Reference no: EM132476968

FIN 472 Fixed-Income Securities Assignment - Kogod School of Business, American University, USA

1. Yields and Bills

(a) Define the following yield concepts:

- Redemption yield

- Par yield

- Yield to put

- Yield to worst

(b) Can a zero and an otherwise identical, maturity-matched level-coupon bond ever have the same duration?

(c) A 3M T-bill currently sells for 98:08 (what does this quotation mean?). Calculate its bond equivalent yield.

(d) Calculate the discount yield of the preceding 3M T-bill currently selling for 98:08.

(e) What does convexity measure and how is it used in the assessment of interest rate risk?

2. Term Structure of Interest Rates

Your investment company's trading system has become unstable after a recent update so that your superiors ask you to verify the calculations displayed on the traders' screens.

Type	Maturity	Coupon	Price	Spot Yield	Disc Factor	Fwd Rate
UST Bill	182D		99.9650
UST P-Strip	1Y		99.9000
UST Note	1.5Y	2.30	100.0152
UST Note	2Y	3.80	100.1403

(a) Using current UST security information from Bloomberg reproduced above, you extract the relevant spot rates by hand and fill in the remainder of the table to verify the computations of your system. Note that the maturities are exactly as stated.

You might want to provide the requisite formulae indicating your exact calculations to convince your boss that it is not you who is at fault but rather the IT techs who botched the update.

(b) Draw the corresponding UST discount yield curve and indicate a hypothetical AAA corporate term structure (sketch) relative to the US TSIR.

(c) What is the relationship between the US sovereign and corporate AAA yield curves? What explains the difference in yields by maturity and how do markets use this information?

(d) The FRB has announced in December 2016 that it will cease to intervene in bond markets and bring its policy of quantitative easing to an end. What will the effect of the Fed's tapering announcement on the yield curve be? Explain.

(e) Optional - Research the current yield curve as of the date of the exam and compare it to the one at the beginning of the year. What do you see? Download the data (e.g., from treasury website), generate the requisite chart, and explain.

3. Interest-Rate Risk Management

As chief financial officer (CFO) of The California Widows & Orphans Insurance Company ("C-WOIC"), one of your primary tasks is the management of your company's interest rate exposure. Following best industry practices, you are currently trying to convince your board to move beyond traditional approaches to interest-rate risk and actively manage your institution's rate exposure by relying less on external consultants but instead implement models based on tried and tested mathematical relations between fixed-income prices and yields (rates).

(a) State a formula which relates changes in fixed-income price to interest-rate variability (i.e., changes in yields) using at least one if not two different measures of yield sensitivity.

Illustrate how bond prices are related to yields on the basis of this formula and a diagram. Why or why not is this approach valid?

(b) The modified duration and convexity of a high-grade corporate bond in C-WOIC's investment portfolio are 5:6 years and 34.9, respectively. By what dollar amounts would you expect its price to change for a 60 bpts rise or fall in interest rates given that the current bond's price is $91.65?

(c) At a meeting of C-WOIC's board you propose to update current A&L management practices focusing more on interest-rate exposure given the shifting monetary environment.

Formulate an appropriate objective in terms of a measure of interest-rate sensitivity.

One of your board members, a retired bank CFO, claims that your approach to interest-rate exposure measurement and management is fundamentally awed. What problems might she referring to? Do you agree with her assessment?

(d) Currently, the average duration of your investment portfolio is 5 years whereas the average duration of your various fixed income liabilities (life-insurance policies, variable rate annuities, and savings products) is 15 years. You may assume that the average yield on assets and liabilities for a company of C-WOIC's credit quality is around 6.00%. Calculate C-WOIC's net rate exposure and propose a strategy to neutralize the effect of interest-rate changes on your balance sheet which is (in billion USD) as follows:

C-WOIC Simplified Balance Sheet
Assets		Liabilities
Fixed-income portfolio	100	Equity	11
Cash and cash equivalent	10	Annuities, policies, saving plans	99
Total	110	Total	110

4. Commercial Banking

You are a corporate account officer with the Commercial & Industrial Bank Corporation (CIBC). One of your major manufacturing clients, who are retooling one of their factories, just bought a piece of customized machinery to be delivered in six months' time. The company's treasurer intends to initially finance the purchase in the short-term loan market for six months and inquires about the possibilities of locking in the borrowing cost now. The amount is USD 10m and the loan would be disbursed in a six months from now to be repaid in exactly one year's time from now. The current short-term USD Libor term structure is as follows:

Maturity (D)	Libor Rate (%)
30	0.15%
90	0.24%
180	0.33%
360	0.55%

(a) What kind of solution to their problem would you suggest to your manufacturing client?

(b) Quote a borrowing cost for the preceding suggestion. Since your boss is of a somewhat suspicious nature you better indicate your methodology to derive the quote.

(c) What alternative could you suggest to your customer?

(d) Define and calculate the LIBOR forward curve. Why or why not is it a good predictor for future LIBOR rates?

(e) Optional - At expiration, i.e., six months after entering into the agreement, the 180D Libor stands at 0.90%. Who wins and who loses? Calculate the client's gain or loss from your suggestion or the alternative, whichever you prefer.

5. Funding Positions

As a junior trader at your investment bank, you quickly and cost-effectively need to fund overnight a $100m position in the on-the-run 5Y UST note. On Feb 17, 2018, this note, which pays a 3% coupon and matures on 03/21/2023, is quoted at a bid-ask of 100 21/32-22/32 (careful: what does the quote convention mean?).

(a) What should the invoice price of this note be? In your computation of accrued interest, please note that February is an odd month.

(b) The general-collateral repo rates rates are 1.10%-1.25% (dealer pays-earns interest) on 02/17/14. If the market required a 2% margin, how much of the purchase price could you have borrowed in the repo market, and how much interest would you have paid for a one-day loan? What would have your equity stake in the position be?

(c) At the expiration of the 1D repo (next day), the bond is trading at 100 22/32-23/32 (careful: what does the quote convention mean?). What is your total profit or loss if you were to close out your position?

(d) As an alternative, you consider an overnight loan in the fed funds market. What are fed funds rates and how do they relate to repo rates? Explain.

(e) Optional - What are 'fails' in the repo market? Describe two strategies to take advantage of fails and to what purpose unscrupulous market participants would use them.

6. Swap Valuation

The date is January 3, 2019 and you just returned to work from a thorough and exhausting celebration of the New Year. As a junior clerk on the USD fixed-income derivative desk your first transaction of the year involves a 5Y fixed-for-floating swap with yearly payments on $100m notional. Bloomberg provides you with the following data:

Payment Dates (years)	Libor-Strip Prices P(0, T)
1.0	95.39
2.0	90.63
3.0	85.78
4.0	80.93
5.0	76.11

(a) In terms of cash-replication, the above 5Y plain vanilla swap corresponds to holding what positions in what type of instruments?

(b) How much is the swap worth at inception?

(c) Calculate the 5Y swap rate for an annual fixed-for-floating USD swap. What is an appropriate bid-ask spread assuming that the Bloomberg data are midpoints?

(d) You ponder various strategies to hedge the resulting interest-rate exposure. Describe two different strategies which you could use to hedge the transaction.

(e) Optional - Your company has sold a 6Y plain-vanilla swap on 1Y LIBOR precisely one year ago for a swap rate of 7.15%; as a consequence, you receive fixed and pay floating. What value should your accounting system attribute to the swap today (notional principal: $40m)?

7. Corporate Bond Issuance and Trading

As a member of the BofA/Merrill Lynch corporate bond origination team, you are working on an upcoming transaction on behalf of Western Digital Corp. (Nasdaq: WDC) which is planning a massive bond offering to fund the acquisition of SanDisk Corp. (Nasdaq: SNDK). You are in charge of all the fixed-income analysis and report directly to the lead banker. A lot is on the line for your company because this deal might become the largest bond offering in 2016 so far. Here is recent press coverage of the announcement of the bond offering:

Western Digital Readies $5.6B Bond Offering Backing SanDisk Buy

Western Digital this morning launched off the shadow calendar its SanDisk acquisition bond financing, comprising $1.5 billion of seven-year (non-call three) secured notes and $4.1 billion of eight-year (non-call three) senior notes, according to sources. Roadshows are scheduled to run Monday, March 21 through Monday, March 28, with pricing to follow via a Bank of America-led bookrunner team, the sources added.

While first call premiums have not been outlined for the two series, take note that while par plus 75% coupon to balance the short schedule is most typical, an issuer-friendly arrangement at par plus 50% coupon has become more acceptable over the past year. Beyond that, market sources relay that the equity-clawback feature on both tranches is most typical, as three-year for up to 35% of the issue, at par plus coupon, and the change-of-control call provisions are also regular-way, at 101% of par.

Additional bookrunners on the long-awaited effort are J.P. Morgan, Credit Suisse, RBC, and HSBC. Proceeds, along with those from a TLA, TLB, and an RC draw, will be used to back the $19 billion acquisition of the rival storage-technology company, and issuance is under Rule 144A for life.

As reported, the company has guided the $4.2 billion U.S. dollar TLB, and $550 million-equivalent, euro-denominated TLB at L/E+450{475, with a 0.75% floor and OID of 98.5. The seven-year, covenant-lite term debt will include 12 months of 101 soft call protection, and at current guidance the term loan would yield roughly 5.64{5.9% to maturity.

Take note that the same bank line up is arranging the loans but J.P. Morgan is the left lead. A planned $3 billion, five-year A term loan has been increased to $3.75 billion, with pricing set at L+200. Western Digital also plans to draw down a portion of its $1 billion, five-year revolver at closing.

Issuer ratings have firmed at BB+/Ba1/BB+. The secured debt is rated BBB{/Ba1/BBB-, with a 2L (lower end of substantial, 80{90%) recovery rating from S&P's. The unsecured debt is rated BB+/Ba2/BB+, with a 4L (lower end of average 40{50%) recovery rating.

Irvine, Calif.{based Western Digital makes hard disk drives, solid state drives, and cloud-network storage solutions, with a client focus on set-top boxes, printers, in-car navigation devices, and other general consumer electronics. Milpitas, Calif.-based SanDisk makes solid-state drives and other storage solutions with a client focus on computers, tablets, phones, and wearables. (March 18, 2016)

(a) Analyze the terms of the Western Digital offering. Here is an extract of the term sheet:

Issuer	Western Digital Corporation (WDC)
Ratings	BBB-/Ba1/BBB- BB+/Ba2/BB+
Amount
Issue	Secured notes (144A-life) Senior notes (144A-life)
Coupon
Price
Yield
Spread UST+
Maturity	April 1, 2023 April 1, 2024
Call
Trade	March 30, 2016 March 30, 2016
Settle (T+10)	April 13, 2016 April 13, 2016
Bookrunners	BAML/JPM/CS/RBC/MIZ/MUFG/HSBC/SMBC

How well has WDC been doing? What is the financing for?

What exactly is on offer? How do the tranches differ?

Are the bond callable? If so, when and why?

What other debt is WDC taking on and how is it structured?

(b) Using the attached information or any other data, whose source you would have to carefully document, price the debt and complete the above term-sheet.

How is corporate debt priced? Propose a methodology.

What yields would you propose for the two series? Carefully explain to the lead banker your reasoning and document your analysis.

Determine the series' coupon and price to fill in all the remaining fields above.

(c) Research the issue and try to find out what happened. Did the final offering differ from the initial announcement and, if so, what happened? How did the pricing vary from your analysis and why?

(d) In order to secure the lead in the deal, your company has agreed to offer liquidity services up to 12 month. In essence, BAML's corporate-bond traders stand ready to make markets in the WDC series, i.e., quote firm bid-ask prices at which they stand ready to buy or sell typical blocks of $1m to $2m. In order to do so, they have to keep significant inventory in the notes.

When traders in corporates have to hold (long) positions for inventory or prop(rietary)-trading purposes they typically take the offsetting position in maturity-matched US Treasuries. Why? What is the purpose of this strategy and what is their residual position?

What are the risks and benefits of this strategy?

How would your colleagues at BAML fund the necessary inventory to provide the promised liquidity services to investors and the issuer and at the same time implement the long-short strategy? Describe two different implementation and recommend your favorite one.

8. Corporates, M&A, and Callability

As a member of the BofA/Merrill Lynch corporate bond origination team, you have been working on a transaction on behalf of CVS Health Corp. (NSE: CVS) which had been planning a massive bond offering to fund the acquisition of Aetna Inc (NSE: AET). You are in charge of all the fixed-income analysis and report directly to the lead banker. A lot is on the line for your company because this deal might become the largest bond offering in 2018.

In addition to the below recent press coverage of the bond issue, you might want to consult the attached extract from the Offering Circular.

CVS Health completes world's third-largest corporate bond sale: US pharmacy chain raises $40bn to fund purchase of health insurer Aetna.

CVS Health completed the third-largest corporate bond sale in history on Tuesday, underlining the market's ability to absorb sizeable debt issuance at the right price, despite a backdrop of rising interest rates and regulatory uncertainty. The pharmacy chain's $40bn sale - to fund its proposed acquisition of health insurer Aetna - attracted $120.7bn of orders, according to four people with knowledge of the sale. Investors said the debt's reasonable pricing supported the record demand, and advance notice from underwriters gave fund managers the chance to set aside cash for the offering.

Bankers and investors said the sale suggested the US bond market was comfortable with two key risks: rising yields on global government debt, and uncertainty about regulators' approach to so-called vertical mergers, or tie-ups between companies that are not direct competitors.

CVS sold nine bonds across seven maturities to fund the deal. Most of the securities face a mandatory redemption if the acquisition is not completed by mid-2019, according to Moody's, which assigned the debt a Baa1 rating.

Investors submitted more than $110bn of orders for $46bn of bonds issued by Anheuser-Busch InBev to fund its acquisition of SABMiller, and $101bn for the $49bn of bonds issued to fund Verizon's acquisition of Verizon Wireless.

Spreads between yields of the new securities and benchmark government debt were mostly similar or wider than spreads offered in other large bond sales. The new five-year CVS bonds were sold at a yield of 3.899 per cent, a spread of 125 basis points over Treasuries. To compare, five-year spreads were 120 basis points in the Anheuser-Busch InBev deal. CVS's new 10-year bonds were sold at a yield of 4.475 per cent, 160 basis points higher than benchmark Treasuries, giving them the same spread as the Anheuser-Busch deal.

Some commentators have questioned the market's resilience | investor Bill Gross, for ex-ample, in January predicted the start of a bear market in bonds. Spreads widened for the corporate debt market as a whole in February, according to ICE Bank of America Merrill Lynch indices. \We anticipate an uptick in M&A activity, so the success of today's transaction is important to show the marketplace there is still plenty of liquidity," said Dan Mead, head of the US investment-grade syndicate desk at BofAML.

Some bond tenors were offered with steeper-than-normal price discounts, which investors said was to compensate for the risk that regulators may block the deal. The Justice Department's challenge to the tie-up between AT&T and Time Warner has fuelled uncertainty about the CVS-Aetna deal. However, bullishness about the prospects of the combined company fed demand for the bonds. (FT, March 06, 2016)

(a) Analyze CVS, Aetna, and the terms of the CVS offering.

How well have CVS and Aetna been doing? What is the financing for?

What exactly is on offer? How do the tranches differ? Present the terms of the various series in table format.

What other debt is CVS taking on and how is it structured?

(b) Are the various tranches callable? If so, when and why? How does callability differ in this case from regular corporate callables? What are CVS trying to accomplish and what is unusual about the series' callability?

(c) Using the attached information or any other data, whose source you would have to carefully document, critically review the pricing and terms of the debt.

How were the bonds rated? How did the deal change CVS' perceived credit risk and how does it influence the pricing of the bonds?

What yields would you propose for the nine series? How should they vary with the terms of the individual tranches?

How do price and proceeds diverge?

(d) Research the issue and try to find out what happened. Did the final offering differ from the initial announcement and, if so, why?

9. Optional Bonus Problem - Treasury Inflation-Protected Securities

Since 1997, the US 100 Treasury has provided inflation insurance to interested parties through its TIPS program. TreasuryDirect explains:

"Treasury Inflation-Protected Securities (TIPS) are marketable securities whose principal is adjusted by changes in the Consumer Price Index. With inflation (a rise in the index), the principal increases. With a deflation (a drop in the index), the principal decreases. The relationship between TIPS and the Consumer Price Index affects both the sum you are paid when your TIPS matures and the amount of interest that a TIPS pays you every six months. TIPS pay interest at a fixed rate. Because the rate is applied to the adjusted principal, however, interest payments can vary in amount from one period to the next. If inflation occurs, the interest payment increases. In the event of deflation, the interest payment decreases. At the maturity of a TIPS, you receive the adjusted principal or the original principal, whichever is greater. This provision protects you against deflation.... TIPS are issued in terms of 5 (auction dates: April, *August, *December), 10 (January, *March, *May, July, *September, *November), and 30 (February, *June, *October) years" (* denotes a reopening, in which the US Treasury sell an additional amount of a previously issued security;

You might also want to refer to the attached analyst report by HIMCO (May 2014), The Case for Treasury Inflation-Protected Securities.

(a) What is the rationale to invest in a TIPS? Does it still hold?

(b) Consider a normal UST security and and otherwise completely equivalent TIPS. Which one should carry a higher yield, the TIPS or the nominal UST security? Explain.

(c) Can the yield (to maturity) of a TIPS ever become negative? Why or why not? Explain.

(d) How much have investors apparently been willing to pay for this privilege recently? You might want to consult recent US Treasury auction results carefully documenting your information source and data.

(e) In 2004, the US Treasury issued the following 10Y TIPS maturing in July 2014:

CUSIP NUMBER	912828CP3
Dated date	July 15, 2004
Original issue date	July 15, 2004
Additional issue date	October 15, 2004
Maturity Date	July 15, 2014
Ref CPI on Dated date	188.49677

Suppose that this security were to trade at a bid-ask price of 102-04/05+ (careful: what does the quote convention mean?) with a coupon rate of 2.0%. Given the reference CPI data below, what should the index ratio be on Feb 7, 2014? What is the accrued interest on this security as of Feb 7, 2014? What is its invoice price?

Day	Calendar day	Ref CPI
02/01/14	1	233.0690
02/02/14	2	233.0683
02/03/14	3	233.0676
02/04/14	4	233.0669
02/05/14	5	233.0661
02/06/14	6	233.0654
02/07/14	7	233.0647
02/08/14	8	233.0640
02/09/14	9	233.0633
02/10/14	10	233.0626