FOREWORD

There is an argument that an understanding of any financial market must incorporate an appreciation of the functioning of the bond market as a vital source of liquidity. This argument is true in today’s financial markets more than ever before, because of the central role that debt plays in virtually every facet of our modern financial markets. Thus, anyone who wants to be a serious student or practitioner in finance should at least become familiar with the current spectrum of fixed income securities and their associated derivatives and structural products.

This book is a fully revised and updated edition of two volumes used earlier in preparation for the Chartered Financial Analysts (CFA^®) program. However, in its current form, it goes beyond the original CFA role and provides an extraordinarily comprehensive, and yet quite readable, treatment of the key topics in fixed income analysis. This breadth and quality of its contents has been recognized by its inclusion as a basic text in the finance curriculum of major universities. Anyone who reads this book, either thoroughly or by dipping into the portions that are relevant at the moment, will surely reach new planes of knowledgeability about debt instruments and the liquidity they provide throughout the global financial markets.

I first began studying the bond market back in the 1960s. At that time, bonds were thought to be dull and uninteresting. I often encountered expressions of sympathy about having been misguided into one of the more moribund backwaters in finance. Indeed, a designer of one of the early bond market indexes (not me) gave a talk that started with a declaration that bonds were “dull, dull, dull!”

In those early days, the bond market consisted of debt issued by US Treasury, agencies, municipalities, or high grade corporations. The structure of these securities was generally quite “plain vanilla”: fixed coupons, specified maturities, straightforward call features, and some sinking funds. There was very little trading in the secondary market. New issues of tax exempt bonds were purchased by banks and individuals, while the taxable offerings were taken down by insurance companies and pension funds. And even though the total outstanding footings were quite sizeable relative to the equity market, the secondary market trading in bonds was miniscule relative to stocks.

Bonds were, for the most part, locked away in frozen portfolios. The coupons were still—literally—“clipped,” and submitted to receive interest payments (at that time, scissors were one of the key tools of bond portfolio management). This state of affairs reflected the environment of the day—the bond-buying institutions were quite traditional in their culture (the term “crusty” may be only slightly too harsh), bonds were viewed basically as a source of income rather than an opportunity for short-term return generation, and the high transaction costs in the corporate and municipal sectors dampened any prospective benefit from trading.

However, times change, and there is no area of finance that has witnessed a more rapid evolution—perhaps revolution would be more apt—than the fixed income markets. Interest rates have swept up and down across a range of values that was previously thought to be unimaginable. New instruments were introduced, shaped into standard formats, and then exploded to huge markets in their own right, both in terms of outstanding footings and the magnitude of daily trading. Structuring, swaps, and a variety of options have become integral components of the many forms of risk transfer that make today’s vibrant debt market possible.

In stark contrast to the plodding pace of bonds in the 1960s, this book takes the reader on an exciting tour of today’s modern debt market. The book begins with descriptions of the current tableau of debt securities. After this broad overview, which I recommend to everyone, the second chapter delves immediately into the fundamental question associated with any investment vehicle: What are the risks? Bonds have historically been viewed as a lower risk instrument relative to other markets such as equities and real estate. However, in today’s fixed income world, the derivative and structuring processes have spawned a veritable smorgasbord of investment opportunities, with returns and risks that range across an extremely wide spectrum.

The completion of the Treasury yield curve has given a new clarity to term structure and maturity risk. In turn, this has sharpened the identification of minimum risk investments for specific time periods. The Treasury curve’s more precisely defined term structure can then help in analyzing the spread behavior of non-Treasury securities. The non-Treasury market consists of corporate, agency, mortgage, municipal, and international credits. Its total now far exceeds the total supply of Treasury debt. To understand the credit/liquidity relationships across the various market segments, one must come to grips with the constellation of yield spreads that affects their pricing. Only then can then one begin to understand how a given debt security is valued and to appreciate the many-dimensional determinants of debt return and risk.

As one delves deeper into the multiple layers of fixed income valuation, it becomes evident that these same factors form the basis for analyzing all forms of investments, not just bonds. In every market, there are spot rates, forward rates, as well as the more aggregated yield measures. In the past, this structural approach may have been relegated to the domain of the arcane or the academic. In the current market, these more sophisticated approaches to capital structure and term effects are applied daily in the valuation process.

Whole new forms of securitized fixed income instruments have come into existence and grown to enormous size in the past few decades, for example, the mortgage backed, asset backed, and structured-loan sectors. These sectors have become critical to the flow of liquidity to households and to the global economy at large. To trace how liquidity and credit availability find their way through various channels to the ultimate demanders, it is critical to understand how these assets are structured, how they behave, and why various sources of funds are attracted to them.

Credit analysis is another area that has undergone radical evolution in the past few years. The simplistic standard ratio measures of yesteryear have been supplemented by market oriented analyses based upon option theory as well as new approaches to capital structure.

The active management of bond portfolios has become a huge business where sizeable funds are invested in an effort to garner returns in excess of standard benchmark indices. The fixed income markets are comprised of far more individual securities than the equity market. However, these securities are embedded in term structure/spread matrix that leads to much tighter and more reliable correlations. The fixed income manager can take advantage of these tighter correlations to construct compact portfolios to control the overall benchmark risk and still have ample room to pursue opportunistic positive alphas in terms of sector selection, yield curve placement, or credit spreads. There is a widespread belief that exploitable inefficiencies persist within the fixed income market because of the regulatory and/or functional constraints placed upon many of the major market participants. In more and more instances, these so-called alpha returns from active bond management are being “ported” via derivative overlays, possibly in a leveraged fashion, to any position in a fund’s asset allocation structure.

In terms of managing credit spreads and credit exposure, the development of credit default swaps (CDS) and other types of credit derivatives has grown at such an incredible pace that it now constitutes an important market in its own right. By facilitating the redistribution and diversification of credit risk, the CDS explosion has played a critical role in providing ongoing liquidity throughout the economy. These structure products and derivatives may have evolved from the fixed income market, but their role now reaches far afield, e.g., credit default swaps are being used by some equity managers as efficient alternative vehicles for hedging certain types of equity risks.

The worldwide maturing of pension funds in conjunction with a more stringent accounting/regulatory environment has created new management approaches such as surplus management, asset/liability management (ALM), or liability driven investment (LDI). These techniques incorporate the use of very long duration portfolios, various types of swaps and derivatives, as well as older forms of cash matching and immunization to reduce the fund’s exposure to fluctuations in nominal and/or real interest rates. With pension fund assets of both defined benefit and defined contribution variety amounting to over $14 trillion in the United States alone, it is imperative for any student of finance to understand these liabilities and their relationship to various fixed income vehicles.

With its long history as the primary organization in educating and credentialing finance professionals, CFA Institute is the ideal sponsor to provide a balanced and objective overview of this subject. Drawing upon its unique professional network, CFA Institute has been able to call upon the most authoritative sources in the field to develop, review, and update each chapter. The primary author and editor, Frank Fabozzi, is recognized as one of the most knowledgeable and prolific scholars across the entire spectrum of fixed income topics. Dr. Fabozzi has held positions at MIT, Yale, and the University of Pennsylvania, and has written articles in collaboration with Franco Modigliani, Harry Markowitz, Gifford Fong, Jack Malvey, Mark Anson, and many other noted authorities in fixed income. One could not hope for a better combination of editor/author and sponsor. It is no wonder that they have managed to produce such a valuable guide into the modern world of fixed income.

Over the past three decades, the changes in the debt market have been arguably far more revolutionary than that seen in equities or perhaps in any other financial market. Unfortunately, the broader development of this market and its extension into so many different arenas and forms has made it more difficult to achieve a reasonable level of knowledgeability. However, this highly readable, authoritative and comprehensive volume goes a long way towards this goal by enabling individuals to learn about this most fundamental of all markets. The more specialized sections will also prove to be a resource that practitioners will repeatedly dip into as the need arises in the course of their careers.

Martin L. Leibowitz
Managing Director
Morgan Stanley