The Handbook of

European Fixed
Income Securities
FRANK J. FABOZZI
MOORAD CHOUDHRY
EDITORS

John Wiley & Sons, Inc.



The Handbook of

European Fixed
Income Securities


THE FRANK J. FABOZZI SERIES
Fixed Income Securities, Second Edition by Frank J. Fabozzi
Focus on Value: A Corporate and Investor Guide to Wealth Creation by James L.
Grant and James A. Abate
Handbook of Global Fixed Income Calculations by Dragomir Krgin
Managing a Corporate Bond Portfolio by Leland E. Crabbe and Frank J. Fabozzi
Real Options and Option-Embedded Securities by William T. Moore
Capital Budgeting: Theory and Practice by Pamela P. Peterson and Frank J. Fabozzi
The Exchange-Traded Funds Manual by Gary L. Gastineau
Professional Perspectives on Fixed Income Portfolio Management, Volume 3 edited
by Frank J. Fabozzi
Investing in Emerging Fixed Income Markets edited by Frank J. Fabozzi and

Efstathia Pilarinu
Handbook of Alternative Assets by Mark J. P. Anson
The Exchange-Traded Funds Manual by Gary L. Gastineau
The Global Money Markets by Frank J. Fabozzi, Steven V. Mann, and
Moorad Choudhry
The Handbook of Financial Instruments edited by Frank J. Fabozzi
Collateralized Debt Obligations: Structures and Analysis by Laurie S. Goodman
and Frank J. Fabozzi
Interest Rate, Term Structure, and Valuation Modeling edited by Frank J. Fabozzi
Investment Performance Measurement by Bruce J. Feibel
The Handbook of Equity Style Management edited by T. Daniel Coggin and
Frank J. Fabozzi
The Theory and Practice of Investment Management edited by Frank J. Fabozzi and
Harry M. Markowitz
Foundations of Economic Value Added: Second Edition by James L. Grant
Financial Management and Analysis: Second Edition by Frank J. Fabozzi and
Pamela P. Peterson
Measuring and Controlling Interest Rate and Credit Risk: Second Edition by
Frank J. Fabozzi, Steven V. Mann, and Moorad Choudhry
Professional Perspectives on Fixed Income Portfolio Management, Volume 4 edited
by Frank J. Fabozzi


The Handbook of

European Fixed
Income Securities
FRANK J. FABOZZI
MOORAD CHOUDHRY
EDITORS


John Wiley & Sons, Inc.


Copyright © 2004 by Frank J. Fabozzi. All rights reserved.
Published by John Wiley & Sons, Inc., Hoboken, New Jersey
Published simultaneously in Canada
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ISBN: 0-471-43039-0

Printed in the United States of America
10 9 8 7 6 5 4 3 2 1



Contents

PREFACE
ABOUT THE EDITORS
CONTRIBUTING AUTHORS

ix
xi
xiii

SECTION ONE
Background
CHAPTER 1
Introduction to European Fixed Income Securities and Markets
Moorad Choudhry, Frank J. Fabozzi, and Steven V. Mann

1

3

CHAPTER 2
Bondholder Value versus Shareholder Value
Claus Huber

23

CHAPTER 3
Bond Pricing and Yield Measures

Frank J. Fabozzi and Steven V. Mann

41

CHAPTER 4
Measuring Interest Rate Risk
Frank J. Fabozzi and Steven V. Mann

89

SECTION TWO
Products
CHAPTER 5
The Euro Government Bond Market
Antonio Villarroya

141

143

v


vi

Contents

CHAPTER 6
The Eurobond Market
David Munves


167

CHAPTER 7
The German Pfandbrief and European Covered Bonds Market
Graham “Harry” Cross

201

CHAPTER 8
European Inflation-Linked Bonds
Barclays Capital Inflation-Linked Research Team

229

CHAPTER 9
The United Kingdom Gilts Market
Moorad Choudhry

283

CHAPTER 10
The European Repo Market
Moorad Choudhry

307

CHAPTER 11
European Residential Mortgage-Backed Securities
Phil Adams


355

CHAPTER 12
European Commercial Mortgage-Backed Securities
Phil Adams

391

CHAPTER 13
European Credit Card ABS
Markus Niemeier

407

CHAPTER 14
European Auto and Consumer Loan ABS
Markus Niemeier

431

CHAPTER 15
Structured Credit: Cash Flow and Synthetic CDOs
Oldrich Masek and Moorad Choudhry

453


Contents


vii

SECTION THREE
Interest Rate and Credit Derivatives

493

CHAPTER 16
European Interest Rate Futures: Instruments and Applications
Brian A. Eales

495

CHAPTER 17
Interest Rate Options
Lawrence Galitz

525

CHAPTER 18
Pricing Options on Interest Rate Instruments
Brian A. Eales and Radu Tunaru

569

CHAPTER 19
Interest Rate Swaps
Frank J. Fabozzi and Steven V. Mann

601


CHAPTER 20
A Practical Guide to Swap Curve Construction
Uri Ron

631

CHAPTER 21
Credit Derivatives
Richard Pereira, Rod Pienaar, and Moorad Choudhry

653

CHAPTER 22
The Pricing of Credit Default Swaps and Synthetic
Collateralized Debt Obligations
Greg Gentile, David Jefferds, and Warren Saft

691

SECTION FOUR
Portfolio Management
CHAPTER 23
Fixed Income Risk Modeling for Portfolio Managers
Ludovic Breger

723

725



viii

Contents

CHAPTER 24
An Empirical Analysis of the Domestic and Euro Yield Curve Dynamics
Lionel Martellini, Philippe Priaulet, and Stéphane Priaulet

753

CHAPTER 25
Tracking Error
William Lloyd, Bharath K. Manium, and Mats Gustavsson

775

CHAPTER 26
Portfolio Strategies for Outperforming a Benchmark
William T. Lloyd and Bharath K. Manium

803

CHAPTER 27
Credit in Bond Portfolios
Claus Huber and Helmut Kaiser

835

CHAPTER 28

Default and Recovery Rates in the Emerging European High-Yield Market
Mariarosa Verde

849

CHAPTER 29
Analysis and Evaluation of Corporate Bonds
Christoph Klein

873

SECTION FIVE
Legal Considerations

889

CHAPTER 30
Legal and Documentation Issues on Bonds Issuances
Lourdes Villar-Garcia and Trusha Patel

891

CHAPTER 31
Trust and Agency Services in the Debt Capital Markets
Nick Procter and Edmond Leedham

935

INDEX


955


Preface

he Handbook of European Fixed Income Securities provides extensive
and in-depth coverage of every aspect of the European fixed income
markets and their derivatives. It includes a description of products and conventions as well as quantitative coverage of valuation and analysis of each
instrument. Its focus is on the diversity of the product range across the markets, which presents features of interest for institutional investors worldwide. The emphasis is on both developed markets, such as the United
Kingdom and Germany government and corporate bond markets as well as
emerging markets in Eastern Europe, and includes instruments and institutions. Both plain “vanilla” and structured finance bond instruments are discussed in detail. There is also an extensive coverage of ancillary areas of
importance such as trust and agency services, and legal documentation
issues. The audience is primarily European institutional investors and portfolio managers worldwide who are diversifying into European instruments,
as well as US-based researchers and academics. A secondary audience is
students and market practitioners based in Europe, for whom no one book
covering all aspects of the European market currently exists.
This last point was behind the motivation for compiling this book.
We feel that there is no one book, aimed at both investors and practitioners, that covers every aspect of the European debt capital markets,
which in terms of diversity, if not size, is the key capital market in the
world. In our view there is a dearth of books written by European
authors and aimed at market practitioners that cover this market. To
facilitate this, we have assembled a field of over 30 authors, all leading
names in their field, who have contributed chapters to this book. They
represent investment bankers, traders, researchers, academics, and legal
counsel. With only a few exceptions, all contributors are based in
Europe. The diversity of contributors’ backgrounds reflects the nature
of our topic and helps us serve two different markets at once, practitioners (including investors and bankers) and students, each having their
own reason for buying this book.
Another motivation for this book was the importance of the market
itself. The advent of the euro currency has created a bond market of


T

ix


x

Preface

roughly equal size to the US dollar market; this is an important market
for global investors. There is also a growing interest in European markets among US and Asian investors: for instance, market statistics show
an increasing share of European issues held by US portfolio managers,
generating greater need for market information in this field. This we
hope we have achieved.
The book is grouped into the following sections:
Section One:
Section Two:
Section Three:
Section Four:
Section Five:

Background
Products
Interest Rate and Credit Derivatives
Portfolio Management
Legal Considerations

Within this broad field there is detailed coverage of specific areas of importance to institutional investors.
We would like to thank all authors for their contributions, as well as

Ruth Kentish and Paula Jacobsen for assistance with the editorial process,
and Dr. Chee Hau at JPMorgan Chase for reviewing drafts of Moorad
Choudhry’s chapters. Special thanks to Professor Steven Mann at the University of South Carolina, for assisting us in several aspects of this
project, in addition to his contribution of four chapters to this book.

Frank Fabozzi
Moorad Choudhry


About the Editors

Frank J. Fabozzi, Ph.D., CFA, CPA is the Frederick Frank Adjunct Professor of Finance in the School of Management at Yale University. Prior to
joining the Yale faculty, he was a Visiting Professor of Finance in the
Sloan School at MIT. Professor Fabozzi is a Fellow of the International
Center for Finance at Yale University and the editor of the Journal of
Portfolio Management. He earned a doctorate in economics from the City
University of New York in 1972. In 1994 he received an honorary doctorate of Humane Letters from Nova Southeastern University and in 2002
was inducted into the Fixed Income Analysts Society’s Hall of Fame. He is
the honorary advisor to the Chinese Asset Securitization Web site.
Moorad Choudhry is Head of Treasury at KBC Financial Products (UK)
Limited in London. He previously worked as a government bond trader
and Treasury trader at ABN Amro Hoare Govett Limited and Hambros
Bank Limited, and in structured finance services at JPMorgan Chase
Bank. Moorad is a Fellow of the Centre for Mathematical Trading and
Finance, CASS Business School, and a Fellow of the Securities Institute.
He is author of The Bond and Money Markets: Strategy, Trading, Analysis, and editor of the Journal of Bond Trading and Management.

xi




Contributing Authors

Phil Adams
Ludovic Breger
Moorad Choudhry
Graham “Harry” Cross
Brian A. Eales
Frank J. Fabozzi
Lawrence Galitz
Greg Gentile
Mats Gustavsson
Claus Huber
Inflation-Linked
Research Team
David Jefferds
Helmut Kaiser
Christoph Klein
Edmond Leedham
William T. Lloyd
Bharath K. Manium
Steven V. Mann
Lionel Martellini

Oldrich Masek
David Munves
Markus Niemeier
Trusha Patel
Richard Pereira
Rod Pienaar

Philippe Priaulet
Stéphane Priaulet
Nick Procter
Uri Ron

Barclays Capital
Barra, Inc.
CASS Business School, London
YieldCurve.com
London Metropolitan University
Yale University
ACF Consultants Ltd.
Lehman Brothers
Barclays Capital
Deutsche Bank
Barclays Capital
CREDITEX, Inc.
Deutsche Bank
Deutsche Asset Management
JPMorgan Chase Bank
Barclays Capital
Barclays Capital
University of South Carolina
University of Southern California and
EDHEC Risk and Asset Management
Research Center
JPMorgan Securities Ltd.
Lehman Brothers International
Barclays Capital
CIBC World Markets PLC

Dresdner Kleinwort Wasserstein, London
Deutsche Bank AG, London
HSBC-CCF and
University of Evry Val d’Essonne
AXA Investment Managers
JPMorgan Chase Bank
Bank of Canada

xiii


xiv
Warren Saft
Radu Tunaru
Mariarosa Verde
Lourdes Villar-Garcia
Antonio Villarroya

Contributing Authors

CREDITEX, Inc.
London Metropolitan University
Fitch Ratings
CIBC World Markets PLC
Merrill Lynch


SECTION

One

Background



CHAPTER

1

Introduction to European Fixed
Income Securities and Markets
Moorad Choudhry
Senior Fellow
Centre for Mathematical Trading and Finance
CASS Business School, London
Frank J. Fabozzi, Ph.D., CFA
Frederick Frank Adjunct Professor of Finance
School of Management
Yale University
Steven V. Mann, Ph.D.
Professor of Finance
Moore School of Business
University of South Carolina

bond is a debt capital market instrument issued by a borrower, who is
then required to repay to the lender/investor the amount borrowed plus
interest, over a specified period of time. Bonds are also known as fixed
income instruments, or fixed interest instruments in the sterling markets.
Usually bonds are considered to be those debt securities with terms to
maturity of over one year. Debt issued with a maturity of less than one year
is considered to be money market debt. There are many different types of

bonds that can be issued. The most common bond is the conventional (or
plain vanilla or bullet) bond. This is a bond paying periodic interest pay-

A

3


4

BACKGROUND

ments at a fixed rate over a fixed period to maturity or redemption, with
the return of principal (the par or nominal value of the bond) on the maturity date. All other bonds will be variations of this basic structure.
A bond is therefore a financial contract from the person or body that
has issued the bond, that is, the borrowed funds. Unlike shares or equity
capital, bonds carry no ownership privileges. The bond remains an interest-bearing obligation of the issuer until it is repaid, which is usually on
its maturity date.
There is a wide range of participants involved in the European
fixed-income markets. We can group them broadly into borrowers and
investors, plus the institutions and individuals who are part of the business of bond trading. Borrowers access the bond markets as part of their
financing requirements; hence borrowers can include sovereign governments, local authorities, public sector organisations and corporations.
Virtually all businesses operate with a financing structure that is a mixture of debt and equity finance. The debt finance may well contain a
form of bond finance, so it is easy to see what an important part of the
global economy the bond markets are.
The different types of bonds in the European market reflect the different types of issuers and their respective requirements. Some bonds are
safer investments than others. The advantage of bonds to an investor is
that they represent a fixed source of current income, with an assurance
of repayment of the loan on maturity. Bonds issued by developed country governments are deemed to be guaranteed investments in that the
final repayment is virtually certain. For a corporate bond, in the event of

default of the issuing entity, bondholders rank above shareholders for
compensation payments. There is lower risk associated with bonds compared to shares as an investment, and therefore almost invariably a
lower return in the long term.
In this chapter, we will provide a basic description of the various types
of fixed-income instruments encountered in the European markets as well
as the definitions of some key terms and concepts that will assist the reader
throughout the remainder of the book. Important groups of investors in
these markets are briefly discussed in the last section of the chapter.

DESCRIPTION OF THE BASIC FEATURES
A bond, like any security, can be thought of as a package of cash flows.
A bond’s cash flows come in two forms—coupon interest payments and
the maturity value or par value. In European markets, many bonds
deliver annual cash flows. As an illustration, consider a 6% coupon


Introduction to European Fixed Income Securities and Markets

EXHIBIT 1.1

5

Bloomberg Security Description Screen for a Spanish Government

Bond

Source: Bloomberg Financial Markets.

bond issued by the Spanish government that matures on 31 January
2008. Exhibit 1.1 presents the Bloomberg Security Description Screen

for this issue. The coupon rate is the rate of interest that is multiplied by
the maturity value to determine the size of the bond’s coupon payments.
Note that this bond delivers annual coupon payments. Suppose one
owns this bond in June 2003, what cash flows can the bondholder
expect between now and the maturity date assuming the maturity value
is A100? On each 31 January for the years 2004 through 2008, the
bondholder will receive annual coupon payments of A6. Moreover, on
the maturity date, the bondholder receives the maturity value of A100,
which is the bond’s terminal cash flow.

Type of Issuer
A primary distinguishing feature of a bond is its issuer. The nature of
the issuer will affect the way the bond is viewed in the market. There are
four issuers of bonds: sovereign governments and their agencies, local
government authorities, supranational bodies such as the World Bank,
and corporations. Within the corporate bond market there is a wide


6

EXHIBIT 1.2

BACKGROUND

Bloomberg Screen of the Benchmark Government Bonds of The

Netherlands

Source: Bloomberg Financial Markets.


range of issuers, each with differing abilities to satisfy their contractual
obligations to investors. The largest bond markets are those of sovereign borrowers, the government bond markets.
The most actively traded government securities for various maturities are called benchmark issues. Yields on these issues serve as reference
interest rates which are used extensively for pricing other securities.1
Exhibit 1.2 is a Bloomberg screen of the benchmark bonds issued by the
government of the Netherlands. European government bonds will be
discussed in Chapter 5. As an illustration of a corporate bond, Exhibit
1.3 shows a Bloomberg Security Description screen for 4.875% coupon
bond issued by Pirelli SPA that matures on 21 October 2008.

Term to Maturity
The term to maturity of a bond is the number of years after which the
issuer will repay the obligation. During the term the issuer will also
1

In some European countries, swap curves are used as a benchmark for pricing securities.


Introduction to European Fixed Income Securities and Markets

EXHIBIT 1.3

7

Bloomberg Security Description Screen for a Corporate Bond Issued

by Pirelli

Source: Bloomberg Financial Markets.


make periodic interest payments on the debt. The maturity of a bond
refers to the date that the debt will cease to exist, at which time the
issuer will redeem the bond by paying the principal. The practice in the
market is often to refer simply to a bond’s “term” or “maturity.” The
provisions under which a bond is issued may allow either the issuer or
investor to alter a bond’s term to maturity after a set notice period, and
such bonds need to be analysed in a different way. The term to maturity
is an important consideration in the makeup of a bond. It indicates the
time period over which the bondholder can expect to receive the coupon
payments and the number of years before the principal will be paid in
full. The bond’s yield also depends on the term to maturity. Finally, the
price of a bond will fluctuate over its life as yields in the market change
and as it approaches maturity. As we will discover later, the volatility of
a bond’s price is dependent on its maturity; assuming other factors constant, the longer a bond’s maturity the greater the price volatility resulting from a change in market yields.
One common way to distinguish between different sectors of the
debt markets is by the maturity of the instruments. The money market is


8

BACKGROUND

the market for short-term debt instruments with original maturities of
one year or less. This market includes such instruments as short-term
government debt, commercial paper, some medium-term notes, bankers’
acceptances, most certificates of deposit, and repurchase agreements.
According to the European Central Bank, as March 2003, the total
short-term debt outstanding (maturities of one year or less) in the Euro
area was A783.6 billion. Although this is an important sector of the
debt market, money market instruments are not covered in this book.2

Instead, our focus is on the capital market, which includes debt instruments that have original maturities of greater than one year.

Coupon Types
As noted, the coupon rate is the interest rate the issuer agrees to pay
each year. The coupon rate is used to determine the annual coupon payment which can be delivered to the bondholder once per year or in two
or more equal installments. As noted, for bonds issued in European
bond markets and the Eurobond markets, coupon payments are made
annually. Conversely, in the United Kingdom, United States, and Japan,
the usual practice is for the issuer to pay the coupon in two semiannual
installments. An important exception is structured products (e.g., assetbacked securities) which often deliver cash flows more frequently (e.g.,
quarterly, monthly).
Certain bonds do not make any coupon payments at all and these
issues are known as zero-coupon bonds. A zero-coupon bond has only one
cash flow which is the maturity value. Zero-coupon bonds are issued by
corporations and governments. Exhibit 1.4 shows a Bloomberg Security
Description screen of a zero-coupon bond issued by the French bank BNP
Paribus that matures March 11, 2005. Since the maturity value is A1,000,
the price will be at a discount to A1,000. The difference between the price
paid for the bond and the maturity value is the interest realized by the
bondholder. One important type of zero-coupon bond is called strips. In
essence, strips are government zero-coupon bonds. However, strips are
issued by governments directly but are created by dealer firms. Conventional coupon bonds can be stripped or broken apart into a series of individual cash flows which would then trade separately as zero-coupon
bonds. This is a common practice in European government bond markets.
Exhibit 1.5 presents a Bloomberg screen of some German government coupon strips. Since zero-coupon bonds can created from coupon payments or
the maturity value, a distinction is made between the two.
2

For a complete treatment of the money markets, see Frank J. Fabozzi, Steven V.
Mann, and Moorad Choudhry, The Global Money Markets (Hoboken, NJ: John
Wiley & Sons, Inc., 2002).