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THE HANHEighth EditionFRANKJ. FABOZZI, PH.D., CFA, CPAEditorWith the assistance ojSTEVEN V. MANN, PH.D.cuOillipNew York Chicago San Francisco Lisbon London MadridMexico City Milan New Delhi San Juan SeoulSingapore Sydney Toronto

C O N T E N T ART ONEBACKGROUNDChapter 1Overview of the Types and Features of Fixed Income SecuritiesFrank J. Fabozzi, Michael C. Ferri, and Steven V. MannB nds 3Preferred Stock15Residential Mortgage-Backed SecuritiesCommercial Mortgage-Backed SecuritiesAsset-Backed Securities17Covered Bonds18Key Points181617Chapter 2Risks Associated with Investing in Fixed Income SecuritiesRavi F. Dattatreya, Frank J. Fabozzi, and Sergio M. FocardiInterest-Rate Risk22Reinvestment Risk23Call/Prepayment Risk24Credit Risk25Inflation, or Purchasing-Power, RiskLiquidity Risk27Exchange-Rate, or Currency, RiskVolatility Risk29Political or Legal Risk29272821

ContentsEvent Risk 30Sector Risk 30Other Risks 30Statistical Measures of Portfolio Risk:Standard Deviation, Skewness, and KurtosisTracking Error Risk 31Key Points 3230Chapter 3Bond Market Indexes33Frank K. Reilly and David J. WrightUses of Bond Indexes 33Building and Maintaining a Bond IndexDescription of Alternative Bond IndexesRisk/Return Characteristics 40Correlation Relationships 45Key Points 483536Chapter 4Electronic Trading for Fixed Income Markets51Marshall NicholsonOverall Bond Market Growth 51The Rise of Electronic Trading 52The Impact of Regulatory Requirements 55Shift to a Fee-Based Broker-Dealer Revenue Model 56Universe of Electronic Trading Platforms 57Current Technologies 59Market Data and the Aggregation of Fixed Income ECNsRetail-Fixed Income Market Participation 62Retail Access to Individual Bonds 63Fixed Income Pricing 66Key Points 6761Chapter 5Macro-Economic Dynamics and the Corporate Bond MarketSteven I. DymThe Macro-Economy 69Corporate Profits 73Interest Rates 73The Central Bank 74Important Considerations 75The Yield Curve 77The Spread Curve 8069

ContentsCyclicality of Credit SpreadsStagflation8381Correlation and Capital StructureKey Points 8784Chapter 6Bond Pricing, Yield Measures, and Total Return89Frank J. FabozziBond Pricing 89Conventional Yield MeasuresTotal Return Analysis113Key Points 120102Chapter 7Measuring Interest-Rate Risk123Frank J. Fabozzi, Gerald W. Buetow, Jr., Robert R. Johnson, andBrian J. HendersonThe Full-Valuation Approach124Price Volatility Characteristics of BondsDuration 137128Modified Duration versus Effective DurationConvexity 149Price Value of a Basis Point164The importance of Yield Volatility165Key Points 166143Chapter 8The Structure of Interest Rates169Frank J. FabozziThe Base Interest RateRisk Premium170169The Term Structure of Interest RatesKey Points 189173PART TWOGOVERNMENT SECURITIES AND CORPORATEDEBT OBLIGATIONSChapter 9U.S. Treasury Securities193Michael J. Fleming and Frank J. FabozziTypes of SecuritiesThe Primary Market194195

ContentsThe Secondary Market199Zero-Coupon Treasury SecuritiesAcknowledgments205Key Points205204Chapter 10Agency Debt Securities207Mark O. Cabana and Frank J. FabozziAgency Debt Market OverviewTypes of Agency Debt Securities208211The Primary Market214The Secondary Market215Agency Debt Issuance215Issuing Agencies217Large, Active Issuers218Smaller, Active Issuers220Nonactive Issuers and Recently Retired GSEsAcknowledgments223Key Points223221Chapter 11Municipal Bonds 225Sylvan G. Feldstein, Frank J. Fabozzi, Alexander Grant, and David RatnerFeature/of Municipal Securities 227Types of Municipal Obligations 229The Commercial Credit Rating of Municipal Bonds 238Municipal Bond Insurance 244Valuation Methods 245Tax Provisions Affecting Municipals 246Yield Relationships within the Municipal Bond Market 249Primary and Secondary Markets 251Bond Indexes 253Official Statement 254Regulation of the Municipal Securities Market 254Key Points 257Chapter 12Corporate Bonds259Frank J. Fabozzi, Steven V. Mann, and Adam B. CohenThe Corporate Trustee 260Some Bond Fundamentals 261Security for Bonds 264Alternative Mechanisms to Retire Debt before Maturity270

ContentsChapter 17Floating-Rate Securities353Frank J. Fabozzi and Steven V. MannGeneral Features of Floaters and Major Product TypesCall and Put Provisions 356Spread Measures 357Price Volatility Characteristics of Floaters 358Portfolio Strategies 362Key Points 363354.Chapter 18Inflation-Linked BondsJohn B. Brynjolfsson365Mechanics and Measurement 367Marketplace 373Valuation and Performance DynamicsInvestors 375Issuers 380Other Issues 382Key Points 383374Chapter 19International Bond Markets and InstrumentsKarthik Ramanathan385Overview and Scope of International Bond Markets 385The Instruments: Domestic, Euro, and Foreign 387Dollar-Denominated International Bonds 389Non-Dollar-Denominated Debt International Bonds 397International Fixed Income and Understanding Currency RiskKey Points 406401Chapter 20Emerging Markets Debt409Jane Sachar BrauerThe Debt Universe 409Emerging Markets Debt Performance History 413Brady Bonds 417Defaults, Exchanges, Restructurings,Workouts, and LitigationDerivatives 432Credit-Linked Notes (CLNs) 434Valuation Methods 435Conclusion 437422

ContentsCollateralized Brady Bonds 437Noncollateralized Brady Bonds 438Chapter 21Fixed Income Exchange Traded Funds439Matthew Tucker and Stephen LaipplyInvestment Characteristics 440Fixed Income ETF Management 447Fixed Income ETF Characteristics and Mechanics 448Trading Behavior: A Closer Look at Premiums and DiscountsKey Points 456453Chapter 22Covered Bonds459Vinod KothariCovered Bonds: From Europe to the Rest of the WorldUnderstanding Covered Bonds 460Structure of Covered Bonds 461Cover Assets and Credit Enhancements 466Asset/Liability Mismatches and Liquidity Risk 467Ratings of Covered Bonds 469Covered Bonds and Securitization 469Accounting for Covered Bonds 472KeyPoints 472460Chapter 23Nonconvertible Preferred StockSteven V. Mann475Preferred Stock Issuance 476Trust Preferred 478Preferred Stock Ratings 478Tax Treatment of Dividends 479Key Points 480PART THREESECURITIZED PRODUCTSChapter 24An Overview of Mortgages and the Mortgage MarketAnand K. Bhattacharya and William S. BerlinerProduct Definition and Terms 484Mechanics of Mortgage Loans 488The Mortgage Industry 492483

ContentsGeneration of Mortgage Lending Rates 496Component Risks of Mortgage Products 502Key Points 507Chapter 25Agency Mortgage-Backed Securities509Andrew Davidson, Anne Ching, and Eknath BelbaseMortgage Loans 509History of Secondary Mortgage Market 513Agency Pool Programs 515Trading Characteristics 518Prepayment and Cash-Flow Behavior 523Prepayment Conventions 523Sources of Prepayments 525Prepayment Models 530Valuation 531Key Points 535Chapter 26Agency Collateralized Mortgage ObligationsAlexander Crawford537The CMO Market 537The Reasons Why CMOs Exist 538CMO Tranche Types 539Agency versus Nonagency CMOs 558Agency CMO Analysis 559Key Points 566Chapter 27The Effect of Agency CMO PAC Bond Features on PerformanceLinda LowellThe Term Structure of CMO Yields 570Collars and Collateral 572Interaction of Collars and Collateral 574PAC Collar Drift 577When the PAC Breaks 578Windows 578Lockout 580Is There a Z in the Deal? 581Effect of Jump-Z and VADM Structures on PAC BondsPriority to Receive Excess Cash Flows 585The Option Costs of PAC Features 585Key Points 592584569

ContentsChapter 28Agency CMO Z-Bonds593Linda LowellThe Basic Accrual Structure594How the Z Interacts with Other Bonds in the StructureCMOs with PACs and a Z-Bond600Performance of Z-Bonds603More Fun with Accrual Bonds604PAC Zs 605Structures with More Than One Z-BondKey Points 611597605Chapter 29Support Bonds with Schedules in Agency CMO Deals613Linda LowellSupport Bond Basics614Support TAC Bonds618Reverse TACs621Layered PAC Bonds624Summary of Average Life VolatilitiesKey Points627628Chapter 30—j—.Stripped Mortgage-Backed Securities629Cyrus Mohebbi, Gary Li, Todd White, and David Kwun629Overview of the SMBS Market630Investment Characteristics633Key Points642Chapter 31Nonagency Residential Mortgage-Backed SecuritiesDapeng Hu and RobertGoldsteinMarket Overview647Collateral652Capital Structure662Housing Market670Mortgage Modification673Relative Value and Risk AnalysisKey Points679675645

ContentsChapter 32Commercial Mortgage-Backed SecuritiesWayne M. Fitzgerald II and Mark D. Paltrowitz681The Collateral Pool 683CMBS Trust Structure 692Transaction Participants 694Transaction Features 695Market Development 700Modeling 701Key Points 705Chapter 33Credit Card Asset-Backed SecuritiesJohn McElravey707Securitization of Credit Card Receivables 707The Credit Card ABS Life Cycle 712Cash-Flow Allocations 716Credit and Investment Considerations 718Key Points 725Chapter 34Securities Backed by Auto Loans and Leases, Equipment Loans andLeases and Student Loans 727John McElraveySecuritization in Brief 727Auto Loans and Leases 730Equipment Loans and Leases 732Student Loans 733Key Points 736Chapter 35Collateralized Loan ObligationsFrank J. FabozziAssets 737Capital Structure 738Creation Purpose 739Credit Structures 739Key Points 741737

ContentsxiiiPART FOURTERM STRUCTUREOF INTEREST RATESChapter 36Overview of Forward Rate Analysis745Antti IlmanenComputation of Par, Spot, and Forward Rates 746Main Influences on the Yield-Curve Shape 749Using Forward Rate Analysis in Yield-Curve TradesKey Points 767757Chapter 37A Framework for Analyzing Yield-Curve Trades769Antti IlmanenForward Rates and Their Determinants770Decomposing Expected Returns of Bond PositionsKey Points 795777Chapter 38Empirical Yield-Curve Dynamics and Yield-Curve ExposureWesley PhoaFundamental Determinants of Yield-Curve DynamicsEmpirical Analysis of Yield-Curve Dynamics805Beyond Level and Slope Risk816Key Points 823797797Chapter 39Term Structure Modeling with No-Arbitrage Interest Rate ModelsGerald W. Buetow, Jr., and Brian J. HendersonIntroduction to Models of the Short RateBinomial Interest Rate Lattices831Trinomial Lattice 851Key Points 854826825

ContentsPART FIVEVALUATION MODELINGChapter 40Valuation of Bonds with Embedded Options 857Frank J. Fabozzi, Andrew Kalotay, and Michael DoriganThe Interest Rate Lattice 858Calibrating the Lattice 862Using the Lattice for Valuation 866Fixed-Coupon Bonds with Embedded Options 866Valuation of Two More Exotic Structures 871Extensions 875Key Points 878.Chapter 41Valuation of Agency Mortgage-Backed SecuritiesFrank J. Fabozzi, Scott F. Richard, and Peter RuStatic Valuation 882Dynamic Valuation ModelingIllustrations 891Key Points 898881883Chapter 42Convertible Securities: Their Structures, Valuation, and TradingMihir BhattacharyaEvolution in the Convertible Markets 903Basic Characteristics of Convertible Securities 920Approaches to Valuation of Convertibles 925Exercising the Embedded Options 939Looking Forward 942Key Points 944PART SIXCREDIT RISKChapter 43Credit Analysis for Corporate Bonds 949Martin Fridson, Frank J. Fabozzi, and Adam B. CohenApproaches to Credit AnalysisIndustry Considerations 952949899