FIXED-INCOME SECURITIES
Chapter 1
Bonds and Money-Market Instruments
Outline • Overview of Bond Markets – Bond Characteristics – Floating-Rate Notes – Inflation-indexed bonds
• Issuers of Bonds – – – – –
Size of fixed-income markets Government Bonds Municipal Bonds Mortgage-Backed Securities Corporate Bonds
• Money-Markets • Other Fixed-Income Markets
Bond Markets Overview • Bonds are claims to a specified stream of income – Typically stream is ‘fixed’ (principal plus interest at an annual coupon rate) – Some ‘floating rate streams’
• Volatile interest rates in 80’s/90’s led to engineering of interest-rate contingent claims – – – –
Zeroes Adjustable rate bonds Bonds with embedded options Foreign currency bonds, etc.
Bond Markets Bond Characteristics
• A debt security (or a bond) is a financial claim by which – – – –
The issuer (or the borrower) is committed …. … to paying back to the bondholder (or the lender) … … the cash amount borrowed (called the principal) … … plus periodic interests calculated on this amount during a given period of time
Bond Markets Bond Characteristics: Indenture
• Bond Indenture – – – –
Coupon rate # payments per year Maturity Face Value
• Example – A US Treasury bond with coupon 3.5%, maturity date 11/15/2006 and a nominal issued amount of $18.8 billion … – … pays a semi-annual interest of $329 million ($18.8 billion times 3.5%/2) – … every six months until 11/15/2006 included, as well as $18.8 billion on the maturity date
coupon rate
price
maturity date
Bond Markets A US T-Bond Description on Bloomberg
yield
Bond Markets Basis – Computing the # of Days • Convention 1 – Actual /360 basis: exact # of days divided by 360 – Used on the money market – Example 764 days between 08/01/1999 and 09/03/2001
• Convention 2 – Actual/Actual basis: exact # of days divided by 365 or 366 – Used for computing accrued interest – Example: from 08/01/1999 to 09/03/2001, 152/365 + 1 + 246/365 = 2.0904
• Convention 3 – 30/360 basis : year divided into12 30-days month – Used on swap market – Example: from 01/01/2001 to 03/25/2001 : 2 x 30 + 24 = 84 days
• Convention on starting/end dates – Most deals start spot (j+2) – For week-ends and holydays: following day, preceding day, following day if same month, preceding day if same month
Bond Markets Basis – Computing the Rate • Conversion formulas 360 r360 = r365 × 365 365 r365 = r360 × 360
• Examples – r365 = 10% corresponds to r360 = 9.86% – r365 = 5% corresponds to r360 = 4.93% – r365 = 20% corresponds to r360 = 19.73% – Difference increases with rate
Bond Markets Settlement Date
• The settlement date is the date on which payment is due in exchange for the bond (used for interest computations) • It is generally equal to the trade date plus a number of working days • Examples:
Bond Markets Settlement Date - Examples – In the US, the settlement date for Treasury bonds and T-bills is equal to the trade date plus 1 working day – In the Euro zone, the settlement date for Treasury bonds is equal to the trade date plus 3 working days as it can be 1, 2 or 3 workings days for T-bills depending on the country under consideration – In the UK, the settlement date for Treasury bonds and T-bills is equal to the trade date plus 1 and 2 working days respectively – In Japan, the settlement date for Treasury bonds and T-bills is equal to the trade date plus 3 working days.
Bond Markets A Corporate Bond Description on Bloomberg
Bond Markets Floating Rate Notes •
Floating-Rate Notes are bonds that bear floating coupon rates – –
•
Coupon rates can be determined in three ways – – –
•
Floating-rate bonds : bonds with a coupon rate indexed on a short-term reference with a maturity inferior to one year (e.g., 3-month Libor rate) Variable-rate bonds or adjustable-rate bonds : bonds with a coupon rate indexed on a longer-term reference with a maturity superior to one year As the product of the last reference index value and a multiplicative margin As the sum of the last reference index value and an additive margin As a mix of the two previous indexations
Example –
– –
An investor buying a floating-rate bond whose coupon rate is equal to three-month Libor + 20bp is entitled to receiving, every period determined in the contract (usually every three months), a coupon payment The coupon rate will be reset every three months in order to reflect the new level of the three-month Libor Usually, the reset frequency is equal to the coupon payment frequency
Bond Markets Inverse Floaters • When the sign of the additive margin is negative, the bond is called an inverse floater – The coupon rate moves in the opposite direction to the reference index – So as to prevent it from becoming negative, a floor is determined that is usually equal to zero – Such bonds have become fairly popular under a context of decreasing interest rates
• Example – An investor buying an inverse floater whose coupon rate is equal to 16%-2 times 2-year T-Bond yield is entitled to receiving, every period determined in the contract (usually every year), a coupon payment – The coupon rate will be reset every two years in order to reflect the new level of the two-year bond yield
Bond Markets Inflation-Indexed Bonds • • • •
•
Inflation-indexed bonds deliver coupons and principal that are indexed on the future inflation rates They are structured so as to protect and increase an investor's purchasing power They are mainly issued by governments to make it clear they are willing to maintain a low inflation level They are more developed in the UK where they represent more than 20% of outstanding government bonds, versus only 7% in the US (1999) An inflation-indexed bond can be used to – –
hedge a portfolio against a rise in the inflation rate diversify a portfolio based on low correlation with stocks, fixed-coupon bonds and cash
Issuers of Bonds Various Issuers • US Treasury – T-Bill (maturity < 1 year) – T-Notes (maturity 2, 3, 5, 7 and 10 year) – T-Bonds (>10 years)
• Municipalities • Corporations • International Governments and Corporations
Issuers of Bonds Size of Fixed Income Markets Security Type
Market Value ($Bill, 1999Q1)
Treasury Securities U.S. Agencies
$3759.7 $1349.9
Bank Loans Mortgages Consumer Credit
$1,270.3 $5,780.5 $1,318.6
State/Local Govt Corporate & Foreign Bonds
$1481.6 $3627.7
Mortgage-Backed Pools Asset-Backed Pools
$2111.4 $1464.2
TOTAL FIXED INCOME Source: April 1999, Federal Reserve Bulletin
$22163.9
Issuers of Bonds Sector Breakdown (June 30, 2001)
Treasury Government Sponsored * Agency * Supranational Collateralized * Mortgage * Asset-Backed Credit * AAA/AA * A * BBB
Market weight 25.81% 12.06% 11.06% 1.00% 36.96% 36.13% 0.83% 25.16% 4.93% 11.48% 8.74%
Source : Salomon Smith Barney
Issuers of Bonds Government Securities • Treasury Bills – Pure discount securities placed through auction – Maturity 13, 26 and 52 weeks
• Treasury Notes and Bonds – – – –
Half coupon paid semi-annually Maturity 2, 3, 5, 7, 10 (notes) and 30 years (bonds) Sold in denominations of $1,000 Bonds may be callable
Issuers of Bonds Country breakdown of the JP Morgan Global Government Bond Index
â&#x201A;Źland * Japan US UK Canada Denmark Sweden Australia
Market Weights Market Weights Weights' evolution as of 06/01/01 as of 09/01/97 between 09/97 and 06/01 33.24% 30.94% +7.43% +105.67% 30.27% 14.72% -36.32% 25.37% 39.84% -13.87% 5.80% 6.73% 3.12% 3.11% 1.14% 1.80% 0.68% 1.74% 0.38% 1.12%
* Belgium, France, Germany, Italy, Netherlands, Spain Source : JP Morgan
Issuers of Bonds Agency Securities • Issued by different organizations – – – – – – –
Federal National Mortgage Association (Fannie Mae) Federal Home Loan Bank System (FHLBS), Federal Home Loan Mortgage Corporation (Freddie Mac) Farm Credit System (FCS) Student Loan Marketing association (Sallie Mae) Resolution Funding Corporation (REFCO) Tennessee Valley Authority (TVA)
• Agencies have at least two common features – First, they were created to fulfill a public purpose. – Second, the debt of most agencies is not guaranteed by the US government
Issuers of Bonds Municipal Bonds • Issued by state and local governments – Exempt from federal income tax – Exempt from (issuing) state local tax
• Types of ‘munis’ – General obligation bonds: baked by the ‘full faith of credit’ of the issuer (taxing power) – Revenue bonds (riskier): issued to finance specific projects (airports, hospital, etc.)
Issuers of Bonds Municipal Bonds (continued) • Who purchases municipal bonds? – T-bond pays 5% and municipal bond 3.8% – If (marginal) tax rate is 20%? 35%?
• After-tax return – MTR = 20%: (.05)x(.8) = .04 > .038 – MTR = 35%: (.05)x(.65) = .0325 < .038
• What MTR is indifferent (‘cutoff rate’)? (.05)x(1 - t) = .038 => t = .24 = 24%
Issuers of Bonds Corporate Bonds • Bonds issued by a corporation • Typically pay semi-annual coupons • 3 Sources of Risk – – –
Interest Rate Risk Default Risk Liquidity Risk
• Bond indenture contracts stipulate collateral and specify terms • Different “seniority” classes – Secured Bonds – Subordinated debentures – Debentures
• Preferred stocks – ‘Promises’ fixed dividend = coupon rate – Cannot force bankruptcy if no dividend paid
Issuers of Bonds Bond Quality • Standard & Poor, Moody’s and other firms score ‘the probability of continued & uninterrupted streams of interest & principal payments to investors’ • Classes of grades – Moody’s Investment Grades: Aaa,Aa,A,Baa – Moody’s Speculative Grades: Ba, B, Caa, Ca, C – Moody’s Default Class: D
• Are ratings agencies better able to discern default risk or simply react to events?
Issuers of Bonds Size of the Corporate Bond Markets - US and Europe Description USD Broad Investment Grade bond market USD Govt./Govt. Sponsored USD Collateralized USD Corporate USD Corporate (Large Capitalizations) USD Corporate AAA AA A BBB Description EUR Broad Investment Grade bond market EUR Govt./Govt. Sponsored EUR Collateralized EUR Corporate EUR Corporate (Large Capitalizations) EUR Corporate AAA AA A BBB
Par Amount (in billion USD) 6,110.51 2,498.23 2,216.73 1,395.56 869.96 1,395.56 35.33 200.81 653.76 505.65 Par Amount (in billion USD) 3,740.77 2,455.24 685.78 599.75 416.96 599.75 143.10 151.55 220.36 84.74
Weight (in %) 100.00 40.88 36.28 22.84 14.24 100.00 2.53 14.39 46.90 36.23 Weight (in %) 100.00 65.63 18.33 16.03 11.15 100.00 23.86 25.27 36.74 14.13
Issuers of Bonds Strips • Initially created by investment banks • Coupons are detached and principal and coupons sold individually – It used to imply a tax break – Not anymore, the law has changed – Even after the law changed, great success
• The government has its own program
Money Markets Money Markets Instruments • Markets for short term debt • Highly marketable (liquid) • Low risk • Very large denominations • MM mutual funds accessible
Money Markets T-bills • Treasury bills: short term gov. debt • Primary market: auction – Competitive bid: specify quantity and price (hope to bid low, not get ‘shut-out’) – Non-competitive bid: specify quantity (receive quantity at ‘average price’)
• Secondary market – Very liquid (low transactions costs) – Denomination = $10,000
Money Markets CDs and CPs • Certificate of Deposit (CD) – Time deposit (penalty for early withdrawal) – Insured by Federal Deposit Insurance Corporation (FDIC) for $100,000
• Commercial Paper – Company borrows from public – Short term, unsecured
• Banker’s Acceptances – Bank guarantees payment – Replaces firm’s credit with bank’s
• Repurchase Agreements (Repo’s) – Effectively an overnight, collateralized loan – Sell government securities, with promise to repurchase at slightly higher price tomorrow
Money Markets Repurchase Agreements • A repo is a way for an investor to borrow money – A commitment by the seller of a security (usually gvt security) to buy it back from the buyer at a specified price and at a given future date – Can be viewed as a collateralized loan, the collateral being the security
• Repo maturity – When repo maturity is one day, called overnight repo – When repo maturity exceeds one day, called term repo
• A reverse repo is a way for an investor to lend money – A reverse repo agreement is the same transaction viewed from the buyer's perspective – The repo desk acts as the intermediary between investors who want to borrow cash and lend securities and investors who want to lend cash and borrow securities – The repo rate is computed on an Actual/360 day-count basis
Money Markets Repo - Example • A German investor needs to borrow € 1 million – He lends € 1 million … – … of the 10-year Bund benchmark bond (i.e., the Bund 5% 07/04/2011 with a quoted price of 104.11, on 10/29/2001) … – … over 1 month at a repo rate of 4% – There is 160 days' accrued interest as of the starting date of the transaction
• Cash payments – At the beginning of the transaction, investor receives an amount of cash equal to the gross price of the bond times the nominal of the loan, that is (104.11+5x160/360)x1,000,000/100= € 1,063,322 – At the end of the transaction, in order to repurchase the securities he will pay the amount of cash borrowed plus the repo interest due over the period, that is 1,063,322 + 1,063,322 x 4 x 30/360= € 1,066,866
Money Markets Repo - Examples • Financing a long position – An investor wants to finance a long position of € 1 million Bund with coupon 5% and maturity date 07/04/2011 – Can purchase these securities and then lend them (repo transaction) – He will gain the coupon income of the securities he owns, that is € 1,000,000 x 5%/360 = € 138.89 a day – He will lose the repo rate, that is € 1,063,322 x 4%/360 = € 118.15 a day – His net gain per day equals $138.89 - 118.15 = € 20.74
• Financing a short position – An investor has to make a delivery of € 1 million Bund on his short sale position – He can borrow the securities through a reverse repo transaction, and then lend the money resulting from the short sale to the repo desk as collateral – Suppose the reverse repo rate is 4%, his net loss per day amounts to € 20.74
Other Fixed-Income Securities • • • • • • • • • •
Swaps (Chapter 10) Futures and forwards (Chapter 11) Bonds with embedded options (Chapter 14) Options (Chapter 14) Swaptions (Chapter 15) Caps, floors, collars (Chapter 15) Exotic options (Chapter 16) Credit derivatives (Chapter 16) Mortgage-Backed Securities (Chapter 17) etc…