Bond Markets, Analysis and Strategies 9e Frank Fabozzi (Solutions
Manual All Chapters, 100% Original Verified, A+ Grade)
OVERVIEW OF CONTENTS
Chapter 1 introduces the fundamental features of bond, the type of issuers, and risk faced by
investors in fixed-income securities. Chapters 2–5 set forth the basic analytical framework
necessary to understand the pricing of bonds and their investment characteristics. Chapter 6
presents Treasury securities, Treasury derivative securities, and federal agency securities.
Chapters 7–9 provides details on the investment characteristics and special features of U.S.
corporate debt, municipal securities, and non-U.S. bonds. Chapters 10–13 focus on residential
mortgage-backed securities. Chapter 14 covers commercial mortgage loans and commercial
mortgage-backed securities. Chapter 15 looks at asset-backed securities and Chapter 16
introduces pooled investment vehicles for fixed-income investors. Chapter 17 provides the basics
of interest rate modeling, while Chapter 18 explains how to analyze bonds with embedded
options. Chapter 19 analyzes residential mortgage–backed securities, while Chapter 20 covers
convertible bonds. Chapter 21 discusses measuring the credit spread exposures of corporate
bonds. Chapter 22 analyzes the corporate bond credit analysis and Chapter 23 provides the basics
of credit risk modeling. Chapters 24–26 covers bond portfolio management in regards to tis
strategies, construction and considerations. Chapter 27 investigates liability-driven investing for
defined benefit pension plans. Chapter 28 examines bond performance measurement and
evaluation. Chapters 29–30 covers interest-rate futures contracts and interest-rate options.
Chapter 31 examines interest-rate swaps, caps, and floors while Chapter 32 investigates credit
derivatives.
CHAPTER 1
INTRODUCTION
CHAPTER SUMMARY
This introductory chapter will focus on the fundamental features of bond, the type of issuers, and
risk faced by investors in fixed-income securities. A bond is a debt instrument requiring the
issuer to repay to the lender the amount borrowed plus interest over a specified period of time.
A typical (“plain vanilla”) bond issued in the United States specifies (1) a fixed date when the
amount borrowed (the principal) is due, and (2) the contractual amount of interest, which
typically is paid every six months. The date on which the principal is required to be repaid is
called the maturity date. Assuming that the issuer does not default or redeem the issue prior to
the maturity date, an investor holding this bond until the maturity date is assured of a known cash
flow pattern. Since the early 1980s a wide range of bond structures has been introduced into the
bond market.
SECTORS OF THE U.S. BOND MARKET
The U.S. bond market is divided into six sectors: U.S. Treasury, agency, municipal, corporate,
asset-backed securities, and mortgage. Bond investors consider these sectors when deciding on
their investment strategies.
Copyright © 2016 Pearson Education, Inc. 1
,The Treasury Sector
The Treasury sector includes securities issued by the U.S. government. These securities include
Treasury bills, notes, and bonds. This sector plays a key role in the valuation of securities and the
determination of interest rates throughout the world.
The Agency Sector
The agency sector includes securities issued by federally related institutions and government-
sponsored enterprises. The securities issued are not backed by any collateral and are referred to
as agency debenture securities.
The Municipal Sector
The municipal sector is where state and local governments and their authorities raise funds. This
sector is divided into two subsectors based on how the interest received by investors is taxed at
the federal income tax level: the tax-exempt and taxable sectors. The municipal bond market
includes two types of structures: tax-backed and revenue bonds.
The Corporate Sector
The corporate sector includes (i) securities issued by U.S. corporations and (ii) securities issued
in the United States by foreign corporations. Issuers in the corporate sector issue bonds, medium-
term notes, structured notes, and commercial paper. The corporate sector is divided into the
investment grade and noninvestment grade sectors.
The Asset-Backed Securities Sector
In the asset-backed securities sector, a corporate issuer pools loans or receivables and uses the
pool of assets as collateral for the issuance of a security. Captive finance companies (subsidiaries
of operating companies that provide funding for loans to customers of the parent company) are
typically issuers of asset-backed securities.
The Mortgage Sector
The mortgage sector is the sector where securities are backed by mortgage loans. The mortgage
sector is divided into the residential mortgage sector and the commercial mortgage sector. The
residential mortgage sector includes loans for one- to four-family homes. The commercial
mortgage sector covers commercial loans for income-producing property.
Bond Investors
Bond investors (including retail investors and institutional investors) have an opportunity to
invest in a pooled investment vehicle in lieu of constructing their own portfolio to obtain
exposure to the broad bond market and/or specific sectors of the bond market. For retail
investors, the benefits of investing in pooled funds are improved means for diversification,
liquidity, and professional management.
Copyright © 2016 Pearson Education, Inc. 2
,OVERVIEW OF BOND FEATURES
A more detailed treatment of bond features is presented in later chapters.
Type of Issuer
There are three issuers of bonds: the federal government and its agencies, municipal
governments, and corporations (domestic and foreign).
Term to Maturity
The maturity of a bond refers to the date that the debt will cease to exist, at which time the issuer
will redeem the bond by paying the principal. There may be provisions in the indenture that
allow either the issuer or bondholder to alter a bond’s term to maturity.
Generally, bonds with a maturity of between one and five years are considered short-term.
Bonds with a maturity between 5 and 12 years are viewed as intermediate -term, and those with
a maturity of more than 12 years are called long-term. With all other factors constant, the longer
the maturity of a bond, the greater the price volatility resulting from a change in market yields.
Principal and Coupon Rate
The principal of a bond is the amount that the issuer agrees to repay the bondholder at the
maturity date. This amount is also referred to as the redemption value, maturity value, par
value, or face value. The coupon rate, also called the nominal rate, is the interest rate that the
issuer agrees to pay each year. The annual amount of the interest payment made to owners
during the term of the bond is called the coupon.
The holder of a zero-coupon bond realizes interest by buying the bond substantially below its
principal value. Interest is then paid at the maturity date, with the exact amount being the
difference between the principal value and the price paid for the bond.
Floating-rate bonds are issues where the coupon rate resets periodically (the coupon reset date)
based on a formula. The coupon reset formula has the following general form:
reference rate + quoted margin.
The reference rate is an index where the exact index change is unknown and uncertain. The
quoted margin is the additional amount that the issuer agrees to pay above the reference rate.
An important and frequently used non-interest rate index is the rate of inflation. Bonds whose
interest rate is tied to the rate of inflation are referred to generically as linkers.
The coupon on floating-rate bonds (which is dependent on an interest rate benchmark) typically
rises as the benchmark rises and falls as the benchmark falls. Exceptions are inverse floaters
whose coupon interest rate moves in the opposite direction from the change in interest rates. To
reduce the burden of interest payments, firms involved in LBOs and recapitalizations, have
Copyright © 2016 Pearson Education, Inc. 3
, issued deferred-coupon bonds that let the issuer avoid using cash to make interest payments for
a specified number of years.
Amortization Feature
The principal repayment of a bond issue can call for the total principal to be repaid either at
maturity or over the life of the bond. In the latter case, there is a schedule of principal
repayments. This schedule is called an amortization schedule. For amortizing securities, a
measure called the weighted average life or simply average life of a security is computed.
Embedded Options
It is common for a bond issue to include a provision in the indenture that gives either the
bondholder and/or the issuer an option to take some action against the other party. The most
common type of option embedded in a bond is a call provision. This provision grants the issuer
the right to retire the debt, fully or partially, before the scheduled maturity date. An issue with a
put provision included in the indenture grants the bondholder the right to sell the issue back to
the issuer at par value on designated dates.
A convertible bond is an issue giving the bondholder the right to exchange the bond for a
specified number of shares of common stock. An exchangeable bond allows the bondholder to
exchange the issue for a specified number of common stock shares of a corporation different
from the issuer of the bond.
Describing a Bond Issue
There are hundreds of thousands of bonds issues. Most securities are identified by a nine
character (letters and numbers) CUSIP number. CUSIP stands for Committee on Uniform
Security Identification Procedures. The first six characters identify the issuer: the corporation,
government agency, or municipality. The next two characters identify whether the issue is debt
or equity and the issuer of the issue. The last character is simply a check character that allows for
accuracy checking and is sometimes truncated or ignored. The CUSIP International Numbering
System (CINS) is used to identify foreign securities and includes 12 characters.
RISKS ASSOCIATED WITH INVESTING IN BONDS
Bonds may expose an investor to one or more of the following risks: (1) interest-rate risk,
(2) reinvestment risk, (3) call risk, (4) credit risk, (5) inflation risk, (6) exchange rate risk,
(7) liquidity risk, (8) volatility risk, and (9) risk risk. In later chapters, other risks, such as yield
curve risk, event risk, and tax risk, are also introduced.
Interest-Rate Risk
If an investor has to sell a bond prior to the maturity date, an increase in interest rates will mean
the realization of a capital loss (such as selling the bond below the purchase price). This risk is
referred to as interest-rate risk or market risk.
Copyright © 2016 Pearson Education, Inc. 4
Manual All Chapters, 100% Original Verified, A+ Grade)
OVERVIEW OF CONTENTS
Chapter 1 introduces the fundamental features of bond, the type of issuers, and risk faced by
investors in fixed-income securities. Chapters 2–5 set forth the basic analytical framework
necessary to understand the pricing of bonds and their investment characteristics. Chapter 6
presents Treasury securities, Treasury derivative securities, and federal agency securities.
Chapters 7–9 provides details on the investment characteristics and special features of U.S.
corporate debt, municipal securities, and non-U.S. bonds. Chapters 10–13 focus on residential
mortgage-backed securities. Chapter 14 covers commercial mortgage loans and commercial
mortgage-backed securities. Chapter 15 looks at asset-backed securities and Chapter 16
introduces pooled investment vehicles for fixed-income investors. Chapter 17 provides the basics
of interest rate modeling, while Chapter 18 explains how to analyze bonds with embedded
options. Chapter 19 analyzes residential mortgage–backed securities, while Chapter 20 covers
convertible bonds. Chapter 21 discusses measuring the credit spread exposures of corporate
bonds. Chapter 22 analyzes the corporate bond credit analysis and Chapter 23 provides the basics
of credit risk modeling. Chapters 24–26 covers bond portfolio management in regards to tis
strategies, construction and considerations. Chapter 27 investigates liability-driven investing for
defined benefit pension plans. Chapter 28 examines bond performance measurement and
evaluation. Chapters 29–30 covers interest-rate futures contracts and interest-rate options.
Chapter 31 examines interest-rate swaps, caps, and floors while Chapter 32 investigates credit
derivatives.
CHAPTER 1
INTRODUCTION
CHAPTER SUMMARY
This introductory chapter will focus on the fundamental features of bond, the type of issuers, and
risk faced by investors in fixed-income securities. A bond is a debt instrument requiring the
issuer to repay to the lender the amount borrowed plus interest over a specified period of time.
A typical (“plain vanilla”) bond issued in the United States specifies (1) a fixed date when the
amount borrowed (the principal) is due, and (2) the contractual amount of interest, which
typically is paid every six months. The date on which the principal is required to be repaid is
called the maturity date. Assuming that the issuer does not default or redeem the issue prior to
the maturity date, an investor holding this bond until the maturity date is assured of a known cash
flow pattern. Since the early 1980s a wide range of bond structures has been introduced into the
bond market.
SECTORS OF THE U.S. BOND MARKET
The U.S. bond market is divided into six sectors: U.S. Treasury, agency, municipal, corporate,
asset-backed securities, and mortgage. Bond investors consider these sectors when deciding on
their investment strategies.
Copyright © 2016 Pearson Education, Inc. 1
,The Treasury Sector
The Treasury sector includes securities issued by the U.S. government. These securities include
Treasury bills, notes, and bonds. This sector plays a key role in the valuation of securities and the
determination of interest rates throughout the world.
The Agency Sector
The agency sector includes securities issued by federally related institutions and government-
sponsored enterprises. The securities issued are not backed by any collateral and are referred to
as agency debenture securities.
The Municipal Sector
The municipal sector is where state and local governments and their authorities raise funds. This
sector is divided into two subsectors based on how the interest received by investors is taxed at
the federal income tax level: the tax-exempt and taxable sectors. The municipal bond market
includes two types of structures: tax-backed and revenue bonds.
The Corporate Sector
The corporate sector includes (i) securities issued by U.S. corporations and (ii) securities issued
in the United States by foreign corporations. Issuers in the corporate sector issue bonds, medium-
term notes, structured notes, and commercial paper. The corporate sector is divided into the
investment grade and noninvestment grade sectors.
The Asset-Backed Securities Sector
In the asset-backed securities sector, a corporate issuer pools loans or receivables and uses the
pool of assets as collateral for the issuance of a security. Captive finance companies (subsidiaries
of operating companies that provide funding for loans to customers of the parent company) are
typically issuers of asset-backed securities.
The Mortgage Sector
The mortgage sector is the sector where securities are backed by mortgage loans. The mortgage
sector is divided into the residential mortgage sector and the commercial mortgage sector. The
residential mortgage sector includes loans for one- to four-family homes. The commercial
mortgage sector covers commercial loans for income-producing property.
Bond Investors
Bond investors (including retail investors and institutional investors) have an opportunity to
invest in a pooled investment vehicle in lieu of constructing their own portfolio to obtain
exposure to the broad bond market and/or specific sectors of the bond market. For retail
investors, the benefits of investing in pooled funds are improved means for diversification,
liquidity, and professional management.
Copyright © 2016 Pearson Education, Inc. 2
,OVERVIEW OF BOND FEATURES
A more detailed treatment of bond features is presented in later chapters.
Type of Issuer
There are three issuers of bonds: the federal government and its agencies, municipal
governments, and corporations (domestic and foreign).
Term to Maturity
The maturity of a bond refers to the date that the debt will cease to exist, at which time the issuer
will redeem the bond by paying the principal. There may be provisions in the indenture that
allow either the issuer or bondholder to alter a bond’s term to maturity.
Generally, bonds with a maturity of between one and five years are considered short-term.
Bonds with a maturity between 5 and 12 years are viewed as intermediate -term, and those with
a maturity of more than 12 years are called long-term. With all other factors constant, the longer
the maturity of a bond, the greater the price volatility resulting from a change in market yields.
Principal and Coupon Rate
The principal of a bond is the amount that the issuer agrees to repay the bondholder at the
maturity date. This amount is also referred to as the redemption value, maturity value, par
value, or face value. The coupon rate, also called the nominal rate, is the interest rate that the
issuer agrees to pay each year. The annual amount of the interest payment made to owners
during the term of the bond is called the coupon.
The holder of a zero-coupon bond realizes interest by buying the bond substantially below its
principal value. Interest is then paid at the maturity date, with the exact amount being the
difference between the principal value and the price paid for the bond.
Floating-rate bonds are issues where the coupon rate resets periodically (the coupon reset date)
based on a formula. The coupon reset formula has the following general form:
reference rate + quoted margin.
The reference rate is an index where the exact index change is unknown and uncertain. The
quoted margin is the additional amount that the issuer agrees to pay above the reference rate.
An important and frequently used non-interest rate index is the rate of inflation. Bonds whose
interest rate is tied to the rate of inflation are referred to generically as linkers.
The coupon on floating-rate bonds (which is dependent on an interest rate benchmark) typically
rises as the benchmark rises and falls as the benchmark falls. Exceptions are inverse floaters
whose coupon interest rate moves in the opposite direction from the change in interest rates. To
reduce the burden of interest payments, firms involved in LBOs and recapitalizations, have
Copyright © 2016 Pearson Education, Inc. 3
, issued deferred-coupon bonds that let the issuer avoid using cash to make interest payments for
a specified number of years.
Amortization Feature
The principal repayment of a bond issue can call for the total principal to be repaid either at
maturity or over the life of the bond. In the latter case, there is a schedule of principal
repayments. This schedule is called an amortization schedule. For amortizing securities, a
measure called the weighted average life or simply average life of a security is computed.
Embedded Options
It is common for a bond issue to include a provision in the indenture that gives either the
bondholder and/or the issuer an option to take some action against the other party. The most
common type of option embedded in a bond is a call provision. This provision grants the issuer
the right to retire the debt, fully or partially, before the scheduled maturity date. An issue with a
put provision included in the indenture grants the bondholder the right to sell the issue back to
the issuer at par value on designated dates.
A convertible bond is an issue giving the bondholder the right to exchange the bond for a
specified number of shares of common stock. An exchangeable bond allows the bondholder to
exchange the issue for a specified number of common stock shares of a corporation different
from the issuer of the bond.
Describing a Bond Issue
There are hundreds of thousands of bonds issues. Most securities are identified by a nine
character (letters and numbers) CUSIP number. CUSIP stands for Committee on Uniform
Security Identification Procedures. The first six characters identify the issuer: the corporation,
government agency, or municipality. The next two characters identify whether the issue is debt
or equity and the issuer of the issue. The last character is simply a check character that allows for
accuracy checking and is sometimes truncated or ignored. The CUSIP International Numbering
System (CINS) is used to identify foreign securities and includes 12 characters.
RISKS ASSOCIATED WITH INVESTING IN BONDS
Bonds may expose an investor to one or more of the following risks: (1) interest-rate risk,
(2) reinvestment risk, (3) call risk, (4) credit risk, (5) inflation risk, (6) exchange rate risk,
(7) liquidity risk, (8) volatility risk, and (9) risk risk. In later chapters, other risks, such as yield
curve risk, event risk, and tax risk, are also introduced.
Interest-Rate Risk
If an investor has to sell a bond prior to the maturity date, an increase in interest rates will mean
the realization of a capital loss (such as selling the bond below the purchase price). This risk is
referred to as interest-rate risk or market risk.
Copyright © 2016 Pearson Education, Inc. 4
