Valuing Fixed Income Securities

To value fixed income securities the Treasury spot rate curves are used. They are theoretical spot rate which can be derived either by observing, bootstrapping or interpolation. Through observation the spot rates can only be derived from Treasury Strips but there are several advantages and disadvantages associated with that. Treasury Strips have the basic advantage of being available for every maturity. On the other hand the liquidity problem exists as a major disadvantage. They have tax disadvantages because of the accumulated interest on strips and there are certain regions where the Non U.S. investor is provided tax advantage. In this way unanimous tax adjustments cannot be done. It is important to understand that zero coupon bonds have no intermediate cash flows and for this reason their discounting factor is the spot rate. Yield is only involved in coupon paying bonds. For this reason the rate on Treasury Strips is considered to be the spot rate because each coupon payment is stripped and can trade as a zero coupon bond.
With On the run issues spot rates can also be derived using the bootstrapping method. In this method the 1 year zero coupon bond is taken and its yield is the spot rate for one year. Then a two year coupon paying bond is taken at par so that its yield to maturity is its coupon rate. The first years coupon payment is discounted at the rate of 1 year zero coupon bond, the spot rate, and the 2nd year's coupon plus principle is discounted with 2nd years spot rate. Since the equation is equal to the par value, the spot rate for 2nd year is calculated. Similarly it is applied for all the maturities to get the theoretical spot rates. This method is known as bootstrapping and the rates gathered through it if drawn graphically are known as Treasury Spot Rate Curve which in fact is used to value Fixed income securities. The issue with on the run securities is that they are not available for all the maturities and relatively liquid than off the run issues. Their price might disrupt the yield calculated from their prevailing prices. In this method the bootstrapping along with interpolation is used.
To counter this problem, a blend of on the run and off the run securities is used and the method of bootstrapping and interpolation is used to get the spot rate curve. Again which securities to use as for similar maturities sometimes multiple off the run issues are available. Some analysts are of the view to use all the issues of Treasury in order to get spot rates which is a complex task and requires diligence.
Can only the Treasury spot rates be used to value fixed income securities? The answer is no! Alternatively to Treasury spot rates curve, the Swap rate curve could also be used to value fixed income securities. It is a noticeable thing that Swap rate curve is an alternative to Treasury Yield curve, not Treasury spot rate curve. To determine spot rates through Swap rate curve the method of bootstrapping is used. Swap rates can be gathered by knowing the inter-bank lending rates. LIBOR is a renowned rate used by banks for lending, the swap rates curve against LIBOR is called the LIBOR rates curve. Bootstrapping the LIBOR rates curve results in LIBOR spot rates curve which is used to value fixed income securities. Due to their advantages, the swap rates are becoming famous and used instead of treasury yield curve. They are above the government regulations, available for more maturities, does not account the technicalities associated with bonds as the principal is 'assumed' not actual and supply of swaps depend upon the number of counterparts.
One must not forget that Swap rates are a proxy to Treasury Yield rates not to Treasury Spot rates where as the method of deriving spot rates is similar. Once spot rates are measured, the future rates can be derived against the spot rates. In this way the circle runs and we can value the fixed income securities. 

Role of Covenants in credit analysis

Indenture is referred to as the lending agreement which contains terms and conditions. These terms and conditions are referred to as covenants. They deal with limitations and restrictions on the borrower's activities and play an important part in minimizing risk of creditors. Covenants could be termed as either Affirmative or Negative.

Affirmative covenants are those which require debtors to do certain set of activities to improve the credit quality of the issuer. Common examples include:

• To pay all taxes and other claims when due
• To maintain all properties used in the borrower's business in working order and good condition
• To pay interest, principal, and premium, if any on timely basis
• To submit periodic certificates to the trustee stating whether the debtor is in compliance with the loan agreement.

Negative covenants are the limitations which restrict borrowers not to take certain actions. Common examples include:

• Limitations on the company's ability to incur debt
• Use of cash flow tests and working capital maintenance provisions
• Limitations on dividend payments and stock repurchase
• Use of interest or fixed charge coverage test to reduce the default risk of creditors. The two common tests are:
• Maintenance Test: This test requires the borrower's ratio of earnings available for interest or fixed charges to be at least a certain minimum figure on each required reporting date
• Debt Incurrence Test: Debt incurrence tests are generally considered less strict than maintenance provisions.

Indentures often classify subsidiaries as restricted or unrestricted. The former are considered for financial test purposes while the later are not. If a firm has unrestricted subsidiaries they are allowed to used outside sources of funds and they are excluded from the covenants of the parent.

Covenants are among the other Cs of Credit Analysis. They are given equal preference while checking the credit quality of an organization. If organizations fail to abide by the covenants then creditors feel reluctant in lending money to such organizations.

Cash Flow Analysis

Capacity to pay is an important element while analysing a company for credit ratings. Usually Traditional Ratio analysis is done to check the capability of a company meet its short term and long term debt obligations. Interestingly Traditional Ratios can give a deceived view. To counter that, eminent credit rating agencies do the cash flow analysis in order to truly judge the capacity of firms meeting their debt obligations. 

Knowing the sources for cash of a firm is an important consideration in this regard. A firm must be able to generate cash flows from its operations to have future prosperity and the ability to meet its obligations. Standards and Poors utilizes the criteria in which it adds depreciation and plus/minus other non cash items to Net Income in order to get Funds from Operations. They are adjusted for working capital to get operating cash flows which are further netted against capital expenditures (operating cash flow - capital expenditure) to get Free Operating Cash Flows. After subtracting cash dividends from Free Operating Cash flows they get Discretionary Cash flows. As its name implies these cash flows are on the discretion of the management to use. Netting these cash flows against acquisitions, adding asset disposals and adding (subtracting) other sources (uses) result in Pre-financing Cash Flows.

The flow can be illustrated as:

Net Income

Plus Depreciation

Plus/Minus: Other non cash items

Funds from Operations

Decrease (increase) in non cash current assets

Increase (decrease) in non debt current liabilities

Operating Cash Flow

Minus Capital expenditure

Free Operating Cash flow

Minus Cash dividends

Discretionary Cash flow

Minus acquisitions

Plus Asset Disposals

Plus (minus) other sources (uses)

Pre-financing Cash Flow

S&P uses the following cash flow ratios in order to analyse a company

1. Funds from Operations / Total debt (netted against off-balance sheet liabilities, leases etc.)

• Higher the ratio, the stronger the issuer's capacity to pay

2. (Free Operating Cash flow + interest) / Interest

• The higher the ratio, the stronger the issuer's capacity to pay.

3. Debt Service Coverage Ratio = (Free Operating Cash Flow + Interest) / (interest + Annual Principal Repayment Obligation)

• The higher the ratio, the stronger the issuer's capacity to pay

4. Debt Payback Period = Total Debt / Discretionary Cash Flow

• The lower the ratio, the stronger the issuer's capacity to pay

5. Funds from Operations / Capital spending requirements

• The higher the ratio, the stronger the issuer's capacity to pay.

It is noticeable that companies with lower credit ratings and Speculative-grade issuers must be analysed using

• Free Operating Cash Flows
• Debt service coverage ratios

High credit rating firms should be analysed using Funds from Operations measure.

Based on above methodologies one can see that cash flow analysis is not only interesting but capable of giving a direction which can be used to judge the capacity of a company to meet its debt obligations. Merely relying on traditional ratio analysis, which itself is an important tool but must not be considered the sole one, can give a view which could be misleading. 

Level II Diary - First Week

I could sense a peculiar feeling developing inside me while attending the Level II class. It was the same auditorium with similar arrangements but I was sitting on a different seat. Plenty of identical faces were present in the class with a few ones missing and several unrecognized. A new motivation was required to grasp the concepts of Level II as it seemed quite different from what we had studied in Level I. 

The major difference which I sensed was the in-depth understanding required of the topics. It started off with Fixed Income, Study Session 14, Reading 50 - Valuing bonds with embedded options. I could recall the first class in Level I which was different in a sense that the terminologies discussed were alien to me. The good thing was whatever was being discussed let it be the key terms, jargon and concepts, it had started to make sense. It was an interesting element as retaining things considering them facts without knowing their reason for existence was the most difficult task for me. 

The first question which troubled me was the relation of Volatility and Option Adjusted Spread for callable bonds. On the first day it was discussed in the class but I was able to figure out the answer after giving a complete reading of the chapter. As with the case of callable bonds, an increase in volatility increases the value of the call option and the option adjusted spread is calculated by subtracting option value from zero volatility spread. Understanding this relation made me figure out the logic behind a line written in text book that when the volatility increases the OAS decreases for callable bonds.

Using the interest rate tree and applying the concept of backwardation was another interesting topic which was covered during the first week. In fact it got even more attractive when it was used in valuing bonds with embedded options and floaters. Analysis of convertible bond was another important area which was covered in the first week and it got more valuable when we were told that Warren Buffet, an investment tycoon, purchased the convertible bonds issued by the Bank of America, which was in grave trouble those days. Securing the downside potential till the straight value, which in fact is a moving floor, of the bonds and having the chance of converting them into stocks when they outperform the fixed income securities, was an appealing aspect.

Towards the end of the week we covered the general principles of credit analysis. As I mentioned earlier, there is so much to learn and associate with the ‘real world’ in Level II that often it is hard to believe! The rating agencies which are considered experts and their opinions are disseminated over Bloomberg and Business week, we practically understood their methodology of rating other companies. Moody’s Investor Service, S&P Corporation, and Fitch ratings were the ones we discussed. The story didn’t stop on these companies in fact it started from them. Learning the ability to do credit analysis was the most interesting and appealing part of Reading 48. It equipped us with the skills required to do credit analysis by first figuring out questions through ratios and then answering them through cash flow, collateral and other investigations.

On the whole the first week was amazing in terms of learning and provided a deep ‘peep’ into the magical world of finance. Way back when I was in school I used to study a book named ‘How the Universe works?’ The first week reminded me off with my deep interest towards knowing things. Life may sometime in the future provide me with an opportunity to understand how the universe works but my joy of understanding how the finance universe works can’t be explained in words… For those who want to explore the different dimensions and levers of this magical world of finance, must take a bold step and become a part of this course. 

One month before the exam...

For Level 1 our course ended on Sunday, 8th of May 2011. Apparently it was hard for me to believe that in less than hundred days, we had completed 5 books covering 10 subjects. I could recall the first day when I had stepped into that auditorium. There was a sense of happiness and an increasing responsibility as only 1 month was left before the exam. I greeted my friends, left the class and gathered my energies to travel back to my house. It was economics which we had covered in just 3 days! I was simultaneously shocked and surprised. The book had three study sessions in it and around 15 chapters but we just skimmed it in three days!

While returning back to home, I was consistently planning the following week. Though when I had decided to travel in February 2011, it was among my principles not to bother much during travelling but the anxiety of the exam had made me break all the rules; my rules! After gathering much courage and potential I decided to revise 5 books in 6 days! Impossible, this is what I said to myself and rested my head back in the bus. The clock struck 1 and I left the bus at an interim terminal. My parents were waiting for me in the car, I ran towards them and after watching their faces all my anxiety and tiredness vanished. I came across to my house telling them all the details of the class and 'out bursting' what I had in my mind. It gave me energies. When I went into my house I realized that I was fresh. It was a hectic weekend, I had covered a complete book in three days, traveled 2 hours in the bus and still I was fresh. That was the moment I realized how necessary it is to remain happier in order to achieve one's goals. It seemed that I had conquered my devil. Nothing is impossible was the next thing which I told to my self and slept. 

Against all odds, I woke up early in the next morning and after a 'vibrant' breakfast I opened my books. I tried to remove all other things especially the fear out of my mind and started my reading. I had realized the organization of information which I had done during my previous readings helped me out dramatically in increasing my efficiency and capability of retaining. I started off with my best portion - Book 4 to gain confidence and completed the book in one day. It wasn't a continuous strive. I took brakes in the mean time, tried to make my self feel relaxed and rejuvenate. I ate well - it makes me happy, done some physical workout to gather energies for my brain, and watched funny short clips. Planning the leisure time and studying in the rest of time was the strategy which made me happy and ultimately completing one book in one day. The quest continued till Saturday 14th May, 2011. I left for Lahore in that evening and took a deep sleep. 

On Sunday 15th May, 2011 it was my first mock. I was fresh and excited. The curiosity was not the actual proxy of the exam yet I could sense a chunk of it! My aim was to check my stamina of sitting in the exam for 3 hours, waiting for 2 hours and then re-sitting for the next 3 hours. The first mock really helped out in evaluating where I had stood. Though I had passed that mock but when I was travelling back I was planning for the next week. 22nd May, 2011 was the destination and I had 6 days, and 5 books to cover...