AIMR Suggested Fixed-Income Readings
- Section I: Perspectives on Interest Rates and the Pricing of Traditional Fixed-Income Securities, Yield Curve Behavior, and Monetary Policy
- Section II: Valuation of Bonds and Derivatives
- Section III: Tax and Accounting Issues
- Section IV: Risk Measurement and Risk Management
- Section V: International Fixed-Income Analysis and Portfolio Management
I. Perspectives on Interest Rates and Pricing of Traditional Fixed-Income Securities, Yield Curve Behavior, and Monetary Policy
Section I Study Guides
STUDY SESSION 1
Overview: Institutional Details and Pricing Fundamentals
READING 1: "An Overview of Fixed-Income Securities," Ch. 1, Fixed Income Markets and Their Derivatives, Suresh M. Sundaresan (South-Western College Publishing, 1997), pp. 3-39. This reading provides a broad perspective on fixed-income securities markets. The roles of issuer, investor, and intermediary are presented from both a domestic (U.S.) and global perspective. The chapter provides a framework for pricing fixed-income securities for each of the security sectors discussed. Sources of risk that must be modeled for pricing purposes for each sector are laid out. Level of difficulty: Not difficult. Estimated study time: 2 hours.
READING 2: "Organization and Conduct of Debt Markets," Ch. 2, Fixed Income Markets and Their Derivatives, Suresh M. Sundaresan (South-Western College Publishing, 1997), pp. 41-75. Various forms of financial market structures, including direct search, brokered markets, dealer markets, and auction markets, are discussed. This reading introduces transparency and adverse selection (which are properties of market organization relating to information). It presents the role of the U.S. Federal Reserve System and the mechanisms by which it operates and attempts to influence financial markets. The reading examines securities dealers in terms of their trading activities, position management (to reflect interest rate predictions), and leveraging activity in the repo market. The reading ends with a review of the role of the U.S. federal government in exercising its responsibility for enforcement and market surveillance. Level of difficulty: Not difficult. Estimated study time: 1.5 hours.
READING 3: "Treasury Auctions and Selling Mechanisms," Ch. 3, Fixed Income Markets and Their Derivatives, Suresh M. Sundaresan (South-Western College Publishing, 1997), pp. 77-102. The reading presents various auction mechanisms, provides details of U.S. government security auctions, and introduces the concept of the "winner's curse" (the possibility of an aggressive bidder paying too much relative to the market consensus) for discriminatory auctions. Furthermore, this reading is important to readers because of the potential for growth in emerging markets; developing countries need to choose mechanisms to carry out their bond sales as their economies mature. Level of difficulty: Moderately difficult. Estimated study time: 1 hour.
READING 4: "Bond Mathematics," Ch. 4, Fixed Income Markets and Their Derivatives, Suresh M. Sundaresan (South-Western College Publishing, 1997), pp. 103-54. This reading serves as a rigorous review of the basic concepts of yield calculation and price risk (duration, convexity) for individual instruments and portfolios. Hedging under conditions of perfect and imperfect correlation is addressed. The actual market mechanisms (e.g., repo financing) are presented in the context of setting up hedged trading strategies. Level of difficulty: Difficult. Estimated study time: 3 hours.
READING 5: "Yield-Curve and Term-Structure Analysis," Ch. 5, Fixed Income Markets and Their Derivatives, Suresh M. Sundaresan (South-Western College Publishing, 1997), pp. 155-205. This reading introduces building blocks for the analysis of the yield curve and concepts relating to the term structure of interest rates. Stripping and reconstituting coupon bonds is discussed with an eye toward examining the arbitrage relationships that hold between zero-coupon and coupon-paying instruments. The reader is cautioned that frictions such as liquidity and coupon (tax) effects may create the appearance of an arbitrage violation where none exists. Level of difficulty: Moderately difficult. Estimated study time: 3 hours.
READING 6: "Piecewise Cubics," Appendix 4C, Fixed Income Securities, University Edition, Bruce Tuckman (John Wiley & Sons, 1996), pp. 60-61. Often when the term structure of interest rates is bootstrapped, observations are not available at every point along the maturity spectrum to allow a smooth, continuous relationship. As a result, the nature of the relationship between observed data points must be estimated. The piecewise cubics procedure permits the estimation of the relationship between two observations so that a smooth relationship between spot rates and maturity is obtained. Note that this procedure is purely an estimation technique and has no financial foundation. Level of difficulty: Not difficult. Estimated study time: 0.5 hour.
STUDY SESSION 2
Yield Curve Analysis-Part 1
READING 1: "Overview of Forward Rate Analysis(Available Online)" Part 1, Understanding the Yield Curve, Antti Ilmanen, Portfolio Strategies, U.S. Fixed Income Research (Salomon Brothers, May 1995), pp. 1-19. The yield curve can be represented either by coupon bond yields (par rates), zero coupon bond yields (spot rates), or forward rates. The yield curve shape depends on three determinants: the market's rate expectations, the required bond risk premiums, and the convexity bias. Thus forward rates do not only reflect the market's rate expectations, because positive bond risk premiums tend to make the yield curve upward sloping, and the convexity bias tends to pull the curve down at very long durations. Forward rate analysis can be useful both for "view-taking" investors and for relative-value analysts. Forward rates are not only breakeven rates against which investors can compare their subjective rate expectations. Forward rates also measure the near-term returns that various zero coupon bonds will earn if the yield curve remains unchanged. Level of difficulty: Moderately difficult. Estimated study time: 3 hours.
READING 2: "Market's Rate Expectations and Forward Rates(Available Online)," Part 2, Understanding the Yield Curve, Antti Ilmanen, Portfolio Strategies, U.S. Fixed Income Research (Salomon Brothers, June 1995), pp. 1-21. The market's interest rate expectations may be the most important determinant of the yield curve's shape. The market's view on the rate direction influences the slope of today's yield curve; the market's view on curve-flattening or curve-steepening influences the curvature of today's yield curve. However, it is more appropriate to view the implied forward yield curves as breakeven yield curves than as the market's rate expectations. The implied forward yield curve shows, by construction, the future yield curve that would make all government bonds earn the same return over the horizon. In contrast, empirical evidence suggests that the implied forward yield curve is a poor predictor-somewhat worse than the current yield curve (a no-change prediction)-of the future yield curve. Level of difficulty: Moderately difficult. Estimated study time: 3 hours.
READING 3: "Does Duration Extension Enhance Long-Term Expected Returns?(Available Online)" Part 3, Understanding the Yield Curve, Antti Ilmanen, Portfolio Strategies, U.S. Fixed Income Research (Salomon Brothers, July 1995), pp. 1-18. The required bond risk premiums, or the near-term expected return differentials between longer bonds and the "riskless" short-term bond, tend to make the yield curve upward sloping. Various theories propose that bond risk premiums should increase with duration, with return volatility, or with sensitivity to systematic risk factors. In addition to these risk differences, expected return differentials across bonds may reflect technical factors, such as liquidity differences. If bond risk premiums are constant over time, one can estimate them by using historical average return differentials. Empirical analysis confirms that average bond risk premiums are positive; thus, duration extension does enhance long-run expected returns. However, although the average returns increase very fast at short durations, the incremental reward from duration extension is small after two years. Level of difficulty: Moderately difficult. Estimated study time: 3 hours.
STUDY SESSION 3
Yield Curve Analysis-Part 2
READING 1: "Forecasting U.S. Bond Returns(Available Online)," Part 4, Understanding the Yield Curve, Antti Ilmanen, Portfolio Strategies, U.S. Fixed Income Research (Salomon Brothers, August 1995), pp. 1-20. If required bond risk premiums vary over time, historical average bond returns may reflect time-varying risk premiums rather than changing rate expectations. Changes in risk premiums may be predictable. The main implication for investors, therefore, is that bond market fluctuations are partly forecastable. Empirical evidence shows that yield curve steepness can be used to distinguish more opportune from less opportune times to invest in long-duration bonds. Combining steepness with other predictors can further enhance the bond return forecasts. Historical backtests show that dynamic strategies that exploit the return predictability would have substantially outperformed passive bond market strategies over the longer run. Level of difficulty: Moderately difficult. Estimated study time: 2 hours.
READING 2: "Convexity Bias and the Yield Curve(Available Online)," Part 5, Understanding the Yield Curve, Antti Ilmanen, Portfolio Strategies, U.S. Fixed Income Research (Salomon Brothers, September 1995), pp. 1-23. Convexity bias is the least-known influence on the yield curve shape. Positive convexity in a bond's price-yield curve is a valuable property because it gives "option like" features to straight bonds and thus implies the possibility of enhancing the bond's performance if large yield changes occur. Because of their convexity advantage, long-duration bonds can have lower yields than short-duration bonds and yet offer similar near-term expected returns. This convexity bias partly explains the Treasury spot rate curve's typical inversion at the long end. The magnitude of convexity bias depends on the perceived level of yield volatility. Incorporating this effect into relative-value analysis is especially important for long-duration bonds. Historical analysis shows that the convexity effect influences the performance of duration-neutral barbell/bullet positions (i.e., buying barbells financed by selling bullets) but tends to be overwhelmed by the curve-reshaping effect. Level of difficulty: Moderately difficult. Estimated study time: 2 hours.
READING 3: "A Framework for Analyzing Yield Curve Trades(Available Online)," Part 6, Understanding the Yield Curve, Antti Ilmanen, Portfolio Strategies, U.S. Fixed Income Research (Salomon Brothers, November 1995), pp. 1-23. Forward rates, and thus the yield curve shape, can be decomposed into three determinants: the market's rate expectations, the required bond risk premiums, and the convexity bias. Similarly, the near-term expected return of government bonds can be decomposed into the following simple building blocks: the yield income, the roll-down return, the value of convexity, and the duration impact of the rate expectation. This framework is useful for evaluating all types of government bond positions and is closely related to scenario analysis. Comprehensive expected return measures are likely to produce better relative-value signals than yield spreads do, especially for barbell/bullet trades. Level of difficulty: Moderately difficult. Estimated study time: 2 hours.
READING 4: "The Cyclical Behavior of U.S. Interest Rates: Theory and Evidence(Available Online)," Michael R. Rosenberg, Currency and Bond Market Trends, Merrill Lynch, Pierce, Fenner, & Smith (August 1, 1991), pp. 60-65. This reading describes a framework for identifying cyclical peaks and troughs in U.S. interest rates. The article introduces a stylized model to describe how short- and long-term interest rates and the yield curve typically behave in the course of a business cycle. Although the precise movements of short- and long-term interest rates differ from cycle to cycle, the article identifies a number of recognizable recurring themes. The reader will be able to put together a list of variables to help identify when cyclical peaks and troughs in U.S. interest rates should occur and thus be able to determine the optimal structure of actively managed bond portfolios in terms of duration. Level of difficulty: Moderately difficult. Estimated study time: 1 hour.
READING 5: "Some Lessons from the Yield Curve," John Y. Campbell, Journal of Economic Perspectives, American Economic Association (Summer 1995), pp. 129-52. This reading summarizes recent research on the term structure of interest rates and relates the research to recent swings in the U.S. bond market. The reader will gain valuable insights into how changes in U.S. monetary policy may affect the U.S. bond market in the future. Level of difficulty: Not difficult. Estimated study time: 2 hours.
STUDY SESSION 4
Monetary Policy, Interest Rates, and Portfolio Strategy
READING 1: "Monetary Policy Actions and Long-Term Interest Rates(Available Online)," V. Vance Roley and Gordon H. Sellon, Jr., Economic Review, Federal Reserve Bank of Kansas City (Fourth Quarter 1995), pp. 73-89. This reading examines the relationship between U.S. monetary policy and long-term interest rates, showing that the relationship is not stable but, instead, varies over the course of a business cycle. The article reviews the empirical work conducted in this area and shows that the response of long-term interest rates to monetary policy actions will vary in both direction and magnitude depending on whether the policy actions are expected to be persistent or transitory. Level of difficulty: Not difficult. Estimated study time: 1 hour.
READING 2: "Interest Rate Policy and the Inflation Scare Problem: 1979-1992(Available Online)," Marvin Goodfriend, Economic Quarterly, Federal Reserve Bank of Richmond (Winter 1993), pp. 1-24. This highly readable article analyzes the roles that Federal Reserve policy and, more importantly, Federal Reserve credibility have played in the determination of U.S. interest rates. The reading contends that the Fed's credibility is extremely fragile and that the result is often long lags between changes in U.S. monetary policy and changes in U.S. long-term interest rates. Level of difficulty: Moderately difficult. Estimated study time: 1 hour.
READING 3: "The Investment Implications of an Inverted Yield Curve(Available Online)," Fixed Income Research, Goldman, Sachs & Co. (January 1989), pp. 1-28. This reading reviews the history of U.S. yield curve inversions and infers from past behavior what strategies should be undertaken when the yield curve becomes inverted. Although this paper was written several years ago and refers to the 1989 outlook, it is appropriate for today's world. The author shows that barbell portfolios will generally outperform intermediate-maturity portfolios when the yield curve is expected to remain inverted. The author also shows how the corporate and mortgage markets typically behave during inverted-yield-curve environments. Level of difficulty: Moderately difficult. Estimated study time: 2 hours.
II. Valuation of Bonds and Derivatives
Section II Study Guides
STUDY SESSION 5
Corporate Bond Pricing and Arbitrage-Free Pricing
READING 1: "Agency and Corporate Debt Securities," Ch. 8., Fixed Income Markets and Their Derivatives, Suresh M. Sundaresan (South-Western College Publishing, 1997), pp. 313-56. The reading provides perspective on volume of trade and bond-rating distribution for the agency, corporate, and hybrid fixed-income sectors. The motivation for issuing various types of debt instruments, such as callable or putable debt, is discussed. The author presents models for analyzing default spreads and financial distress in the corporate debt market and shows how they explain observed spreads of corporate bonds over U.S. Treasuries. Level of difficulty: Moderately difficult. Estimated study time: 3 hours.
READING 2: "Understanding Aggregate Default Rates of High Yield Bonds(Available Online)," Jean Helwege and Paul Kleiman, Current Issues in Economics and Finance, Federal Reserve Bank of New York (May 1996), pp. 1-6. This reading presents a summary of previous research on predicting high-yield default rates. It uses refined proxies (relative to past work) for credit ratings, the macroeconomy, and an aging factor to show how default rates can be predicted with substantial confidence. Level of difficulty: Moderately difficult. Estimated study time: 1 hour.
READING 3: "An Introduction to Arbitrage-Free Pricing of Derivatives," Ch. 5, Fixed Income Securities, University Edition, Bruce Tuckman (John Wiley & Sons, 1995), pp. 67-72. This reading provides an example of the arbitrage-free pricing of an interest rate option. Given a binomial model of the future and random movement of interest rates, one can replicate the cash flow of an interest rate option by trading in a portfolio of two zero coupon bonds. In other words, the replicating portfolio mimics the value of the option at its expiration regardless of what happens to interest rates. Therefore, the replicating portfolio and the option must have the same value. And because the value of the portfolio is known from the value of its component zeros, the value of the option is also known. Level of difficulty: Moderately difficult. Estimated study time: 1 hour.
READING 4: "Risk-Neutral Pricing," Ch. 6, Fixed Income Securities, University Edition, Bruce Tuckman (John Wiley & Sons, 1995), pp. 73-76. Finding the composition of the portfolio that replicates a particular interest rate derivative is tedious. Fortunately, as this reading shows, a short-cut to arbitrage-free pricing exists. One can adjust the assumed interest rate process so that all zero coupon bonds are priced correctly. Then, pricing the derivative by discounting its expected value in the adjusted interest rate process produces the same result as the more cumbersome portfolio replication technique. This subtle result of financial economics has an intuitive explanation. Level of difficulty: Moderately difficult. Estimated study time: 1 hour.
READING 5: "Arbitrage-Free Pricing in a Realistic Setting," Ch. 7, Fixed Income Securities, University Edition, Bruce Tuckman (John Wiley & Sons, 1995), pp. 77-87. This reading extends the analysis of Chapters 5 and 6 in the following ways. First, the author shows how to extend the pricing framework to an arbitrary number of dates. Second, he shows how to allow for time intervals of any length between model dates. Usually, using a small time interval increases accuracy at the expense of added computational effort. Level of difficulty: Moderately difficult. Estimated study time: 1 hour.