Corporate Bond Portfolio Management Leland E Crabbe, Ph.D Frank J Fabozzi, Ph.D., CFA JOHN WILEY & SONS Corporate Bond Portfolio Management Corporate Bond Portfolio Management Leland E Crabbe, Ph.D Frank J Fabozzi, Ph.D., CFA JOHN WILEY & SONS Copyright © 2002 by Leland E Crabbe and Frank J Fabozzi All rights reserved Published by John Wiley & Sons, Inc Published simultaneously in Canada No part of this publication may be reproduced, stored in a retrieval system or transmitted in any form or by any means, electronic, mechanical, photocopying, recording, scanning or otherwise, except as permitted under Sections 107 or 108 of the 1976 United States Copyright Act, without either the prior written permission of the Publisher, or authorization through payment of the appropriate percopy fee to the Copyright Clearance Center, 222 Rosewood Drive, Danvers, MA 01923, (978) 750-8400, fax (978) 750-4744 Requests to the Publisher for permission should be addressed to the Permissions Department, John Wiley & Sons, Inc., 605 Third Avenue, New York, NY 10158-0012, (212) 850-6011, fax (212) 850-6008, E-Mail: PERMREQ@WILEY.COM This publication is designed to provide accurate and authoritative information in regard to the subject matter covered It is sold with the understanding that the publisher is not engaged in rendering professional services If professional advice or other expert assistance is required, the services of a competent professional person should be sought ISBN: 0-471-21827-8 Printed in the United States of America 10 LEC To Thomas George Crabbe FJF To my wife, Donna, and my children, Karly, Patricia, and Francesco About the Authors Leland E Crabbe is a fixed income portfolio manager at Credit Suisse Asset Management in New York, and global head of emerging market debt He received his Ph.D in Economics from the University of California at Los Angeles in 1988 Subsequent to that, he worked for the Federal Reserve Board in Washington, DC as an economist in the capital market section, focusing on corporate bond and high yield research From 1994 to 1998, he worked at Merrill Lynch in various capacities: in research as Merrill’s Corporate Bond Strategist; in corporate bond syndicate as a developer of structured corporate bonds; and in emerging market bond trading Frank J Fabozzi is editor of the Journal of Portfolio Management and an Adjunct Professor of Finance at Yale University’s School of Management He is a Chartered Financial Analyst and Certified Public Accountant Dr Fabozzi is on the board of directors of the Guardian Life family of funds and the BlackRock complex of funds He earned a doctorate in economics from the City University of New York in 1972 and in 1994 received an honorary doctorate of Humane Letters from Nova Southeastern University Dr Fabozzi is a Fellow of the International Center for Finance at Yale University vi Preface T he purpose of this book is to present the essential elements of corporate bond portfolio management We develop a framework to assess the key risks in the corporate bond market, such as credit risk, interest rate risk, and redemption risk Also, along with covering the key features of corporate bonds, we discuss trading, yield curve, and sector strategies We have grouped the 18 chapters in this book into four major sections: Section I: An Introduction to Corporate Bonds Section II: Corporate Bond Valuation and Price Dynamics Section III: Corporate Credit Risk Section IV: Redemption Analysis The material in those four sections gives portfolio managers the state-of-the-art analytical tools to enhance returns and control risk Several of the chapters in this book draw from research Leland Crabbe conducted while at the Federal Reserve Board in Washington D.C in the early 1990s, next at Merrill Lynch in the mid-1990s, and more recently at Credit Suisse Asset Management In particular, we would like to acknowledge permission granted by Merrill to use substantial portions of selected published research that he prepared when he was employed as an analyst at that firm Specifically, the following material, all published and copyrighted by Merrill Lynch, Pierce, Fenner & Smith, was used in this book: “Deferrable Bonds: An Analysis of Trust Preferreds and Related Securities” (January 2, 1997) Portions of this material appear in Chapter 14 “An Introduction to Spread Curve Strategies” (November 7, 1996) This piece is the basis of Chapter “A Framework for Corporate Bond Strategy” (September 16, 1994) This piece is the core of Chapter 13 “Corporate Yield Volatility — Part 1” (December 12, 1994) Portions of this material appear in Chapter “Corporate Yield Volatility — Part 2” (June 5, 1995) This material was used in the preparation of Chapter 17 “The Putable Bond Market: Structure, Historical Experience, and Strategies” co-authored with Panos Nikoulis, former Analyst at Merrill Lynch (December 1997) A few sections of this material are used in Chapter 18 vii Chapter 18 311 Exhibit 12: Return Difference between a Putable Portfolio and a Bullet Portfolio (1-Year Horizon) Putable Portfolio Dollar Duration Weight Bullet Portfolio Dollar Duration Weight WMX 7.1% 2026PUT2003 0.5 WMX 6³⁄₈% 2003 0.65 VO 9.65% 2018PUT2003 0.5 VO 8.35% 2022 0.35 In Exhibit 12, we show the 1-year total returns of a portfolio that contains the WMX and VO put bonds and a portfolio of two bullet bonds: the WMX 6³ ₈% of 2003 and the VO 8.35% of 2022 The portfolios are constructed such that they will have the same expected option-adjusted durations at the 1-year horizon (6.9), and both portfolios have roughly equivalent exposure to WMX and VO credit risk If interest rates move to levels predicted by the forward curve, the return on the putable portfolio is 6.32%, compared with 6.47% for the bullet portfolio Thus, with no volatility in forward rates, putables will underperform bullets by 15 bps over the 1-year horizon However, because the portfolio of putable bonds has greater convexity, the return difference will favor the putables in a volatile rate environment, regardless of whether rates move higher or lower For example, if rates rise or fall by 100 bps over the next year, the portfolio of putable bonds will outperform the bullet portfolio by 33 to 55 bps, respectively For a 50 bps change in yields, the portfolios will have roughly equal returns Therefore, investors should prefer the putable portfolio over the bullet portfolio if they expect that yields will continue to be volatile, but are uncertain about the direction of rates The convexity difference between the putable portfolio and the bullet portfolio can be demonstrated with an analysis of duration drift Effectively, convexity measures the drift in duration as interest rates change As shown in Exhibit 13, if rates rise by 100 bps over the 1-year horizon, then the duration of all four bonds will shorten All four bonds have positive convexity However, the rise in rates would cause the option-adjusted duration of the VO 9.65% putable bond to shorten markedly, from 8.64 to 6.37 over a 1-year horizon As a result, in the rising rate scenario, the putable portfolio will shorten to 5.6, while the bullet portfolio will shorten to 6.52, a difference in duration drift of 0.93 All durations are option-adjusted Option-Adjusted Duration (in August 1996) Portfolio Weight Horizon Change in Yields −100 −50 +50 +100 8.64 0.5 6.08 0.5 10.76 0.35 5.66 0.65 7.36 7.45 −0.09 Putable Bond Durations at Horizon Bullet Bond Durations at Horizon Portfolio Durations VO 9.65% of WMX 7.1% of VO 8.35% WMX 6³ ₈% Put Bullet 2018PUT03 2026PUT03 of 2022 of 2003 Portfolio Portfolio Difference 9.84 8.01 11.17 5.09 8.93 7.22 1.71 9.25 6.01 10.82 5.06 7.63 7.08 0.55 8.21 5.47 10.48 5.03 6.84 6.94 −0.10 7.26 4.99 10.15 5.01 6.13 6.81 −0.68 6.37 4.82 9.38 4.98 5.60 6.52 −0.93 Exhibit 13: Duration Drift Analysis (1-Year Horizon) 312 Putable Bonds and Their Role in Corporate Bond Portfolios Chapter 18 313 By contrast, if rates fall by 100 bps over the 1-year horizon, the durations of all four bonds will lengthen relative to the base case that rates move to forwards However, a 100 bps decline in rates would cause the duration of the WMX 7.1% putable bond to lengthen dramatically, from 6.08 to 8.01 over the investment horizon In the falling rate scenario, the duration of the putable portfolio will extend to 8.93, compared with 7.22 for the bullet portfolio, a difference of 1.71 This example highlights why investors have become eager to buy putable bonds Many investors are uncertain about the direction of interest rates, but most investors believe that interest rates will be volatile As long as interest rates remain volatile, portfolios that contain putable bonds will earn higher returns than portfolios that contain bullet bonds with the same duration, but less convexity Index Numerics 10PUT5 bonds, 309 10PUT5 structures, 250 20PUT10 bond, 250 30NC10 bonds, 288 30PUT10 bond, 250–252, 303–309 30PUT10 structure, 308 A Absolute priority, theory/practice, 165–167 Accelerated sinking fund provisions, 57, 245 Accrual bonds, 20 Accrued interest, 14, 26–28, 65 period, 27 Acid-test ratio, 188 Acme Boot, 197 Adjustable-rate structure, 25 Adjusted simple margin, 72 Adjusted total margin, 72 ADM See Archer-Daniels-Midland Company Affirmative covenants, After-acquired property clause, 11 After-tax basis, 272 Aggregate sinking fund, 246 Airline equipment debt, 16–17 Allied Products Corporation, 191 Altman, Edward I., 168, 169, 171, 172, 200 American-type call option, 258 Amortization, 190 Analytical systems, vendor, 260 Anheuser-Busch Company, 236 Annualized yield volatility, 110 Arbitrage profits, 59 Arbitrage-free approach, 59 Arbitrage-free value, 61, 258, 260, 279 Archer-Daniels-Midland Company (ADM), 239 Arizona Public Service, 247 Asquith, Paul, 49, 168 Asset classes, 201 Asset turnover, 187 Asset-backed MTNs, 32 Asset-backed securities, 68 Assets sale, 195 See also Redemption values See Tangible asset values Atlantic Richfield, 238 AT&T, 103 bond spreads, 107 B Bad-year matrix, 206–207 Bad-year scenario, 207 Bahar, Reza, 200, 288 Baird, Douglas G., 166 Balance sheet, 189 Baltimore Gas and Electric Company, Bank bonds, weighted average recovery price, 173 Bank debt, 194, 195 Bank holding companies bonds See Long-term bank holding company bonds subordinated bonds, 228 Bank level creditors, 172 Bank loans, 201 Bank profitability, 158 Bankers Trust, 23 Bank-related securities, 18 Bankruptcy, 3, 15, 172, 183 See also Chapter bankruptcy; Chapter 11 bankruptcy; Involuntary bankruptcy; Railroads; Voluntary bankrupty creditor rights, interaction, 164– 167 discouraging, 167 process, 165 Bankruptcy Reform Act of 1978, 16, 17, 165 Barbell portfolio, 96–99 Base-case scenarios, 206, 207 Basis points change, 91 number, 95 Bebchuk, L.A., 166 Beginning-of-period duration, 129 Benchmark interest rates, 281 rates, 59 spot rate curve, 70–71 zero-coupon rate curve, 70 Bhattacharya, Mihir, 50 Bid-ask spread, 118–122, 129–132 See also Corporate bonds BIG See Broad-Investment Grade Binomial interest rate, construction, 279 Binomial interest rate tree, 261–264, 277 construction, 266–271 Binomial lattice model, 259 Binomial model, 259–271, 275 illustration, 283 usage, 283–285 Binomial tree, 276 Black box risk, 41 Blanket indenture, Blanket sinking fund, 246 Blume, Marshall, 168 Bond See 20PUT10 bond; 30PUT10 bond credit risk differences, option values, 293–294 dealers, 119–120 liquidity, 132 duration, 95 315 indentures, 7–10 market liquidity, 118 structure See Putable bonds value, 267 math, 138 maturities, shortening, 242 pre-maturity payment provisions, 29–30 price, 62 sensitivity, 80 ratings, 163 sectors See Generic bond sectors structures, 122 swaps, 122–133, 139–142 See also Duration-neutral bond swaps valuation, 261 value, 264, 276 yields See Forward bond yields Bond-equivalent basis, 63, 66 Bond-equivalent yield, 62 Bondholders, Book value, 179 Bootstrapping See Corporate yield methodology, 60 usage, 75, 261 Box trades, 147 See also Dollarfor-dollar box trade; Durationneutral box trades; Optimal box trade; Spread-neutral box trade Brand, Leo, 200, 288 Breakeven analysis, 126–127 Breakeven price, 46 Breakeven spread, 122, 127–128, 135, 217 See also Subordinated bonds analysis, limitations, 229–230 model, 222 See also Credit risk; Senior bonds; Subordinated bonds; Subordinated deferrable bonds relationship See Deferrable bonds variance, 224 Breakeven time, 47 Brennan, Michael, 50 Brenner, Robin, 292 Bridge loans, 194 Broad-Investment Grade (BIG), 88 Broker loans, 194 Broker/dealer, 27, 31 Bullet bonds, 240, 305, 309, 313 See also High-coupon bullet bond Bullet issues See Short-term bullet issues Bullet portfolio, 96, 97 Bullet spreads, 291, 296, 298 curve, slope, 291–292 Bulow, J.I., 167 Business cycles, 114, 153 corporate bond spreads, 153–156 corporate profits, 156–157 features, 159 industry sector strategies, 157–160 316 Index Busted convertible, 48 Buyback price, 249 C Call bonds, 253–255 Call option, 51 See also Embedded call option valuation methods, 289 value, determination, 273–274 Call provisions, 29, 44–45, 235–250 features, 235–239 Callable bonds, 29, 57, 66 See also Currently callable bond company issuance reasons, 240– 241 disappearance, reasons, 242–244 existence, 241 value, 273 yields, 241 Callable corporate bonds, 82–83, 93, 280 valuation, 271–274 Callable debt, holdings, 243 Callable, noncallable (contrast), 237–239 Callable note See Multiple step-up callable note Callable securities, holding, 244 Callable structure, disappearance, 242 Capacity, 184 analysis See Payment capacity Capital charges, 120 expansion, 193 expenditures, 192 ratio See Cash flow from operations to capital expenditures ratio gain, 136 goods companies, 159 loss, 64, 136–137 securities, 216 Capital Notes, 18 Capitalization ratios, 187, 189 See also Long-term debt to capitalization ratios Capitalized assets, 190 Capped floating-rate corporate note, valuation, 276–277 Caps, 22–23, 73 Carleton, Willard, 100 Carty, Lea V., 171, 200, 224 Cash dividend payments, 10 Cash flow, 45, 120 See also Contractual cash flows; Default-free cash flow; Discretionary cash flow; Expected cash flows; Operating cash flow; Short-term cash flows adjustment, 281 analysis, 190–193 availability, 191 definition See Free operating cash flows determination, 57 discounting, 58–59, 61 estimation, 57–58 packages, 58 statement, 187, 191 tests, timing, 230 Cash flow from operations to capital expenditures ratio, 193 Cash interest payments, prohibition, 21 Cash security, duration, 39 Casualty occurrence, 15 CDs See Certificates of deposit Certificates of deposit (CDs), 36 CG&E See Cincinnati Gas & Electric Company Chambers, Donald, 100 Change-in-control put, 252–253 Chapter bankruptcy, 165 Chapter 11 bankruptcy, 165 Character, 184 analysis See Issuer character Chase Manhattan Bank, 18 Choie, Kenneth S., 198 Cincinnati Gas & Electric Company (CG&E), 237 Claims-paying ability, 18 Clawback provisions, 238 Close substitutes, 119 CMT See Constant-maturity Treasury Collateral, 184 See also Surplus collateral analysis, 193 selling, 14 substitution See Mandatory collateral substitution trust debentures, 14 Commercial banks, 173 Commercial paper, 36, 38 Commercial rating companies, 189 Commission, 27 Commodity exchange, 41 prices, 31 swap, 35 Commodity-linked structured notes, 38 Common stock, 50, 52, 197 contrast See Convertible securities equivalent, 48 purchase, 43 Company capitalization, 13 dividend, safety, 191 earnings, 186 funds, 191 structure, 185 Company-specific event risk, Company-specific risk, 121 Competitive markets, animal spirit, 183 Competitive position, 185 Conditional sales agreement (CSA), 14 See also New York CSA Connecticut Light and Power Company, 12 Conservatism, 185 Constantinides, George, 50 Constant-maturity Treasury (CMT) indexed notes, 37 yields, 38 Consumer Price Index for All Urban Consumers (CPI-U), 26 Contractual agreement See Parent company Contractual cash flows, 257 Control systems, 185 Conversion parity price, 46 Conversion price See Market; Stated conversion price Conversion ratio, 43–44, 50 Conversion value, 46 Convertible bonds, analysis, 43 downside risk, 48 features, 43–45 investment characteristics, 48–49 option-based valuation approach, 49–52 risk/return profile, 52–53 upside potential, 48 value, 50 Convertible issues, 44 Convertible securities See Noncallable securities; Nonputable securities current income, common stock (contrast), 47–48 minimum value, 45–46 traditional analysis, 45–48 Convex bonds, 251 Convexity, 2, 91–95, 145, 179 See also Dollar convexity; Effective convexity; Modified convexity; Negative convexity; Positive convexity adjustment, 93–94 See also Percentage price change analysis, relationship See Volatility computation, 283–285 measure, 92 See also Securities scaling, 93–95 Coordination problems See Liquidity Cornish, William A., 194 Corporate bonds, 1–3, 27–28, 31, 118, 249 See Callable corporate bonds; Investment-grade corporate bonds; Long-term corporate bonds; Putable corporate bonds bid-ask spread, 117 breakeven spread, relationship See Deferrable bonds components, 257–258 credit analysis, introduction, 183 embedded options, 257 excess returns, 201 Index face value, 218 features, general principles, 57 interest rate risk, 235 investors, 132, 254 issue, 58 liquidity, 117 markets, 164, 212, 244 portfolios, 3, 86, 130, 167 management, 4, 215 managers, 159 managers, implications, 155 putable bonds, role, 301 price/yield relationship, 83 recovery value, 218 special considerations See Highyield corporate bonds spreads, 147 See also Business cycles strategies, 153 rating transition framework, 199 valuation, 61 See also Callable corporate bonds; Option-free corporate bond; Putable corporate bonds embedded options, usage, 257 structured notes, usage, 257 Corporate borrower, 120 Corporate credit analysis, elements, 184 curve, 208 Corporate debt instrument, holder, 164 Corporate entity, 165 Corporate note, valuation See Capped floating-rate corporate note Corporate profits, 158 See also Business cycles Corporate restructurings, 248 Corporate returns, 137 Corporate spot spread, 71 Corporate spreads, 2, 157 curve, 140, 143 strategies, 135 Corporate structure, analysis, 196– 197 Corporate yield curve, bootstrapping/splining, 71 historical evidence, 112–113 ratios, 107 volatility, 108, 110–112 arithmetic, 108–110 implications, 294–295 Corporates/Treasuries, swaps, 127 Correlation coefficients, 301 Cost/benefit framework, 123 Countercyclical Federal Reserve policy, 158 Counterparties, 71 Coupon, 276 anniversary date, 258 bonds See Deferred coupon bonds; Step-up coupon bonds deferral, 229 formulas, 22, 57 types, 23–26 interest, 47 payment, 57, 62 payments, 20, 25, 63, 66, 231, 265–269 reinvestment, 64 period, 28 rate, 19–21, 24–25, 62, 245 See also Fixed coupon rates reset date, 23–26, 85 spread curve See Implied coupon spread curve strips, 60 Covenants, 8–10, 120, 184 See also Affirmative covenants; Negative covenants; Restrictive covenants analysis, 193, 197 Coverage ratios, 187 Coverage tests, 190 See also Fixedcharge coverage test; Interest coverage test CPI-U See Consumer Price Index for All Urban Consumers Crabbe, Leland E., 37, 177, 241, 253 Credit analysis, 163, 194 elements, 184 introduction See Corporate bonds curve, 202 See also Corporate credit flattening, 142 derivatives, 177–181 deterioration, risk, 203 enhancement, types, 18 evaluation, 39 forward contracts, 180–181 forwards, 177 options, 177, 179–180 quality, 26, 290–292 See also Investment-grade credit quality; Static credit quality curves, 204 cyclicality, 114 deterioration, 205, 297 implicit assumption, 293 portfolio returns, 205–207 re-evaluation, 241 ratings, 69, 120, 163–164 See also Investment-grade credit ratings swaps, 177, 181 weakening, 249 Credit risk, 1–3, 39, 163, 177, 291 assumption, 287 breakeven spread model, 217–221 complication, 113–114 differences, option values See Bond effect See Embedded options; Putable bonds embedded options, relationship, 287 level, 71 usage See Options 317 Credit spreads, 174, 180 products, 71 risk, 163, 174–175 term structure, 69–70 Creditor See Junior creditors; Secured creditors; Senior creditors; Unsecured creditors rights, interaction See Bankruptcy CSA See Conditional sales agreement Currency swap, 35 Current assets, 188 Current floor, 48 Current liabilities, 188 Currently callable bond, 29 Currently callable debentures, 236 Cyclical patterns, 157 Cyclical risk, 1, 120 D DBL See Drexel Burnham Lambert de Angelis, Robert, 168 Dealers See Bond Debentures, 239 See also Collateral Debt burden, 249 financings, 240 incurrence test, instrument, 32 obligations, 187 prospectus, repayment, 10 securities, structure, analysis, 194–196 Debt and coverage analysis, 187 ratios, 186 Debt/equity hybrids, 216 Debtor-in-possession (DIP), 165 Default loss See Principal Default loss rate, 167, 169 Default probability, 296 Default rates, 168–169, 215 See also Marginal default rates historical data, 229 Default risk, 163–174, 217, 296 Default statistics, 167–174 Default-free cash flow, 58 Default-free securities, 59, 69 Defensive sectors, exposures, 159 Deferrable bonds, 216 breakeven spreads, 222, 223 model See Subordinated deferrable bonds corporate bonds, breakeven spread relationship, 224–229 coupons, 221 credit risk, 231 Deferrable recoveries, 224 Deferral period, expected length determination, 223–224 Deferral risk, 223 Deferred coupon bonds, 21, 196 Deferred coupons, 221 318 Index Deferred income taxes, 190 Deleveraged floater, 22 Depreciation, 190 Derivative counterparty, 39 Derivative instruments, usage, 23 Derivative pricing, 41 Derivative securities, 201 Derivative transaction, 37 Derivatives, 39 See Credit markets, 38 usage, 39 DIP See Debtor-in-possession Dirty price, 62 Discount margin, 72 Discount rate, 267 Discretionary cash flow, 191, 192 Disney, Inc., bonds, 121 Divestitures, 239 Dividend payments accounting, 192 limitations, 10 Dividends, 15 See also Stock Dollar convexity, 96 Dollar duration, 96 Dollar exposure, 87 Dollar-for-dollar box trade, 149 Double-up option, 245 Dow Jones Capital Markets News Wire Service, 239 Downgrade risk, 163, 175–177, 183 Downgraded bonds, 203 Downgrades, 206–207 Downgrading date, 253 Downpayments, 157 Drexel Burnham Lambert (DBL), 168 Drop-lock bonds, 23 Dual-indexed floaters, 24 Duff & Phelps Credit Rating Company, 194 Dugan, Michael T., 191 Dun & Bradstreet, 188 DuPont formula, 187 Duration, 2, 79–91, 179 See also Beginning-of-period duration; Bond; End-of-period duration; Horizon duration; Key rate duration; Portfolio; Volatility contrast See Modified duration exposure, 297 impact, 204 usage See Fixed-rate bonds; Floating-rate securities; Inverse floaters; Market vectors, 100 Duration-adjusted holding period, 136 Duration-adjusted returns, 135, 139 Duration-neutral bond swaps, 141– 142 Duration-neutral box trades, 142–146 algebra, 150–151 Duration-neutral putable bond strategies, 309–313 Duration-neutral swaps, 125–126 Dutch auction tender, 249 E Earnings before interest taxes depreciation and amortization (EBITDA), 190 interest coverage ratio, 190 Earnings before interest taxes (EBIT), 190 interest coverage ratio, 190 Eastman Kodak Company, zero-coupon convertible bond, 44–45 EBIT See Earnings before interest taxes EBITDA See Earnings before interest taxes depreciation and amortization Economic activity, decline, 156 Economic cycles, 155, 185 Economic developments, 40 Economic expansion, 157, 158 Economic indicators, 155–156 EETCs See Enhanced Equipment Trust Certificates Effective convexity, 95, 284, 285 Effective duration, 82, 88 computation, 283–285 contrast See Modified duration Electric utility, 13 Embedded call options, 51, 241 value, 242 Embedded leverage, 91 Embedded options, 35, 89, 95, 235, 257–258 benefits, 303 credit risk, effect, 288–289 relationship See Credit risk usage See Corporate bonds Eminent domain See Redemption End-of-period duration, 123, 126– 128, 210 Enhanced Equipment Trust Certificates (EETCs), 17 Equipment bonds, 14 Equipment debt See Airline equipment debt Equipment trust certificates (ETCs), 14–15 See also Enhanced Equipment Trust Certificates; Philadelphia Plan ETC Equipment trust financing, 14–16 Equity analysis approach, 197–198 Equity prices, 31 ER See Excess return Esser, Stephen F., 198 ETCs See Equipment trust certificates European call option, 289 Event risk, 177 See also Companyspecific event risk; Special event risk Excess return (ER), 124–129 See also Corporate bonds; Portfolio calculation, 205 rating transition, usage See Expected excess return calculation contrast See Yield spread estimates, 199 adjustment, 208 spread changes, effect, 210–212 Exchangeable bond, 43 Exercise price, 235–236 Exercise probability, 294 Exercising, restrictions, 237–239 Expansion, 114, 155–157 See also Capital; Economic expansion years, 205 Expected cash flows, 65 Expected excess return calculation, rating transition matrix (usage), 201–203 Expected yield volatility, 103 Exponential spline fitting, 60 Exponential spline model, 292 Extendible bond, 26 Extendible reset bond, 25 Extension option, 304, 306, 308 F Fabozzi, Frank J., 72, 166, 167, 261 Fabozzi, Frank J (ed.), 37, 50, 84, 165, 195, 198, 259 Face value, 19 Farley, Inc., 196, 197 FDIC See Federal Deposit Insurance Corporation FDICIA See Federal Deposit Insurance Corporation Improvement Act Federal Deposit Insurance Corporation (FDIC), 174 Federal Deposit Insurance Corporation Improvement Act (FDICIA) of 1991, 174 Federal Home Loan Bank, 26 System, 24 Federal Home Loan Mortgage Corporation (FHLMC), 59 Federal National Mortgage Association (FNMA), 59 Federal Reserve, 38 policy See Countercyclical Federal Reserve policy Federated Department Stores, FHLMC See Federal Home Loan Mortgage Corporation Financial flexibility, 191 Financial Institutions Reform, Recovery, and Enforcement Act (FIRREA) of 1989, 174 Financial leverage, 189 ratios, 187, 189 Financial philosophy, 185 Financial position, 185 Financials, 214 FIRREA See Financial Institutions Reform, Recovery, and Enforcement Act First and general mortgage bonds, 12 First and refunding mortgage bonds, 12 Index First Mortgage Bonds, 247 First mortgage bonds, 12 First priority lien, 13 First refunding mortgage bonds, 12 Fitch, 163–164, 183 Fixed coupon rates, 31 Fixed income equivalent, 48 Fixed-charge coverage test, Fixed-income investors, 135 Fixed-income market, 214, 242 Fixed-income portfolio, 309 Fixed-rate bonds, 90, 91 spread duration, 84–85 Fixed-rate corporate bond, 57, 85, 88 Fixed-rate debt, 32 Fixed-rate note, 35 Fixed-rate payer, 71 Fixed-rate security, 85 Floaters See Dual-indexed floaters; Inverse floaters; Stepped spread floaters long, 91 sensitivity, 85 Floating interest rates, 31 Floating rate, 71 Floating-rate debt, 32 Floating-rate note, 35, 36, 38 Floating-rate securities, 21–26 duration, 85 yield spread measures, 72–73 Floors, 22–23, 73 See also Current floor Florida Power & Light, 237–238 FNMA See Federal National Mortgage Association FOMC meeting, 122 Fons, Jerome S., 69, 200, 217 Ford, bond spreads, 107 Forward bond yields, 38 Forward contracts See Credit Forward rates, 136, 303–307 See also One-period forward rates curve, 306 dependence, 306 Forward spread, 291–292, 294 analysis, 136–139 curve, 138–139 differential, 294 scenarios, 138 transition probabilities, relationship, 295–297 Forward yield spreads, 291 Franks, Julian R., 166 Free operating cash flows, definition, 190 Fridson, Martin S., 191, 193, 220 Fruit of the Loom, 197 Full price, 62 Funnel sinking fund, 246 Future spreads, 290–291 Futures markets, 39 G Garman, M Christopher, 220 GDP See Gross Domestic Product General & refunding (G&R) mortgage bonds, 13, 17 General Signal Corporation (GSX), 43–45 common stock, 52 convertible issue, 44–48, 51–52 stock price, 53 Generic bond sectors, 199 Good-year matrix, 206 Good-year scenarios, 206, 207 Gordon, Richard, 72 G&R See General and refunding Grant, W.T., 190, 191 Gross Domestic Product (GDP), 156 GSX See General Signal Corporation H Hard puts, 45 Harrington II, Preston M., 52 Hedge fund crisis (1998), 111, 121 Helwege, Jean, 69, 241 High-coupon bond, 254, 305 High-coupon bullet bond, 254 High-coupon debt, 11, 240, 248 High-coupon/low-coupon putable bond strategy, 310–313 High-grade bonds, risk, 197 High-grade issuer, 195 High-quality bonds, 123 High-rated bonds, 210 High-yield bonds, 1, 164, 168 analysis, 198 market, 21 High-yield corporate bonds, 168 special considerations, 194–198 High-yield debt structure, 194 High-yield issuance, 169 High-yield issuers, 194–196 High-yield spreads, 159 Historical recovery rates, 169–170 seniority, relationship, 170–171, 216–217 Ho, Thomas S.Y., 101 Holding company See Bank holding companies debt, 228 securities, 173 Holding period, 128 See also Duration-adjusted holding period returns, 136 Horizon duration, 123 Howe, Jane Tripp, 165–167, 195 Hradsky, Gregory T., 168 Humana, Inc., 13 Hybrid securities, regulatory restrictions, 38 I Iben, Thomas, 69 ICN Pharmaceuticals, Inc., 252 Ilmanen, Antti, 136 Implied corporate yield volatilities, 298 Implied coupon spread curve, 71 319 Implied Treasury yield volatility, implications, 292–293 Implied volatility, 287, 309–310 Improvement fund, 244 See also Sinking and improvement fund Incentive hypothesis, 166 Incremental return, 138 pickup, 151 Indentures, 7, 253 See also Blanket indenture; Bond; Open-ended indenture Index See Noninterest rate indexes duration, 85 See also Market swap See Stock Industrial bond, 70 Industrial companies, classification, 13 Industrial Company Rating Methodology, 185 Industrials, 214 Industries, recovery rates, 172–174 Industry profits, 159 risk, 1, 120–121 sector strategies See Business cycles spread, 159 trends, 185 Inflation-indexed bonds, 26 Inflation-linked bonds, 26 Information costs, 120 problems See Liquidity Ingersoll, Jonathan, 50 In-kind interest payments, 21 Institutional market structure, 119– 120 Insurance proceeds, 17 Intangible asset, 172 Interest coverage test, Interest on interest, 62 Interest payments, 19–28 Interest rate See Benchmark; Floating interest rate; Semiannual interest rate; Short-term interest rates change, 48, 311 decline, 237 environment, 189 expected direction, 72 futures, 39 level, 25 model, 259 movement, 310 risk, 1–2, 63, 146, 174 See also Corporate bonds measurement, 79 swap, 34 tree, 259 See also Binomial interest rate tree volatility, 90, 259 assumption, 261 Interest-on-interest, 221, 230 Intermediaries, 119 Intermediate-term bonds, 29, 144 International Harvester Company, 19 320 Index International Harvester Credit Company, 19 Inventories, 119, 120 Inverse floaters, 23–24 duration, 90–91 Inverse floating-rate notes, 37 Investment alternative, 97 banks, 31, 36, 37, 254 See also New York-based investment banks decisions, 131 horizon, 65, 97, 135–137, 199, 313 change, 208, 212 reduction, 127–128 value, 45 Investment grade markets, 164 Investment-grade aggregate index, Investment-grade bonds, 113, 163, 241 Investment-grade callable bonds, 241–242 Investment-grade companies, 215, 224 Investment-grade corporate bonds, 69 Investment-grade corporate market, 203 Investment-grade corporate sectors, 112 Investment-grade credit quality, 292 Investment-grade credit ratings, 31 Investment-grade debt, 248 Investment-grade market, 288 Investment-grade sectors, 112 Investors See Unsophisticated investors demand, 251 purchase, reasons See Structured notes Involuntary bankruptcy, 165 Issuer character, analysis, 184–185 Issues, dollar volume, 301 Iterative process, 266 ITT Corporation, 252 J Jackson, Thomas H., 165, 166 JC Penney, 107, 250 Jensen, Michael C., 167 Jim Walter Corporation, Joseph Seagram & Sons, 310 J.P Morgan & Company, 26 Junior creditors, 165 Junior subordinated debt, 196 Junk bonds, 1, 164 K Kalotay, Andrew J., 261 Kao, Duen-Li, 200 Keim, Donald, 168 Kerr-McGee Corporation, 252 Key rate duration, 79, 99–103 Kishore, Vellore M., 169, 171, 172 Kitto, Thomas C., 200, 288 Klaffky, Thomas E., 84 Krasker, William, 84 L Largay III, J.A., 190 Lattice model, 258–261 LBO See Leveraged buyout Leading indicators, 155 Leaseway Transportation Corporation, 14 Leibowitz, Martin L., 84 Letter of credit (LOC), 18 Level risk, 79 Level shift, 99 Leverage, 205 See also Embedded leverage gaining, 37 ratios, 120 Leveraged buyout (LBO), 177, 195, 205, 248 Levine, Robert, 197 Li, Bin, 292 LIBOR See London Interbank Offered Rate Lieberman, Dana, 171 Lien bonds, 12 Liquid bonds, 71 L i q u i d Yi e l d O p t i o n N o t e s (LYONs), 51, 52 Liquidation, 165 Liquidity, 117 See also Offeredside liquidity; Strips market; Structured notes accounting, 129–133 analytical framework, 122 conceptual framework, 118–122 coordination/information problems, 120 generating, 186 premium, 71–72 ratios, 190 risk, 1, 40, 117, 132 See also Portfolio premium, 132 sources, 185 trading costs, interaction, 118–122 Litigation risk, 120 Litterman, Robert, 69 LOC See Letter of credit Log ratio, standard deviation, 109 Lognormal random walk, 262 London Interbank Offered Rate (LIBOR), 22, 24–25, 38, 71–72 See also Six-month LIBOR multiple, 34 relative spread, 59 usage, 85, 282 yield curve, 282 Long Island Lighting, 107 Long maturity corporates, 210 Long, Robert D., 168 Long-duration bond, 150 Longer-term securities, 38 Long-term bank holding company bonds, 228 Long-term bonds, 29, 96–98, 136, 144, 206 Long-term corporate bonds, 137– 138, 141, 212 Long-term debt to capitalization ratios, 189 Long-term lease contracts, 189 Long-term Treasury securities, 59 Low-quality bonds, 206 Low-rated bonds, 210 Low-yield volatilities, 107 Lucas, Gerald, 292 LYONs See Liquid Yield Option Notes M M&A See Mergers and acquisitions Maintenance and replacement funds, 11, 246–247 Maintenance fund, 11 Maintenance test, Makabe, Takashi, 166, 167 Make whole call, 239 Make whole provisions, 238–239 Management expertise, 120 Mandatory collateral substitution, 14 Mandatory Part Put or Remarketed Securities (MOPPRS), 253–255 Mandatory specific sinking fund, 244–245 Mann, Steven V., 72 Margin See Adjusted simple margin; Adjusted total margin; Discount margin; Simple margin requirement, 25 Marginal default rates, 219 Market conditions, 37 conversion premium, 47 price, 46–47 index, duration, 88 interest rates, 20 participants, 71, 175 price, 50, 70 psychology, 72 rates, 35 risk characteristics See Structured notes structure See Institutional market structure volatility, 121 Market directional strategies See Putable bonds Material adverse change clause, 186 Maturity, 15, 28–29, 63, 120 See also Yield to maturity bond, 303 date, 28–29, 64, 235, 274 points, 74 structure, 187 value, 19, 269, 270 May Department Stores Company, 9, 244–245 Meckling, William H., 165 Medium-term notes (MTNs), 1, 31– 34 See also Asset-backed MTNs Index agents, 37 issuer, 37 market, 33–34 development, institutional changes, 32–33 reverse inquiry, 34 offering, 33 program, 33–35 See also Shelfregistered MTN program reloading, 34 Mergers, 239, 248–249 Mergers and acquisitions (M&A), 239 Merrill Lynch theoretical valuation model, 52 valuation model, 53 Merton, Robert C., 69 Metals and mining companies, 159 Miller, Merton H., 165 MIPS, 216, 223 Modeling risk, 260 Modified convexity, 95 Modified duration, effective duration (contrast), 81–84 Modified rating transition matrices, usage See Portfolio Monetary policy, vagaries, 132 Money market activities, 189 Moody’s Investors Services, 163– 164, 183–185, 224 default data, 219 MOPPRS See Mandatory Part Put or Remarketed Securities Moriarty, Bernie, 52 Mortgage See Open-ended mortgage pools, 243 Mortgage bonds, 13 See also Utility mortgage bonds Mortgage-backed bonds, 14 Mortgage-backed securities, 68 market, 243 Motorola, 51, 52 MTNs See Medium-term notes Mullins, Jr., David W., 168 Multiple step-up callable note, 277 N Name recognition See Trading costs Nammacher, Scott A., 168 National Association, 18 National Bureau of Economic Research (NBER), 153–155 NBER See National Bureau of Economic Research Negative convexity, 83 Negative covenants, Negative pledge clause, 18–19 Net worth, 248–249 New York CSA, 15 New York Plan, 14–15 New York-based investment banks, 33 Nodes bond values, 270, 275 valuation, determination, 264–266 Nominal rate, 19 Nominal spread, 67, 280 Noncall period, 44 Noncallable bonds, 4, 66 yields, 241 Noncallable, contrast See Callable Noncallable convertible security, 49 Noncallable offerings, 244 Noncallable straight bond, 49 Noncallable-for-life issues, 238 Noncash items, 190 Noncyclical companies, 215 Noninterest rate indexes, 26 Noninvestment-grade bonds, 164 Noninvestment-grade markets, 164 Nonmandatory specific sinking fund, 244–246 Nonputable convertible security, 49 Nonputable straight bond, 49 Nonspecific sinking funds, 246 Non-U.S investors, 60 Notes structure, 35, 37 valuation See Structured notes Nozari, Ardavan, 84 O OAS See Option-adjusted spread Obazee, Philip O., 259 Off-diagonal elements, 210 Offer to redeem, 248 Offered-side liquidity, 118 Offered-side spread, 135 One-factor model, 50, 259 One-period forward rates, 283 On-the-run coupon issue, 74 On-the-run issues, 60, 74, 260, 269 See also Treasury on-the-run issues On-the-run Treasury, 46 issues, 74, 259 On-the-run yield curve, 74, 261, 281 Open market purchases, 245, 249 Open-ended indenture, Open-ended mortgage, 11 Operating cash flow, 192 repayment, 195 Operating leases, 189 Operating position, 185 Operating subsidiaries, 196 Optimal box trade, 146–149 Option value, 290, 291, 298 Option-adjusted duration, 311 Option-adjusted spread (OAS), 82– 84, 89, 279–283 Option-based valuation approach See Convertible bonds Option-free bond, 57, 83 purchase, 258 value, 273, 275, 278 Option-free corporate bond, 1, 57 valuation, 271 value, 273, 274 Option-pricing model, 49, 287 321 Options See Credit exercise date, 235–237 features, 120 valuation (alternative methods), credit risk (usage), 289–292 Outright redemptions, 239–240 Over-the-counter, 177 P Palo Verde nuclear power plant, 248 Paper companies, 159 Par value, 19, 20 Par yield curve, 74, 75 Parallel yield curve, 103 shift assumption, 79 Paranjape, Hareesh, 52 Parent company, 196 contractual agreement, 186 support agreements, 185 Payment capacity, analysis, 185– 193 Payment frequency, 26–27 Payment-in-kind (PIK) bonds, 21, 194, 196 Percentage price change, convexity adjustment, 92–93 Philadelphia Plan ETC, 15 Philip Morris, spreads, 107 PIK See Payment-in-kind Poison puts, 252–253 Portfolio See Barbell portfolio allocations, framework See Strategic portfolio allocations analysts, 260 context, liquidity risk, 132–133 credit quality, change, 199 duration, 86–88, 101, 131 contribution, 87–88 excess return, 200 management, uncertainty, 132 managers, 118, 122, 126, 155, 260 implications See Corporate bonds putable bonds, role See Corporate bonds returns, 200–201 See also Credit risks, 117 spread duration, 88–89 strategies fine-tuning, modified rating transition matrices (usage), 205–207 implications, 207 trading cost, 130–131 turnover, 130 value, 101–102 Positive convexity, 83, 309 Preferred dividend deferral, 224 Preferred stock, 189 Pre-maturity payment provisions See Bond Premium payback period, 47 Present value, 68, 72, 265 Price sensitivity See Bond 322 Index Price volatility, 29, 49 exposure, 103 Price/yield relationship See Corporate bond Principal, 19 default loss, 169 strips, 60 Pro rata redemption, 235 Probabilities, 127 distribution, 130 Probyn, Christopher, 168 Product line, diversification, 185 Productive equipment, 189 Profit cycles, 153 risk, 159 Profit margin, 187 Profitability ratios, 186–187, 190 Property clause, release/substitution, 12, 236, 247 Public Service Electric and Gas Company, 245 Purchase funds, 244–246 Put bonds, 253–255 spread, 306–307 Put date, 250 Put provisions, 30, 250–253 Putable bonds, 57, 58, 67 credit risk, effect, 297–299 market directional strategies, 308–309 structure, 250–251 portfolio, 311 quoted spreads, understanding, 251–252 role See Corporate bonds strategies, 308–313 See also Duration-neutral putable bond strategies; High-coupon/lowcoupon putable bond strategy valuation, 303–307 volume, 301–303 Putable corporate bonds, 83–84 valuation, 274–276 Putable provision, 45 Put/call bonds, 254 Puts See Hard puts; Poison puts; Soft puts Q Quick ratio, 188 Quoted margin, 22 Quoted spreads, understanding See Putable bonds R Railroads, 14–16 bankruptcies, 16 Range bound floating-rate note, 24 Range notes, 24–25, 37, 57 Ratchet bonds, 25 Rate duration, 100 See also Key rate duration Rating transition method, 298 probabilities, 290–291 historical data, usage, 289 risk, 204 Rating transition matrix, 175 historical data, 200–201 usage See Expected excess return calculation; Portfolio Rating volatility, complication, 113– 114 Ratings See Trading costs agencies, 163 Ratios See Capitalization ratios; Debt and coverage; Profitability ratios Real Estate Investment Trust (REIT), 121 Receivables, 249 Recessions, 114, 153–157, 249 risk, 159 Recontracting process hypothesis, 166 Recovery rates, 171, 173, 220 See also Historical recovery rates; Industries absolute level, 224 historical rates, 217, 229 Recovery risk, 217 Recovery statistics, 167–174 Recovery values, 171, 230 Recursive valuation formula, 272 Redemption, 248–249 See also Outright redemptions assets, sale, 247–248 eminent domain, 247–248 features, 120, 235 prices, contrast See Regular redemption prices value, 19 Reference rate, 22–24, 72, 85 change, 73 Reference Treasury securities, 238 Refinancing, 195 cost, 288 Refunding, 29 protected period, 240 provisions, 235–250 Regular redemption prices, special redemption prices (contrast), 236 Regulatory environment, 185 Regulatory forbearance, 158 Reilly, Frank K., 194 Reinvestment income, 62, 63 Reinvestment rate, 97 Reinvestment risk, 63 REIT See Real Estate Investment Trust Reitano, Robert R., 100 Relative value See Spread analysis, 203–204 Renewal and replacement fund, 11 Reorganization, 165 plan, 193 trustee, 16 Replacement funds See Maintenance and replacement funds Reset margin, issuer determination, 25–26 Reset notes, 194, 196 Restrictive covenants, Return pickup, 145 See also Incremental return standard deviation, 197 Reverse floaters, 23 Reverse inquiry See Medium-term notes Risk See Black box risk; Convertible bonds; Default risk; Liquidity; Structured notes; Systemic risk; Yield curve characteristics, 38, 230 complication See Credit risk dimension, 215 managers, 120 measurement See Interest rate risk premium, 138 See also Uncertainty risk premium Risk-neutral pricing, 132 Risk/return profile See Convertible bonds Risk/return tradeoffs, 40 RJR Nabisco, 177, 253 RLC Corporation, 14 Robert Morris Associates, 188 Rolldown, 208 Ryder Systems, Inc., 14 S Salomon Brothers, 88 Samson, William D., 191 Sarig, O., 69 Scenario analysis, 122 Schuylkill Navigation Company, 14 Schwartz, Eduardo, 50 SEC See Securities and Exchange Commission Second priority lien, 13 Secondary market price, 40 Secured bonds, 11–17 Secured creditors, 165 Securities See Floating-rate securities convexity measure, 92 Securities and Exchange Commission (SEC), 7, 165 registration, 34 Rule 415, 32 shelf registration, 33 Security design process See Structured notes Security value, spot rates application See Treasury coupons Sell-off, 307 Semiannual interest rate, 63 Senior bondholders, 221 Senior bonds, 171, 196, 216, 229 breakeven spreads, 219–221 model, 218–219 portfolios, breakeven spread, 221 Index Senior creditors, 165 Senior debt, 171, 194 securities, 31 Senior lenders, 221 Senior subordinated debt, 194, 196 Seniority, 120 relationship See Historical recovery rates Senior-secured bonds, 215 Senior-unsecured bonds, 172 recovery rate, 219 Senior-unsecured claim, 216 Service Corporation, 238–239 Settlement date, 180 Shapiro, Arnold, 292 Shelf registration See Securities and Exchange Commission market timing benefits, 32 Shelf-registered MTN program, 32 Short coupon, type, 26 Short-duration bond, 150 Shorter-term bonds, 136–139, 142 Shorter-term security, 26 Short-term bonds, 29, 303 Short-term bullet issues, 68 Short-term cash flows, 69 Short-term debt, 189 Short-term funds, 195 Short-term interest rates, 38, 259 Short-term rate, 49 Short-term solvency ratios, 187–188 Shoven, J.B., 167 Simple margin, 72 See also Adjusted simple margin Single step-up callable note, 277 Sinking and improvement fund, 244 Sinking funds, 244–246 See also Aggregate sinking fund; Funnel sinking fund; Mandatory specific sinking fund; Nonmandatory specific sinking fund; Nonspecific sinking funds; Tunnel sinking fund bonds, 68 payments, 245 provisions see Accelerated sinking fund provisions Six-month LIBOR, 72–73 Soft puts, 45 Solvency ratios See Short-term solvency ratios Sondhi, Ashwinpaul C., 198 Southern Cal Edison, 107 Special event risk, 185 Special redemption prices, contrast See Regular redemption prices Special-purpose companies, Speculative-grade bonds, 35, 201 Speculative-grade levels, 202 Spin-offs, 239 Spot rate, 59, 271 See also Theoretical spot rate; Treasury spot rates application See Treasury coupons curve See Benchmark derivation, 74–77 role See Valuation term structure, 67 Spread See Bid-ask spread; Future spreads; Industry; Put bonds; Static spreads; Swap spreads; Treasuries; Zero-volatility spread advantage, 137 analysis See Forward spread changes, 212 effect See Excess returns correlation, 310 curve, 148, 295 convergence, 144 flattening, 140, 143 slope, 138–139 See also Bullet spread curve strategies, 136 See also Corporate spreads duration, 85 See also Fixed-rate bond; Portfolio math, review, 123–128 math, update, 129–133 measures See Floating-rate securities; Yield spread narrowing, 125 probability distribution, 127 shifts, relative value, 212–214 term structure See Credit spread volatility, 2, 107, 174, 310 historical evidence, 112–113 Spread for life, 72 Spread-neutral box trade, 144–146 algebra, 150–151 Spread-to-maturity, 251 Spread-to-put date, 251, 303 Standard & Poor’s (S&P) Corporation, 163–164, 183 Stated conversion price, 43 Static credit quality, 289–290 Static spreads, 289–290 Stepped spread floaters, 25 Step-up callable note, 277 See also Multiple step-up callable note; Single step-up callable note value, 278 Step-up coupon bonds, 71 Step-up noncallable note value, 278 Step-up notes, 20–21, 57 Stickney, C.P., 190 Stock dividends, 43 exchange, 41 index swap, 35 position, 53 price volatility, 52 repurchases, limitations, 10 splits, 43 Stockholder equity, return, 187 Stockholders’ influence on reorganization plan hypothesis, 166 Straight bond See Noncallable straight bond; Nonputable straight bond Straight value, 45, 51, 53 Strategic bargaining process hypothesis, 166 323 Strategic direction, 185 Strategic portfolio allocations, framework, 208–214 Strike price, 49 Strike spread, 179, 180 Stripped Treasury securities, 60 Strips market, liquidity, 60 Structured notes, 31, 34–41, 57 See also Commodity-linked structured notes characteristics, 35–36 examples, 24, 37–38 investing risks, 39–41 investor purchase, reasons, 38–39 liquidity, 40 market risk characteristics, 39 security design process, 36–37 usage See Corporate bonds valuation, 277–278 Subordinated bonds, 171, 196, 229 breakeven spreads, 219–221 model, 218–219 portfolios, breakeven spreads, 221 Subordinated debt, 18, 194 See also Junior subordinated debt; Senior subordinated debt recovery rate, 228 Subordinated deferrable bonds, breakeven spread model, 217, 221–222 Subordinated notes, 196 Subordinated securities, Subordinated structures, valuation, 215 Subsidiaries, 196 See also Operating subsidiaries Succession planning, 185 Sudo, Toshiihide, 166, 167 Surplus collateral, 247 Swap See Bond; Commodity; Corporates/Treasuries; Credit; Duration-neutral bond swaps; Duration-neutral swaps; Interest rate agreements, 39 market, emergence, 244 spreads, 71–72 Swaption, 309 Systemic risk, 41 T Takeovers, 252 Tangible asset values, 172 Tax system symmetry, 167 Telecommunications, Inc., 107 Tenant diversification, 121 Tenders, 249–250 Tennessee Valley Authority (TVA), 25, 29 Ten-year Treasury, 30PUT10 spreads, 304–305 Term structure See Credit spreads; Spot rate Theoretical spot rate, 75 324 Index Theoretical valuation model See Merrill Lynch Theoretical value, relationship See Volatility Third-party guarantees, 186 Thirty-year Treasury, 30PUT10 spreads, 305–306 Time horizon, 128 Time Warner, bonds, 121 TIPS See Treasury Inflation Protection Securities TOPrS, 216, 223 Torous, Walter N., 166 Total assets, return, 187 Total return, 65, 66 Trades See Duration-neutral box trades Trading, 117 costs, 4, 131 analysis, 130 Trading at a premium, 19 Trading at discount, 19 Trading costs, 117 See also Portfolio accounting, 129–133 industry issues, 121 interaction See Liquidity name recognition, 121 ratings, 121 sector issues, 121 structure, 122 understanding, 120 Transaction amounts, 119 TransAmerica Finance Corporation, 10 Transition matrixes, 295 See also Rating transition matrix; Year-byyear transition matrixes Transition probabilities, relationship See Forward spread Transparent pricing, 119 Treasuries 30PUT10 spreads See Ten-year Treasury; Thirty-year Treasury index, outperforming, 167 swaps See Corporates/Treasuries Treasury bills, 38, 74 Treasury bonds, 74 yield, 218 Treasury coupons market, 60 security value, spot rates application, 61 Treasury curve, slope, 141 Treasury Inflation Protection Securities (TIPS), 26 Treasury notes, 74 Treasury on-the-run issues, 281 Treasury securities, 28, 34, 71, 76– 77 See also Long-term Treasury securities; Reference Treasury securities; Stripped Treasury securities; Zero-coupon Treasury securities Treasury spot rates, 61, 67, 69, 71 Treasury strips, 60 market, 59 Treasury volatility, 294 Treasury yield, 59, 84, 108–109, 125 curve, 59, 298 change, 301 volatility, 110–112, 292–295 implications See Implied Treasury yield volatility Triangle trade, 147 Triple-up option, 245 Trust debentures See Collateral Trust deferreds, 216 Trust Indenture Act of 1939, Trustee, 8, 15 See also Reorganization trustee Tunnel sinking fund, 246 Turner, Christopher M., 69 Turnover ratio, 117, 131, 190 TVA See Tennessee Valley Authority U Uncertainty, accounting, 129–130 Uncertainty risk premium, 132 Unsecured bonds, 11, 17–19 Unsecured creditors, 165 Unsecured debt, redemption, 248 Unsophisticated investors, 41 Upgrade, 183 U.S government securities, 14 U.S Treasury, 59 issue, 249 market, 71 Utilities, 214 Utility company profits, 158 Utility indentures, 246 Utility mortgage bonds, 11–13 V Valuation See Subordinated structures approach See Convertible bonds formula See Recursive valuation formula general principles, 57–61 models, 50–51, 80, 260, 279 process, 271 spot rates, role, 59–61 van de Wetering, Eddy, 292 Volatility, 127, 278, 307–308 See also Expected yield volatility; Interest rate; Low-yield volatilities; Market; Price volatility; Spread; Stock; Treasury yield; Yield arithmetic See Corporate yield assumption, 259, 266–269 change, 307 changing, 89 complication See Rating volatility convexity analysis, relationship, 309–310 curve, 309 duration, 89–90 implications See Corporate yield; Implied Treasury yield volatility recognition See Yield volatility statistical measure, 264 theoretical value, relationship, 278–279 Voluntary bankruptcy, 165 W WAC See Weighted average coupon Waldman, Michael, 84 Walt Disney Company, 29 Warga, Arthur D., 69 Warner, Jerold B., 165 Waste Management Inc (WMX), 310 Weighted average, 132 Weighted average coupon (WAC) rate, 169 Weighted average recovery price See Bank bonds Weiss, Lawrence A., 166 West Point Pepperell, 197 Whirlpool Corporation, 44, 52 White, Rodney L., 168 Williams, George O., 261 WMX See Waste Management Inc Wolff, Eric D., 168 Working capital, 187, 192 maintenance provisions, ratios, 188 World War II, 16, 153, 156–157 Wruck, Karen Hooper, 166, 167 Wyss, David, 168 Y Yankees, 214 Year-by-year transition matrixes, 205 Yield advantage, 136 hogs, 123 log normal distribution, 108 volatility, 103, 287 Yield curve, 29 See also London Interbank Offered Rate; On-therun yield curve; Par yield curve environment, 68 flattening, 35, 40, 98, 120 nonparallel shifts, 304 normalization, 158 notes, 37, 38 parallel shifts, 80, 304–306 risk, 2, 79, 95–103 shift, 82 assumption See Parallel yield curve slope, 120–121, 301–303, 306–307 steepening, 40 Yield measures general principles, 57 limitations, 62–67 Index Yield ratio See Corporate yield formulation, 108–109 Yield spread, 37, 132, 253 excess returns, contrast, 199 historical data, 126 level, change, 199 measures, 57, 67–73 See also Floating-rate securities Yield to call, 62, 65–66 Yield to first call, 65 Yield to maturity, 62–65, 99 Yield to next call, 65 Yield to put, 62, 66 Yield to refunding, 65 Yield to worst, 62, 66–67 Yield volatility, 107, 174 See also Annualized yield volatility; Corporate yield; Expected yield volatility; Treasury yield volatility definition, 109–110 implications See Corporate yield; Implied Treasury yield volatility interpretation, 113 recognition, 103 Z Zero spreads, 70 Zero-coupon bonds, 20, 21, 196 Zero-coupon convertible bond See Eastman Kodak Company Zero-coupon instruments, 59, 75 Zero-coupon rate curve See Benchmark Zero-coupon securities, 60, 69 Zero-coupon Treasury, 75 securities, 60, 76 Zero-sum game, 131, 241 Zero-to-full bonds, 71 Zero-volatility spread, 67–68, 70–71 Zhu, Yu, 50 325 .. .Corporate Bond Portfolio Management Leland E Crabbe, Ph.D Frank J Fabozzi, Ph.D., CFA JOHN WILEY & SONS Corporate Bond Portfolio Management Corporate Bond Portfolio Management Leland E Crabbe, ... Chapter 5, we present the valuation framework, as well as various measures of corporate bond yields and spreads The yield spread is defined as the difference between the corporate bond yield and. .. asset-backed securities Like corporate bonds and ETCs, the credit risk of EETCs is linked to the corporate borrower, namely, the airline Like asset-backed securities, EETCs are issued in several