • Subordination/credit tranching: multiple tranches with different priorities; junior tranches absorb losses first, protecting senior tranches.
    • Waterfall concept: losses flow from junior to senior until senior tranches are fully paid.
  • Types of ABS and non-mortgage collateral (LOS 66.c)
    • Credit card ABS: back by credit card receivables; nonamortizing receivables; revolving period with interest-only distributions during lockout; later amortization.
    • Solar ABS: back by solar loans; often ESG-aligned; can be secured on the solar system or the home; may include overcollateralization and other internal enhancements.
    • Other assets: auto loans, student loans, franchise payments, royalties, etc.
  • Securitization: non-mortgage ABS structures (LOS 66.c)
    • AR/receivables-backed securitization; pre-funding periods; trust structures; external credit enhancements (letters of credit, insurance) and tranching.
  • Collateralized debt obligations (CDOs) and CLOs (LOS 66.d)
    • CDOs: securitized debt obligations; collateral manager actively buys/sells assets within the collateral pool to generate payments; issued by SPV.
    • Types: Cash-flow CLOs (payments from collateral cash flows), Market-value CLOs (payments from collateral market value), Synthetic CLOs (credit derivatives exposure rather than physical collateral).
    • CLOs historically faced regulatory changes after the financial crisis; today focus largely on leveraged loans and structured within tighter risk controls.
    • Notable risk controls: covered tests for cash flows, overcollateralization thresholds, diversification requirements.
  • Mortgage-Backed Securities (MBS) and RMBS/CMBS (LOS 67.a, 67.b, 67.c, 67.d)
    • Prepayment risk in MBS: borrowers may prepay loans when rates decline; leads to extension risk (slower than expected) or contraction risk (faster than expected).
    • Prepayment speeds determine MBS valuation; contraction risk tends to hurt when prices rise slowly due to early prepayments; extension risk hurts when rates rise and cash flows are delayed.
    • Time tranching as a risk management tool: time-based tranches (e.g., sequential pay) redistribute prepayment risk across tranches; short-maturity tranches absorb more contraction risk; longer-maturity tranches absorb more extension risk.
    • Mortgage pass-through securities: investors receive monthly cash flows after servicing fees; WAM (weighted-average maturity) and WAC (weighted-average coupon) characterize the pool:
    • WAM = \frac{\sumi (Balancei \times Monthsi)}{\sumi Balance_i}
    • WAC = \frac{\sumi (Balancei \times Ratei)}{\sumi Balance_i}
    • Collateralized Mortgage Obligations (CMOs): securitization of RMBS pools into tranches with different prepayment risk exposures (short vs long maturity).
    • Common CMO structures: Sequential pay, Planned Amortization Class (PAC), support tranches, Z-tranches, PO (principal-only), IO (interest-only), floating-rate, residual tranches.
    • PACs provide more predictable payments within a prepayment-speed range; if speeds deviate, support tranches absorb the excess.
    • Residential RMBS (RMBSS) details (LOADING):
    • Agency RMBSS: guaranteed by government or GSEs; must satisfy underwriting standards.
    • Non-agency RMBSS: private sector; often include external credit enhancements and more bespoke structures.
    • LTV and DTI are key risk indicators for RMBSS (LTV lower is better; DTI lower is better).
    • Collateralized Mortgage Obligations (CMOs) specifics
    • Z-tranches: accrual/tranches that increase principal while not paying cash interest until later periods.
    • Principal-only (PO) and Interest-only (IO) tranches: PO receives only principal; IO receives only interest (cash flows depend on prepayment).
    • Planned Amortization Class (PAC) and Support Tranches: PAC provides predictable cash flows; support tranches absorb variance in prepayment speeds.
  • Commercial Mortgage-Backed Securities (CMBS) (LOS 67.d)
    • Backed by commercial mortgages on income-producing real estate (office, retail, multifamily, industrial, etc.).
    • CMBS coupons are typically fixed in the U.S.; Europe has more floating coupons.
    • Analysis focuses on property cash flows rather than borrower credit quality.
    • Key ratios:
    • DSCR (debt service coverage ratio) = Net Operating Income / Debt Service.
    • LTV (loan-to-value) = Current mortgage amount / Current appraised value.
    • Call protection and balloon risk
    • Call protection via prepayment lockouts, prepayment penalties, or defeasance.
    • Balloon risk: CMBS often partially amortize; balloon at the end may require refinancing, leading to extension risk if not refinanced.
  • Covered bonds (LOS 66.a)
    • Covered bonds are senior debt obligations where the cover pool remains on issuer’s balance sheet; investors have recourse to both the cover pool and issuer’s unencumbered assets.
    • Cover pools typically have strict LTV caps and overcollateralization; third-party monitoring ensures compliance.
    • Covered bonds generally have lower yields than equivalent ABS due to dual recourse, but the issuer’s capital relief may be limited since assets stay on balance sheet.
  • Final key takeaways (LOS 66.a–66.d, 67.a–67.d)
    • Securitization links lenders (issuers) with investors via SPVs, enabling risk transfer and liquidity improvements; the structure matters for risk transfer and asset protection.
    • Internal enhancements (overcollateralization, excess spread, subordination) help absorb losses and protect senior tranches; credit risk is redistributed across tranches.
    • RMBS/CMBS introduce prepayment/extension/contraction risk; time-tranching and CMO structures attempt to manage timing risk for different investor preferences.
    • CDOs/CLOs shift active collateral management risk to the collateral manager; risk-control features are essential to maintain investor protection.

Quick reference: Formulas and key relationships

  • Credit risk science
    • Expected loss: EL=POD×LGDEL = POD \times LGD
    • Loss given default: LGD=Expected Exposure×(1−Recovery Rate)LGD =\text{Expected Exposure} \times (1 - \text{Recovery Rate})
    • Credit spread proxy: Credit spread≈POD×LGD%\text{Credit spread} \approx POD \times LGD\%
  • Bond cash-flow math (example structures)
    • Bullet: payments are constant until final large payment at maturity.
    • Fully amortizing: constant PMT; principal reduces to zero at maturity.
    • Balloon: final payment includes remaining principal; other payments may be lower.
  • Inflation-linked bonds (capital-indexed)
    • Principal adjustment with inflation: final coupon based on adjusted principal; real rate concept implied.
    • Example principal adjustment: if inflation of 1% occurs in six months, new principal = 1.01 × par; semiannual coupon uses adjusted principal.
  • MBS and CMOs parameters
    • WAM = weighted average maturity of underlying mortgages:
      WAM=∑<em>i(Balance</em>i×Maturity<em>i)∑</em>iBalancei\text{WAM} = \dfrac{\sum<em>i (\text{Balance}</em>i \times \text{Maturity}<em>i)}{\sum</em>i \text{Balance}_i}
    • WAC = weighted average coupon of underlying mortgages:
      WAC=∑<em>i(Balance</em>i×Rate<em>i)∑</em>iBalancei\text{WAC} = \dfrac{\sum<em>i (\text{Balance}</em>i \times \text{Rate}<em>i)}{\sum</em>i \text{Balance}_i}
  • Repo mechanics (example relationships)
    • Loan amount (purchase price) with initial margin: Loan=Market ValueInitial Margin\text{Loan} = \dfrac{\text{Market Value}}{\text{Initial Margin}}
    • Repurchase price: RP=Loan×(1+repo rate×days360)\text{RP} = \text{Loan} \times \left(1 + \text{repo rate} \times \frac{\text{days}}{360}\right)
    • Haircut: Haircut=Market Value−LoanMarket Value\text{Haircut} = \dfrac{\text{Market Value} - \text{Loan}}{\text{Market Value}}

Notes:

  • All LaTeX expressions are enclosed in double-dollar signs as requested.
  • The notes above consolidate major and minor topics from the provided transcript, organized by reading/module for use as study notes. You can drill into any section for more detailed subpoints or examples as needed for exam prep.