Introduction To Fixed Income Derivatives

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1 Introduction To Fixed Income Derivatives Derivative instruments offer numerous benefits to investment managers and the clients they serve. The goal of this paper is to give a high level overview of derivatives and their role in fixed income portfolios. While providing an introduction to fixed income derivatives, we highlight the immense growth of the market, the current uses of various derivative instruments, the issues currently facing the market as well as derivatives impact on fixed income portfolios. This paper is intended to be an educational piece in order to provide clarity to our clients on the complex instruments that are used to more effectively manage risk in their portfolios. Derivatives Defined Derivatives are financial instruments whose value depends on the value of an underlying financial instrument or security, with each instrument possessing its own features and provisions and serving a specific purpose in portfolios. Fixed income managers have come to use derivatives quite frequently in their portfolios. This paper provides an overview of the derivatives market, focusing on the growth and regulation of fixed income related derivatives, as well as some background on fixed income strategies that employ these instruments. As an entirely unique class of financial instruments, derivatives enable investors to obtain exposure to certain factors and/or manage various risks more effectively whether it is taking a view on credit, extending duration or hedging exposures in client portfolios. The derivatives market also offers numerous benefits to investment managers in that they are advantageous in reducing transaction costs, offering alternatives to transferring risk, and producing other forms of trading efficiency. Prior to the use of derivatives, the primary way for managers to manage credit risk was to buy or sell the physical assets. Derivatives, however, offer fixed income managers the ability to manage credit risk independently from their bond positions by separating the credit risk from the return streams by transferring credit exposure to another party. These benefits are not without risk and institutional investors must consider some of the potential risks associated with derivatives usage by fixed income managers. Derivatives have developed from minimal significance to playing a key role in virtually all financial markets. As Exhibit 1 on the following page illustrates, the size of the global over-thecounter (OTC) derivatives market was $592 trillion at the end of 2008, 12 times the size of the combined U.S. equity and fixed income markets. The immense growth of the market can be attributed to many factors, including innovations in financial theory the use of derivatives in new applications that explore uses beyond the management of price and event risk, and the growth of underlying risks beyond interest rate, currency, and equity markets to include credit and inflation as well. ENNISKNUPP STRENGTH FROM KNOWING SM 2009 Ennis, Knupp & Associates, Inc.

2 Exhibit 1 Growth of Total Derivatives Market, $800 $700 $ trillions notional outstanding $600 $500 $400 $300 $200 $100 $- Jun-98 Jun-99 Jun-00 Jun-01 Jun-02 Jun-03 Jun-04 Jun-05 Jun-06 Jun-07 Jun-08 Source: Bank for International Settlements The Role of Derivatives in Fixed Income Portfolios The most commonly used financial derivatives in fixed income portfolios are options, futures, forward contracts, and swaps. Managers typically implement these instruments in fixed income portfolios to hedge risks and to obtain exposure to securities in an efficient manner. Options are contracts between two counterparties that provide the owner, for a fee (premium), the right but not the obligation to buy or sell an underlying asset for a specified price over a specified period of time. Options allow investment managers to mitigate the risk of their portfolios and speculate on the movement of security prices or the volatility of asset prices. For example, suppose an investor purchases a call option on a corporate bond. This gives the investor the option to purchase that bond at a specified price for a specified period of time, hedging the risk of increasing bond prices. Alternatively, if the investor purchases a put option on a corporate bond, it gives them the right to sell the underlying bond at a specified price, hedging against the risk of a price decline. Buyers of options only risk the premium paid on the option while sellers of options have much higher risk profiles that are dependent upon the magnitude of price changes in relation to the specified strike price. A futures contract is an agreement between parties for a delayed delivery of a financial instrument where the buyer agrees to purchase and the seller agrees to deliver a specified product at a specified price at some point in time in the future. Investment managers use futures for hedging purposes or to gain exposure to a particular maturity along the yield curve which aides in the management of overall duration and yield curve management. Futures are traded on established exchanges and trades are cleared through a central clearinghouse. Forward contracts, much like futures, require the exchange of goods or securities between counterparties at a specified date in the future. The major difference between the two products lies in the manner in which they are traded. Forwards generally trade in an unregulated, over-the-counter market whereas futures trade through a clearinghouse and are regulated by an identifiable government agency. 2 -E NNISKNUPP STRENGTH FROM KNOWING SM 2009 Ennis, Knupp & Associates, Inc.

3 Mortgage To-Be-Announced (TBAs) are forward contracts for the purchase or sale of agency mortgage-backed securities (MBS) to be delivered at a future date. At the time of the trade, the identities of the actual pools of assets are unknown. The mortgage TBA market allows mortgage lenders to lock in mortgage rates while funding or hedging their origination pipelines by securitizing the originations in the secondary market. For example, an investor may purchase $200 million Fannie Mae mortgage-backed securities with a 5% coupon for a delivery in six months. The buyer will not know the exact details of the pools or underlying loans until two days prior to settlement, but will have exposure to agency MBS from the time it enters the agreement. Fixed income managers commonly use swaps, namely credit default swaps and interest rate swaps, as hedging vehicles, to gain synthetic exposure to particular securities, and to employ leverage. A swap is an agreement between parties to exchange sets of cash flows, securities, interest rates, or other risks over a period of time in the future. Credit default swaps (CDS) are considered to be insurance-like contracts in which one party pays an annual premium over a period of time in return for credit protection in the form of loss mitigation provided by the seller of the swap. In the event of default (EOD) by the underlying issuer, the seller of protection must effectively pay the buyer par value. If there is no EOD by the time of the contract s maturity, the seller of the protection pays nothing and has collected premiums. Credit default swaps are utilized in fixed income portfolios in order to gain credit exposure more cheaply versus the cash market, generating exposures that may not be available due to lack of issuance, and to reduce exposure to specific entities without selling the actual security. Buyers of protection insure their portfolio while sellers of protection accept credit risk, similar to the function of put options. Interest rate swaps are agreements between two counterparties to exchange periodic interest payments based on a predetermined dollar principal, or notional principal amount. Investors typically use interest rate swaps to capitalize on changes in interest rates and to manage fixed or floating assets and liabilities. Only interest cash flows are exchanged between counterparties, not the notional amount. For example, bank A agrees to pay bank B a fixed interest rate payment of 5% in exchange for floating interest rate payments of LIBOR + 50 basis points on a predetermined notional amount. Total return swaps are agreements in which one party makes payments to another based on a predetermined fixed or floating rate in exchange for the total return realized on a reference asset(s) such as bonds, an equity index, or underlying loans. Total return swaps allow managers to gain exposure to securities, markets and indexes and share in their total return without having to provide the capital to own the actual security or basket of assets. For example, bank A pays bank B the returns of the Barclays Capital Aggregate Bond Index basis points and receives the returns of the S&P 500 Index. Common Investment Manager Uses of Derivatives Investment managers utilize derivative instruments in several ways in client portfolios. The most prevalent reasons for using derivatives, as opposed to purchasing physical securities, are to hedge factor exposures, obtain synthetic exposure to a security, employ leverage, or obtain diversified exposure to a basket of securities. Investment managers and other market participants also look to the derivatives market to gain insight into available liquidity and the value of credit risk. Hedging Instrument. Hedging refers to an action taken that reduces a certain risk in a portfolio. Fixed income managers commonly use derivatives to hedge various exposures in portfolios. Risks that a manager may want to hedge include interest rate risk, credit risk, currency risk, or risks unique to mortgage-backed securities, such as prepayment and extension risk. Instruments such as futures, swaps, forward contracts, and options are used by managers for hedging purposes. For example, suppose a manager purchases several long-dated corporate bonds but wants to maintain an interest rate risk profile similar to that of its short-dated benchmark. The manager can enter into an interest rate swap that provides exposure to short-term rates at the expense of long-term rates to lessen its exposure to long-term interest rates. Another example of a transaction involving derivatives for 3 -E NNISKNUPP STRENGTH FROM KNOWING SM 2009 Ennis, Knupp & Associates, Inc.

4 hedging purposes involves currency risk. If a manager identifies an attractive local currency foreign bond but does not want to introduce currency volatility into the portfolio, the manager can sell a forward contract on the local currency to receive a fixed U.S. dollar rate, thus eliminating the exposure to the foreign currency. Leverage Vehicle. Leverage is the opposite of hedging in that it increases a certain risk in a portfolio rather than decreases it. While leverage is most commonly associated with opportunistic strategies such as hedge funds, transactions that introduce leverage are common in traditional long-only fixed income portfolios. Similar to hedged positions, leverage may be employed to increase the same set of risk factors while using the same set of derivative instruments. An example of a leveraged position that managers commonly employ appears in portfolios managed to an extended duration target. In those portfolios, a manager may purchase a number of physical bonds to achieve a diversified bond portfolio and purchase long-dated Treasury futures or enter into an interest rate swap that supplies long-term interest rate exposure at the expense of short-term interest rates. The manager will also have to manage a high-quality, short-term collateral pool to meet margin requirements, or collateral needed to cover the credit risk associated with obtaining the long-term interest rate position. The result is that the portfolio will be over-exposed to long-term interest rates, while a portion of assets will be managed as collateral. Synthetic Exposure. A manager may purchase or sell a derivative in order to achieve synthetic exposure to a security that the manager does not want to purchase in the cash market. Reasons for gaining exposure to a security synthetically may include cheaper transactions costs, liquidity issues associated with certain cash bonds, and the lack of supply of availability of certain physical bonds in the marketplace. A common example of managers utilizing derivatives to gain synthetic exposure to a corporate credit is by selling protection via a credit default swap (CDS) to gain exposure to the same credit risk as a physical corporate bond. If an investment manager wants to express a position on a small issue of a corporate bond, the cash market may not provide the liquidity necessary to build such a position in a timely fashion. Instead, the manager can buy a similar-maturity Treasury bond in the cash market and sell protection of a similar-maturity CDS of the corporation to capture the credit risk associated with the corporate bond issue. Managers can also utilize the derivative markets to gain synthetic exposure to long-term interest rates that the cash market does not provide. For example, by entering into an interest rate swap, an investment manager can extend its duration exposure to 35-, 40-, 45-, and 50-years, while the longest-dated bond available in the cash market has a 30-year term structure. An investment manager may utilize such swaps in an extended duration bond portfolio that is structured to match the duration profile of a liability stream with some long-dated obligations. Diversification. A manager may purchase or sell a derivative in order to achieve diversified exposure to a basket of securities instead of purchasing each security directly in the cash market. This is a common practice when an investment manager wants to gain exposure to an asset class, such as investment-grade or high yield corporate bonds, in a diversified manner with a small amount of money. Because the dollar amount is relatively small, transaction costs would be large if the underlying bonds were purchased in the cash market. Examples of such derivatives include CDX, which is the credit default swaps index, a derivative that tracks a basket of investment grade credit, high yield corporate, or emerging market debt; ABX.HE, the asset-backed credit derivative index that tracks baskets of home equity asset-backed securities; and CMBX, the commercial mortgage-backed securities derivative that offers exposure to various commercial mortgage-backed security indexes. Contemporary Issues Facing the Derivatives Markets The term derivatives often carries with it a negative connotation due to the complexity of the various instruments and the potential damage that can arise from excessive speculative activity. Not every derivative instrument merits a negative connotation, especially exchange-traded instruments such as futures and options that are collateralized by daily margin requirements mandated by the exchanges. Swaps, on the other hand, carry the potential to cause widespread problems to the capital markets, as we have witnessed with the collapse of Lehman 4 -E NNISKNUPP STRENGTH FROM KNOWING SM 2009 Ennis, Knupp & Associates, Inc.

5 Brothers and AIG. There are several factors that make such concerns well justified, including the size and growth of the swap markets, the lack of regulatory oversight, and counterparty risk. Futures and options are exchange-traded. The exchange serves several purposes: it provides a regulated environment in which the instruments can be purchased, sold and traded; it acts as a counterparty for all transactions; and it ensures that all parties meet minimum margin requirements on a daily basis. Swaps, on the other hand, are transactions that occur in the unregulated over-thecounter (OTC) market, i.e. through the investment bank dealer community. It is the responsibility of the two parties involved to vet the creditworthiness of the other party, which introduces another layer of risk to the instrument: counterparty risk, or the risk of nonpayment on the obligation. It is also the responsibility of the two parties to ensure the counterparty posts sufficient collateral in a timely manner to meet its financial obligations set forth in individual OTC transactions and master agreements. The Size and Growth of Swap Markets Derivative markets have grown exponentially since the beginning of the decade. Exhibit 2 illustrates the growth and size of the credit default swap (CDS) and derivatives referenced to currencies and interest rates. At the end of 2008, there was nearly $450 trillion in notional value outstanding of OTC derivatives tied to fixed income instruments. Exhibit 2 Growth of Fixed Income Derivative Markets, $ trillions notional outstanding Interest Rate & Currency Swaps and Options (LHS) 0 Jun-01 Dec-01 Jun-02 Dec-02 Jun-03 Dec-03 Jun-04 Dec-04 Jun-05 Dec-05 Jun-06 Dec-06 Jun-07 Dec-07 Jun-08 Dec-08 Credit Default Swaps (RHS) $ trillions notional outstanding - Source: ISDA 5 -E NNISKNUPP STRENGTH FROM KNOWING SM 2009 Ennis, Knupp & Associates, Inc.

6 To illustrate the potential problems that may arise from the size of the derivatives market, consider the following example. Exhibit 3 displays the size of the CDS market relative to other markets. Because the CDS market is roughly six times the size of the physical corporate bond market, most CDS contracts do not own the underlying reference entity. Exhibit 3 Total Market Value Outstanding, as of 12/31/ $ Trillions U.S. Corporate Bonds U.S. Stock Market (Wilshire 5000) Sources: SIFMA, ISDA, Wilshire Associates U.S. Bond Market Credit Default Swaps Prior to April 2009, there were two methods for settling a CDS contract: physical delivery of the underlying bond or cash settlement. If a corporation defaulted on its debt obligation, a credit default swap would be settled in one of the following two manners: 1) the buyer of the swap delivered the physical bond to the seller of the swap, who in turn delivered the face value of the bond to the buyer; or 2) the seller of the swap delivered the difference between the face value of the bond and the current market price of the underlying bond, without exchanging the physical bond that is referenced. As Exhibit 3 illustrates, with the credit default swap market over six times the size of the corporate bond market many market participants entered into swap agreements solely for speculative purposes as they did not own the underlying credit that the swap insured. Under the first settlement option above, when an issuer defaulted, there was the potential for buyers of protection rushing to purchase the underlying corporate bond in order to ensure physical delivery to the counterparty. This wave of buying artificially inflates the price of the underlying cash bond well beyond that of its intrinsic recovery value. This phenomenon occurred when Delphi filed for bankruptcy in 2005 and as a result of the recent credit crisis, ISDA has created an additional auction settlement process which is a standard part of new CDS contracts. If investors do not wish to settle their contracts via auction, they will have to opt-out. Lack of Regulatory Oversight As previously mentioned, swaps are traded in the over-the-counter marketplace, which makes it free from regulatory oversight. This presents several 6 -E NNISKNUPP STRENGTH FROM KNOWING SM 2009 Ennis, Knupp & Associates, Inc.

7 challenges to the swap market, especially as it pertains to trading the instruments and monitoring counterparties. Many problems arise from the lack of regulatory oversight: swaps are difficult to value because contracts are not standardized and there is no outside party that assures each counterparty meets their financial obligations. Since swap contracts are traded OTC, are not regulated, and are not standardized, pricing of the instruments is ambiguous. Exchange-traded derivatives are typically valued based on the last price of a trade involving the security and have relatively active bid-ask markets. Swaps, however, can be valued based on complex mathematical models, and not based on contracts that are traded in an organized market. The two parties may disagree on the valuation of the swap at any given time, making it difficult to assess the swap s value in real-time. Effectively, the market for a swap is negotiated between the dealer and the investor at that moment in time. As the price of the reference security changes, the value of the swap contract changes for both parties; one party is positively impacted by the change in price, and one party is negatively impacted by the change in price. To mitigate liquidity risk when the value of the swap changes, there are often margin calls requiring the posting of additional collateral. However, because the valuation of swaps is ambiguous, it is common for investment managers, counterparties, and custodians to disagree on the valuation of a swap. However, in October 2008 the CME Group, the world s largest derivatives exchange, and Citadel Investment Group, LLC, a leading investment and technology firm, announced a joint venture to reduce the lack of oversight and the amount of counterparty risk inherent in the current market environment for over-the-counter credit default swaps. The two firms will launch a joint venture company, CME Clearing, which will serve as an electronic trading platform for credit default swaps, serving as the clearinghouse for CDS trades. The creation of an oversight mechanism will result in more effective risk management and bring stability and standardization to the CDS market. Congress has also proposed a bill that would comprehensively regulate the OTC derivatives market by improving the transparency of these trades. The aim of the proposed legislation is to guard the financial system from derivative activities including fraud and market manipulation as well as other activities that pose excessive risks to the heath of the financial marketplace. Congress also wants to ensure that these instruments are not inappropriately marketed to unsophisticated investors and under this legislation, OTC derivatives would be required to be traded via regulated exchanges. Relevance to Fixed Income Investment Managers Fixed income investment managers must address all of the issues that face the OTC derivative markets when integrating such securities into client portfolios. These issues are broadly defined as counterparty risk. Counterparty risk refers to the risk that a counterparty will not meet its financial obligation set forth by the contract. This is a risk of instruments traded over the counter; exchange-traded derivative instruments do not carry this risk because the clearinghouse acts as the counterparty for all market participants in all transactions. Counterparty risk may come to fruition if a counterparty does not post sufficient collateral as the price of the underlying security changes or if it does not settle its obligation under the contract terms at the settlement dates. Investment managers usually dedicate intensive resources to monitoring counterparties. The credit research teams are responsible for monitoring the creditworthiness of the various counterparties, and work in conjunction with a committee to compile a list of counterparties that are approved for trading purposes. In addition, the managers must commit resources to several back-office operations, such as compliance systems and staff to monitor when the counterparty should be contacted to post collateral. 7 -E NNISKNUPP STRENGTH FROM KNOWING SM 2009 Ennis, Knupp & Associates, Inc.

8 The Impact of the Credit Crisis on Mortgage TBAs & Over-the-Counter Derivative Instruments The credit and liquidity crises that began in August 2007 have had interesting implications on the mortgage TBA, credit default, and interest rate swap markets. As institutions such as Fannie Mae, Freddie Mac, and AIG received support from the government and Lehman Brothers and Washington Mutual filed for bankruptcy protection, several intricacies regarding CDS and other swap contracts have been observed. Examples of such intricacies include the meltdown of the mortgage market due to illiquidity, treatment of default in a CDS contract, counterparty default, the concept of basis in cash-pay vs. derivative instruments, and observed negative swap spreads. Each of these events, as well as the implications that it may have had on fixed income portfolios, are discussed below. Mortgage TBAs: Illiquidity and Mark-to- Market Mortgage TBA trades are typically executed with the expectation of boosting the effective yield on mortgage holdings rather than holding the mortgagebacked securities outright. Instead of paying for the purchases immediately, portfolio managers set aside cash or cash equivalents for payment at a future date. In order for the buyer to make the trade, the price of the TBA should be discounted to current mortgage prices so that the combination of the interest earned on the earmarked cash plus the discount exceeds the coupon income that could have been received by holding mortgages outright. It is advantageous for the seller because it allows them to hedge their mortgage origination pipeline. While TBA positions provided better liquidity than cash mortgage pools, they were still negatively impacted due to the spread widening and illiquidity of agency mortgagebacked securities. The large majority of the underperformance related to mortgage TBA positions was due to the investment in "cash equivalent" securities that were intended to outperform the implied financing costs of owning the TBAs. Cash equivalents are typically securities with less than 1 year duration (e.g., T-bills, money markets, repurchase agreements, commercial paper, and structured products). The distressed nonagency mortgage paper within the structured product space is what contributed mostly to the fallout of the TBA market. While managers attempted to insulate themselves from risk by buying higher-quality floating-rate non-agency MBS, leveraged investors such as banks, hedge funds and other structured investors became forced sellers of the securities in order to raise capital. This resulted in lower mark-tomarket prices, creating a cycle of more margin calls and distressed pricing well below what is believed to be the intrinsic value. CDS Contracts: Credit Event The International Swaps and Derivatives Association (ISDA) defines a credit event as an action that necessitates the settlement of a CDS contract. ISDA identifies the following as credit events: 1) bankruptcy, 2) obligation acceleration, 3) obligation default, 4) failure to pay, 5) repudiation/moratorium, and 6) restructuring. However, it is possible for an entity to experience a credit event while not defaulting on the debt obligation that the contract references. For example, when Fannie Mae and Freddie Mac were placed in conservatorship by the federal government, it qualified as bankruptcy, and triggered a credit event. The government provided the entities capital in the form of preferred stock, which is lower in the capital structure to the senior and subordinated debt of the entities, and therefore the debt s market value rallied substantially on the news of the bondholder-friendly action. Exhibit 4 shows how Fannie Mae debt performed following the announcement of the federal government s capital interjection. However, CDS contracts referenced to the entities had to be settled. Therefore, if a manager s exposure to one of the entities was implemented by selling a CDS contract, the manager must work to receive (or pay) the necessary settlement or re-negotiate its contract to maintain exposure to the entity. Lehman Brothers: Counterparty Default When Lehman Brothers filed for Chapter 11 bankruptcy in September 2008, it also announced that it would be unable to settle its outstanding derivative contracts, which marked the first time that a large counterparty defaulted on all of its contractual obligations. The event had wide-ranging implications on clients fixed income portfolios. Lehman Brothers 8 -E NNISKNUPP STRENGTH FROM KNOWING SM 2009 Ennis, Knupp & Associates, Inc.

9 was the dealer for many mortgage TBA contracts, and its bankruptcy resulted in clients having exposure to a dealer that was unable to deliver the referenced security in the TBA contracts. Of course, Lehman Brothers also served as counterparty to a large number of interest rate and credit default swaps. As a result of its default on its swap contract obligations, clients began a process of netting, which refers to the procedure of offsetting its derivative positions with other contracts in its portfolio in which Lehman Brothers was the counterparty. For example, assume a fixed income portfolio contains two managers: Manager X and Manager Y. If Manager X owned an interest rate swap that was $150,000 outof-the-money, and Manager Y owned an interest rate swap that was $200,000 in-the-money, the client can direct the managers to offset the positions against each other, netting a gain of $50,000 from the two contracts. Exhibit 4 Fannie Mae Yield Curves Following a "Credit Event" 6 5 9/5/2008 Yield (%) 4 9/8/ Source: Bloomberg Term Basis Risk: Pricing Differences between Cash and Derivative Instruments As mentioned earlier, derivatives are instruments that derive their value from other securities. For example, in the case of a credit default swap, the value of the derivative contract can be calculated using a mathematical model that uses the market price of the referenced security (i.e., cash-pay corporate bond). In general, the prices of the derivative contract and the referenced cash-pay security are closely related (otherwise arbitrage opportunities exist). However, during the liquidity crisis that occurred in September and October 2008, the difference in price between the derivative instruments and the cash-pay securities increased markedly as spreads in the cash-pay market widened significantly more than the derivatives market. This was attributable to the capital requirements for initiating positions in each instrument: swaps require only a portion of the contract s notional value to be exchanged, while the cash-pay bonds require the entire amount to be paid when entering a position. Managers refer to the pricing difference between the instruments as basis, and some will even initiate positions based on a relative value analysis between the cash-pay and derivative instrument. For example, managers will decide whether it is more advantageous to purchase the physical security or to purchase Treasuries and sell protection on the physical security. 9 -E NNISKNUPP STRENGTH FROM KNOWING SM 2009 Ennis, Knupp & Associates, Inc.

10 The widening basis between cash-pay and derivative instruments has implications for fixed income portfolios in which credit default swaps are utilized. Most clients benchmark fixed income mandates against indices comprised of cash-pay securities (e.g., the Barclay s Capital Aggregate Index, the Barclay s Capital Long Government/Credit Index, etc.). If an investment manager expressed a position in a security through selling a CDS contract instead of owning the cash bond, that synthetic position fared better than the cash-pay security in the benchmark, all else equal. Other investment managers attempt to profit off the wide basis by purchasing cash-pay securities and also buying CDS contracts referenced to the security. By doing so, the manager eliminates the credit risk on the referenced security, and captures the basis by being long the cash-pay instrument. If the basis between the cash-pay security and the swap narrows, the manager profits from the position. This is an example of arbitrage referred to as a basis trade. Negative Swap Spreads: Theoretically Impossible? Swap spreads is a term that refers to the interest rate differential between a cash-pay security, such as a Treasury bond, and an interest rate swap referenced to the same bond. Recall that an interest rate swap is an instrument where one party pays a floating rate, typically referenced to LIBOR, in order to receive a fixed stream of cash flows. LIBOR is an acronym for the London Interbank Offered Rate, which is the interest rate that banks charge each other for overnight deposits. Because LIBOR has a credit element to it, interest rate swaps generally offer higher interest rates than cash-pay bonds to compensate investors for the higher level of credit risk embedded in swap-based interest rates. For example, interest rate swaps are priced based on expectations of future interest rate movements. However, actual movements do not always match expectations, hence the additional credit risk. The concept of a negative swap spread has long been viewed as theoretically impossible. The reason for this is that a negative swap spread implies that an investor s assets are safer when lending to a bank than lending to the federal government. In recent history, market data supported the theory until the negative spreads were observed during the credit crunch and liquidity crisis in late Exhibit 4.1 illustrates the level of swap spreads in an environment that is consistent with theory; swap spreads generally range from basis points. "Normal" Swap Spreads Exhibit % 5.0% 4.0% 3.0% 2.0% Interest Rate Swaps Treasury STRIPs Swap Spread 1.0% 0.0% Source: Barclays Global Investors 10 -E NNISKNUPP STRENGTH FROM KNOWING SM 2009 Ennis, Knupp & Associates, Inc.

11 Introduction To Fixed Income Derivatives Swap Spreads During Credit Crisis Exhibit % 5.0% 4.0% 3.0% 2.0% 1.0% Interest Rate Swaps Treasury STRIPs Swap Spread 0.0% -1.0% -2.0% Source: Barclays Global Investors Exhibit 4.2 illustrates the same set of yield curves as of October 29, 2008, in which swap spreads range from over 100 basis points at the short end of the yield curve to as little as -100 basis points near the 10-year portion of the yield curve. Exhibit 4.2 also suggests that this may be partly attributable to a pricing anomaly in the Treasury-based yield curve as opposed to the interest rate swap-based yield curve. Regardless, this phenomenon has implications for fixed income portfolios. In simple terms, the implication of this phenomenon is that interest rate swaps performed better than the referenced securities, all else equal. If a portfolio is benchmarked to an index that is comprised of cashpay securities and the investment manager held interest rate swap contracts, those positions were likely an out-of-benchmark source of relative value. Conversely, if a manager s portfolio is measured against a swap-based benchmark (which is common among long-dated liability aware portfolios) and the manager holds cash-pay securities, the manager s performance likely struggled on a relative basis. Managers are exploiting this anomaly by expressing trades that are similar to the CDS basis trades; investment managers identify that cash-pay securities offer better relative value than their swapbased counterparts. 11 ENNISKNUPP STRENGTH FROM KNOWING SM 2009 Ennis, Knupp & Associates, Inc.

12 Conclusion The derivatives market offers numerous benefits to investment managers and the clients they serve by providing the opportunity to manage risks more effectively. Investment managers creatively use derivative strategies in client portfolios in order to mitigate risk, employ leverage, gain synthetic exposure to securities, and diversify exposure. As the derivatives market has evolved, the instruments have become more complex in nature and their use has become increasingly common. We identified the most commonly used derivative instruments, their role in fixed income portfolios and pricing anomalies that can make them more or less attractive than cash-pay securities. We also outlined the potential risks of the over-the-counter swaps market given the lack of regulatory oversight. With respect to all derivative instruments, we encourage our clients to be cognizant of their exposure and the risks and rewards that are involved in using such instruments. The appropriate level of derivative exposure depends on a client s risk tolerance and portfolio objectives. Given the complexity of instruments, clients should discuss with their fixed income managers the current exposure to derivatives, the intended use within portfolios and appropriate guideline restrictions. Nikoa Milton Tom Brennan September E NNISKNUPP STRENGTH FROM KNOWING SM 2009 Ennis, Knupp & Associates, Inc.