ming,small business, or loans to first-time home buyers. Agency bonds do notcarry the full faith-and-credit guarantee of government-issued bonds, but theycarry triple-A ratings due to the implicit guarantee that exists between thegovernment and a government agency. This implicit guarantee allows therespective government agency to access low-cost capital to support objectivesdeemed to be consistent with the national interest. Federal agencies that issuebonds include:• Federal National Mortgage Association (Fannie Mae)• Federal Home Loan Mortgage Corporation (Freddie Mac)• Farm Credit System Financial Assistance Corporation• Federal Agricultural Mortgage Corporation (Farmer Mac)• Federal Home Loan Banks• Student Loan Marketing Association (Sallie Mae)• College Construction Loan Insurance Association (Connie Lee)• Small Business Administration (SBA)• Tennessee Valley Authority (TVA)
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Corporate bondsCorporate bonds are bonds issued by corporations to meet their short- andlong-term working capital requirements. “Non-dollar corporate bonds” areissued in currencies other than the U.S. dollar. Secondary trading activitiestend to be most robust at dealers that have strong deal flow and a reputablecredit research department. These research departments are always analyzingprospective bond swaps and are searching for favorable relative value trades(e.g., swapping down in credit or within similarly rated paper for a pick-up inyield, or swapping up in credit for a minimal yield give-up).Corporate bonds are typically divided into two markets: high grade and highyield. Whether a bond is high grade or high yield depends on credit ratingsgiven to the company by credit rating agencies like Standard & Poor’s andMoody’s. The higher the credit rating, the lower the risk of default, and thelower the interest. High grade bonds are issued by companies with goodcredit ratings and offer a lower yield (interest) for investors. High yieldbonds (also known as “junk bonds”) are any issues that trade below BBBfrom Standard & Poor’s and Baa from Moody’s. Sometimes, in anticipationof a credit downgrade, high grade bonds can trade with spreads equivalent tohigh yield bonds and vice versa.
International bondsInternational bond markets are less regulated than domestic bond markets, andtherefore carry greater default risk. Anytime an investor buys bonds outsideof his local currency, he is also incurring foreign currency risk (the currencyinvested in can drop relative to the dollar), and in certain emerging markets,there is the added dimension of political risk (a coup will make bonds issuedfrom that country lose their value really quickly). There are four main typesof international bonds issued by corporations, governments, sovereigns andsupranationals: foreign bonds, eurobonds, dragon bonds and gobal bonds.1. Foreign bonds are issued by foreign borrowers in a domestic marketdenominated in that market’s own currency. The domestic market authoritiesregulate the issuance of these bonds. An example of a foreign bond would beIBM (an American company) issuing bonds in the United Kingdom, or SAP(a German company) issuing bonds in the United States. Several of the largestforeign bond markets and their associated names are as shown in the chartbelow:Visit the Vault Finance Career Channel at http://finance.vault.com — withinsider firm profiles, message boards, the Vault Finance Job Board and more.
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COUNTRY OF ISSUE
MARKET NAME
United States
Yankee
United Kingdom
Bulldog
Japan
Samurai
Spain
Matador
Australia
Matildas
Portugal
Navigators
Circling back to our two given examples, IBM issuing bonds in the UnitedKingdom would be a Bulldog issue, and SAP issuing bonds in the UnitedStates would be a Yankee issue.2. Eurobonds are instruments for unsecured debt issued by governments,banks, corporations and supranationals which are outside the domesticmarket of the currency of denomination. Eurobonds are sold to aninternational group of investors who are beneficial owners of the currency ofissue but not resident in the country of that currency. This last attribute meansthat Eurobonds enjoy a less restrictive regulatory environment, since they arenot subject to national laws or regulations. A further advantage of Eurobondsis that they can be issued in any country and in any currency other than thatof its country of issue, affording maximum flexibility to the issuer.The Eurobond market is a 24-hour over-the-counter telephone and screenbased market. The historical unofficial home of Eurobond trading is theUnited Kingdom.3. Dragon bonds are issued in any currency and trade on at least two of the“Dragon” exchanges – Hong Kong, Singapore or Taiwan.4. Global bonds are traded simultaneously in the Eurobond market and onone or more domestic markets. Global bond issuers are typically triple-Arated and are frequently accessing the capital markets.
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Elements of a Bond Trade: The Need forAnonymityCantor Fitzgerald is the dominant government bond broker, and it makesmarkets in all maturities for U.S. government bonds. Bond brokers actas intermediaries between dealers, between dealers and customers(e.g., Fidelity, Vanguard, etc.), as well as between customers. So whydon’t dealers sell directly to customers? And why don’t customerstrade directly with other customers?The answer to the first question is that all else being equal, dealerswould prefer to transact directly with customers (who potentially areless informed about the real value of a particular security). However,when a big firm like PIMCO is selling, there’s probably not going to beanywhere else to offload the position except through the bond brokers.The second question is somewhat more nuanced. Customers might selldirectly to other customers but for the problem that in so doing, PIMCOmight be tipping its hand to the potential buyer, who becomes sospooked that PIMCO is selling that instead of buying decides to sit onthe sidelines waiting for a more favorable supply/demand picture. Nextto proper execution, the most important element that customers in fixedincome (and really any market for that matter) demand is anonymity inthe marketplace. This objective is best achieved through brokers whotransact huge volumes on an agency basis and charge a commission.The convention in the bond market is that whoever hits the bid or takesthe offer pays the commission, so the cat-and-mouse game that tendsto evolve (among the broker-dealers at least) is who avoids payingcommission on his trades.Calling in a bond tradeMost bonds and derivatives trade over-the-counter. To get a quote youneed to call a broker-dealer. For example, Cigna may decide that itneeds a quote on its bond portfolio. It can go to Bloomberg to get arough idea of what its bond portfolio is worth. Bloomberg maintains anextensive and proprietary bond pricing database. But the reality is thatfixed income traders scoff at the Bloomberg generic quote, and thesequotes should be treated as a general indication of the bond’s valuerather than a real-time assessment. A more accurate quote can beachieved by faxing over the portfolio to a broker-dealer’s fixed incomebond trading desk. If it’s just one bond, the trader at Cigna can call hissales contact at Merrill Lynch, for example, who will then ask for aquote from the appropriate trader. The trader will ask who the quote isfor. He’ll check what type of merchandise is for sale by the bond
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brokers and make a price, say “101 22 – 101 25, 5 million up.” Thismeans that the trader is willing to buy or sell 5 million bonds from Cignaat 101 22/32nds or sell 5 million bonds to Cigna at 101 25/32nds. Thisis a two-way market, and while the trader is definitely willing to buy orsell at the prices he’s indicated, chances are good that the bid price isthe one where he had to sharpen his pencil on, since he knows Cigna isan owner and is probably looking to sell some or all of its position. OTCtrading relies on the relationship between the dealer and the customer.The customer who does not trust the first quote can make a few calls,but generally speaking he doesn’t want to make too many calls, becauseby the time he’s called Morgan Stanley and Goldman Sachs, the Streetis getting worried that there’s a seller in the market, and the bid willstart to fade accordingly.
Municipal bonds (“Munies”)Municipal bonds are issued by local and state governments. Typically, thesesecurities are tax-exempt, and therefore trade at lower yields. Investors needto consider their individual tax brackets to consider the relative attractivenessof municipal bonds relative to comparable taxable bonds. Municipal bondsare favored by wealthy investors in higher tax brackets.
Asset-backed securitiesAsset-backed securities include any products that are secured by some typeof asset. These products include securities collateralized by mortgages(mortgage backed securities), credit cards, aircraft loans, and so on.
Mortgage securitiesMortgage securities represent an ownership interest in mortgage loans madeby financial institutions to finance the borrower’s purchase of a home or otherreal estate. Mortgage securities are created when these loans are pooled byissuers or servicers for sale to investors. A couple of types of mortgagesecurities that are worth knowing about:Pass-throughs or participation certificate (PC)The issuer or servicer of pass-through securities collects the monthlymortgage payment from homeowners whose loans are in a given pool (a pool
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brings together loans of the same maturity and same coupon rate) and “passesthrough” the cash flow to investors in monthly payments. Most pass-throughmortgage securities are issued by Ginnie Mae, Fannie Mae or Freddie Macand carry an implied AAA credit rating. Most pass-through securities arebacked by fixed-rate mortgages, but adjustable-rate mortgages (ARMs) arealso pooled to create pass-through securities. ARMS typically have caps andfloors. These option-like characteristics require a higher yield on the ARMbacked pass-through security.Real estate mortgage investment conduit (REMIC) / Collateralizedmortgage obligation (CMO)Mortgage-backed-securities collateralized by mortgage pass-throughsecurities. REMICs allow cash flows to be directed so that different classesof securities with different maturities and coupons can be created.
CMO PrimerCollateralized Mortgage Obligation (CMO) structures are complex. Thefollowing discussion is meant to give you a sense of whether or not thisbusiness is for you. If you don’t particularly enjoy talking about TACtranches and Z-bonds, then perhaps you should consider a less complex,more flow-oriented product.The CMO is a multi-class bond backed by a pool of mortgage passthroughs or mortgage loans. In structuring a CMO, an issuer distributescash flow from the underlying collateral over a series of classes (calledtranches). Taken together, these tranches comprise the CMO. CMOshave two or more tranches, and each tranche has an expected cashflow pattern designed to meet the need of a particular investor. Theseexpected cash flows are measured according to Weighted AverageMaturity and Weighted Average Coupon. For example, a five-trancheCMO might have two-, five-, seven-, 10- and 20-year tranches. Theactual realization of cash flows can be substantially different from theexpectation if the assumed prepayment rate differs from the actualprepayment rate.Sequential-pay CMOs (plain vanilla CMO)All scheduled and unscheduled principal payments pay down investorsin the first tranches (alphabetically listed so that the A tranche is retiredbefore the B tranche, the B tranche before the C tranche, and so on).Investors in later tranches have more prepayment stability than
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investors in earlier tranches, since the late tranches do not startreceiving principal payments until prior tranchers are paid off.Z-bond (accretion bond)Z-bonds are the final tranche of CMOs which do not pay interest ( thisinterest is accrued) until all prior tranches are retired. When the priortranches are retired, the Z-bond receives coupon payments based on thehigher principal balance and any principal prepayments from theunderlying mortages. The Z-bond tranche helps stabilize the cash-flowpatterns in the other tranches, but the Z-bond is itself a highly volatiledebt instrument.Planned amortization class (PAC) and targeted amortization class (TAC)The planned amortization class (PAC) and targeted amortization class(TAC) reduce investors’ prepayment risk by establishing a sinking-fundstructure. PAC and TAC bonds assure to varying degrees that theirinvestors will receive payments over a predetermined time period undervarious prepayment scenarios. PAC bonds tend to provide more stablecash flow under a greater number of prepayment scenarios than TACbonds.To establish the desirable stability of PAC or TAC tranches, support ornon-PAC bonds must be created to absorb the variability of collateralprincipal cash flows. Unscrupulous mortgage dealers often do not labelthese support bonds as such, but these support bonds will often beattractive to potential investors due to their higher yield.Floating-rate CMO tranche (Floaters)Floaters pay a variable rate of interest normally tied to LIBOR. Variantsof the floater include the superfloater (which pays a spread aboveLIBOR) and inverse floaters which vary inversely with LIBOR.StripsStripped mortgage securities can create bonds that receive someinterest and some principal (strips). Mortgage securities that arecompletely stripped form interest-only securities (IO) and principal only(PO) securities. IOs and POs are more sensitive to changes inprepayment rates and interest rates than standard pass-throughsecurities. POs increase in value as rates decrease, whereas IOsdecrease in value as rates decrease. Think of a PO as a zero-couponbond that has the additional risk of prepayment and is therefore lessdesirable than an option-free zero coupon bond in a falling rate
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environment (due to faster than expected prepayments) and also lessdesirable in a higher rate environment (again due to prepayments).Think of an IO as an annuity of variable maturity, which contracts in afalling rate environment and also receives less than expected interestpayments. In a rising rate environment, the life of the IO extends,exactly at the worst possible time, when an investor would prefer tohave as much income as possible to reinvest at higher rates. IOs areoften used as hedges to fixed-income securities due to their uniquereturn characteristics.Callable pass-throughsThe callable class receives all of the principal and interest from theunderlying collateral. Rather than being short a series of call options tothe underlying borrowers, the callable class investor is short a call optionto another investor. The call class receives no principal or interest, buthas the right to call the underlying pass-through from the callable classholders after a specified period of time has passed at a stated price.Consequently, the callable class receives a higher yield to compensatefor more limited upside, relative to a straight pass-through.
Convertible SecuritiesConvertible bond basicsConvertibles combine the equity upside with the income characteristics ofbonds. Convertible bond desks offer a nice work environment for peoplewith an analytical bent who want something a little more exciting than bonds.Here’s a basic example of how a convertible bond might be structured:convertible bonds of Company X can be converted into 5 shares of CompanyX stock if its stock price rises above a pre-specified threshold. There are threedeterminants of value in a convertible bond: investment value, conversionvalue and option value. Investment value refers to the value of theconvertible bond if it were a straight bond. This is the value below which aconvertible can never trade. The conversion value is the value of the bond ifit were to be converted into stock of Company X. In this case, if CompanyX stock currently trades at $20/share, and converting one bond for 5 bondsproduces a conversion value of $100. If the conversion value exceeds theinvestment value, then conversion value takes precedence. Note thatVisit the Vault Finance Career Channel at http://finance.vault.com — withinsider firm profiles, message boards, the Vault Finance Job Board and more.
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conversion value can only be positive since it is a right and not an obligationavailable to convertible bond investors. This option normally translates intoa convertible bond price that exceeds the investment and conversion value.The present value of this premium represents the option value of the convert.
Convertible arbitrage trade exampleThis transaction type consists of matching a long position in a convertiblesecurity (owning the security) with an offsetting short position (owning theright to sell at a certain price) in the underlying stock. The main driver ofprofitability in convertible arbitrage transactions is the current incomegenerated by combining the yield of the convertible security with the interestincome on the proceeds from the short positions, less any dividends on theshares sold short.Additional profit is generated through delta hedging. First, the setup: supposethe price of a convertible bond is $1000, and that the company’s current stockprice is $75 with a 33% conversion premium, so the value of the stockconversion premium is $100. Option delta is the change in the price of theoption for a 1% increase in the stock option. Assuming an option delta of 0.5,then the amount of shares to sell short is given by the following formula:Hedge ratio = (Convertible bond price/Conversion premium) * Option delta= ($1000/$100) * 0.5 = 5 sharesThe hedge ratio indicates that for every 1 convertible bond owned, 5 sharesshould be sold short. For small changes in the price of the stock, this deltahedge creates a market-neutral position where the profit from this convertiblearbitrage trade is the income from the short and the coupon on the bond. Involatile markets, this hedge breaks down and a large decrease in the value ofthe stock will create an additional profit, since the stock will lose more invalue than the convertible. Similarly, if the price of the stock increasessubstantially, the convertible will gain more than the short stock position,again earning a profit for the convertible arbitrage trader. Typically, the bondside of the trade needs to be hedged, since if the yield curve shiftssignificantly, the trader could end up reaping an additional windfall gain orloss, which is not part of the game for most convertible arb trades.
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DerivativesA derivative is an agreement between two parties in which each agrees totransfer an asset or amount of money on or before a specified future date at aspecified price. A derivative’s value is derived from one or more underlyingvariables. Originally, derivatives trading involved commodities as a way forfarmers to hedge away the financial risk of their business, but todayderivatives are tied to everything from currencies and interest rates to theweather.A forward contract is a transaction in which the buyer and seller agree uponthe delivery of a specified quality and quantity of asset at a specified futuredate. A price is normally specified in advance or at the time of delivery.• A futures contract is a legally binding obligation for the holder of thecontract to buy or sell a particular commodity at a specific price andlocation at a specific date in the future. The appeal of an exchange-tradedfuture is that the contracts can be standardized, so that everyone in themarket is trading the same contract.• An option gives the buyer the right but not the obligation to buy (call) orsell (put) the underlying asset at a specified price (called the “strike price”)up to or on a specific future date (expiration date). The buyer of the optionpays the seller of the option a premium for this right.• A swap is the simultaneous buying and selling of a similar asset orobligation of equivalent capital amount. This exchange of financialarrangements provides both parties with more favorable conditions thanthey would otherwise expect. For example, a payer of fixed-rate debt maydesire paying floating-rate debt, and a payer of floating-rate debt may wantto pay fixed-rate debt. If the two sides can agree on a notional amount uponwhich to compute coupon payments, then they can swap fixed for floatingand floating for fixed. The notional amount never changes hands, andinterest payments are netted.
A look at swapsHow is a swap possible? How can both sides be made better off in an interestrate swap transaction? What we’ve learned from financial derivatives is thatit’s a tough world out there, and if you’re making money, that’s becauseVisit the Vault Finance Career Channel at http://finance.vault.com — withinsider firm profiles, message boards, the Vault Finance Job Board and more.
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you’re breaking someone else’s back (i.e., it’s a zero sum game). If you’vetaken an international economics class, you may remember discussing gainsfrom international trade. A similar concept is at work in the financialmarkets. Let’s take a look at an example:MMMM (“Four M”) is a multinational corporation with a triple A creditrating. MMMM needs to borrow $100 million for 5 years. MMMM canborrow at a low fixed rate, but would prefer to take advantage of a floatingrate basis loan.Chewbacca is a triple B rated energy trading company named after the StarWars character. Chewy needs to raise $100 million for 5 years. Because ofChewy’s lower credit rating, it is easier for the firm to borrow on a floatingrate basis, or to issue debt with a high coupon. But alas, Chewy would prefera fixed-rate loan in order to better predict future interest payments.Each firm’s situation is summarized below:RATES
MMMM CAN BORROW FIXED
CHEWY CAN BORROW FLOATING
FIXED
6%
10%
FLOATING
LIBOR
LIBOR + 1%
Assuming that both corporations do not believe there to be substantial defaultrisk, then an interest rate swap can be negotiated as follows:1. MMMM borrows fixed rate at 6%2. Chewy borrows floating at LIBOR + 1%3. MMMM and Chewy enter into a $100 million notional interest rate swapagreement for five years such that:MMMM makes floating rate payments of LIBOR + 1% to ChewyChewy makes fixed rate payments 9% to MMMM. Chewy agrees to makethis higher fixed rate to MMMM because of its lower credit rating.
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Now both sides of the swap look like this:MMMM CAN BORROW FIXED
CHEWY CAN BORROW FLOATING
LIBOR + 1% + 6%
9% + LIBOR + 1%
LIBOR
LIBOR + 1%
NET PAYMENTS
LIBOR – 2%
9%
WITHOUT SWAP
LIBOR
10%
SWAP SAVINGS
2%
1%
PAYSRECEIVESFLOATING
9%
Notice that the swap has allowed both MMMM and Chewy to achieve alower cost of borrowing than either would have been able to access withouteach other. Notice also that these savings were possible even thoughMMMM had a lower fixed and floating rate available to it at the outset.These savings will be reduced by the dealer’s fee for arranging the swap. Inthis happy world, customers and dealer both profit. Originally, dealers actedas matchmakers between counterparties. Today, the swaps market hasbecome so standardized that dealers stand ready to take the other side of theproposed interest rate swap trade.
Risk managementThe main reason for using derivatives is to manage risk. The derivativesmarket offers hedgers like the CFO of a large industrial company a way tohedge away his firm’s financial risk, and it provides speculators (who arehopelessly addicted to leverage) an opportunity to profit from a particularmarket view. Arbitrageurs keep the market efficient by exploiting any pricediscrepancies between different markets or between the derivative and theunderlying asset. Derivatives can trade in three ways, explained in thefollowing sections.
Fixed income derivativesFixed income derivatives are any derivatives instruments which derive valuefrom a fixed income security. Typically these instruments are structured byWall Street firms as a way to reallocate risks from corporations (who areseeking to mitigate business or financial risk) to speculators (who are seekingrisk exposure in the expectation of profiting from a particular market view).Dealers will create a derivative instrument, and to support the development ofVisit the Vault Finance Career Channel at http://finance.vault.com — withinsider firm profiles, message boards, the Vault Finance Job Board and more.
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this market will subsequently engage in creating and maintaining an activesecondary market. As the market becomes more developed, spreads that thedealers pocket decrease dramatically. When interest rate swaps werepopularized by Bankers Trust, BT was able to extort exorbitant fees fromrelatively unsophisticated corporate treasurers. Today, the interest rate swapsmarket is a screen-based market with razor-thin margins, and creditderivatives are all the rage. One word of caution for the neophyte fixedincome derivative enthusiast: Warren Buffet has characterized derivatives as“financial weapons of mass destruction.” While Wall Street has peddledderivatives as an efficient manner of reallocating risk, as the Long TermCapital Management debacle demonstrated, there are tremendous amounts ofcounter-party risk, since risk ends up being concentrated in relatively fewhands, and one default in the derivatives market can trigger multiple defaultsthroughout the system, threatening the integrity of the entire worldwidefinancial market.
Equity derivativesEquity derivatives trade listed and OTC equity options. OTC options arecontracts structured by the firm to meet the needs of specific institutionalcustomers. Listed options are exchange-listed products that are completelystandardized and more liquid. Call holders have the right (but not theobligation) to purchase shares of the underlying company at a pre-specifiedprice. Put holders have the right to sell shares of the underlying company ata pre-specified price. Dealers are typically sellers of options, and the vastmajority of options expire worthless (out-of-the-money). Being short optionsis equivalent to being short volatility (some options desks now callthemselves “Volatility Trading Desks”). Options give the right to buy or sellan underlying stock: the higher the volatility, the greater the price of theoption; the lower the volatility, the lower the price of the option. When a deskis net short options, it is short volatility, and will profit if volatility does notexceed the implied volatility at which the options were sold at. Think ofoptions desks as insurers who are constantly collecting small premiums, butmust every once in a while make a large payout related to a natural or manmade disaster.
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Over-the-counter (OTC) derivativesDealers structure and trade just about anything that can generate a fee, buttypically these structured products compete with standardized exchangetraded products. These products include currency and commodityderivatives, as well as interest rate swaps. Structured products like interestrate swaps will typically trade over-the-counter, whereas more standardizedproducts are traded on exchanges such as the Chicago Board of Trade(CBOT) and the London International Financial Futures and OptionsExchange (LIFFE).By now you should understand that the OTC equity market, the OTC bondmarket and the OTC derivatives market are all inter-dealer markets connectedby telephone and computer network. There is no centralized exchange floor.
Trading Systems for DerivativesOn the exchange floor (open outcry)Note that structured products are normally built with standardizedderivative securities, and that in most circumstances, the dealer mustthen go out and hedge the exposure that he’s taken on from the client(at least until he can find another customer to take an equal andoffsetting position) by going to the exchange. This requires the dealerto structure a hedge using standardized future and option contracts thattrade on the exchange floors.Regional exchanges are continuously rolling out new products to trade,and successful products tend to develop pockets of liquidity on one ortwo major exchanges. For example, the Philadelphia Stock Exchangehas a booming business in currency options. The Chicago MercantileExchange trades, among other things, currency and equity options.Some futures exchanges use specialists in the same way that the NYSEemploys specialists as a buyer or seller of last resort. On otherexchanges, like the NYME, a trade cannot be completed unless there issomeone else willing to take the other side of the trade. The commodityfutures prices are determined in an open and continuous auction on thefloor by brokers acting as agent (preserving anonymity of the customer)or principal. This auction process involves a lot of yelling and hollering,and is appropriately called “open outcry.” Highest bids are matchedwith lowest offers and supply and demand push the contract price in theappropriate direction.
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Electronic trading (GLOBEX)Electronic trading was introduced as a way to extend the trading hoursof the major exchanges, and today has grown into a big business.Electronic trading systems apply the same rules that are enforced on thetrading floor. Customers enter bids and offers into the system. Thisinformation is disseminated electronically to all market participants, andthe orders are matched off subject to the individual rules of the market.
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Trends in the IndustryCHAPTER 6
Technology TrendsA dominant trend affecting the equity, fixed income and derivative markets isthe impact of technology on spreads. Information technology is constantlyimproving the efficient dissemination of information through themarketplace. This effect is mitigated by increased volume in trading (i.e., twonickels make one dime) but to the extent that this shortfall is not fullyrecovered, broker-dealers must accept lower commission income or seek toimprove trading revenues by taking on more risk. The technology landscapeis constantly changing and technologists en