Chapter 1 Bonds and Money-Market Instruments

1. FIXED-INCOME SECURITIES Chapter 1 Bonds and Money-Market Instruments

2. 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

3. Bond MarketsOverview • 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.

4. 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

5. Bond MarketsBond 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

6. coupon rate price maturity date Bond Markets A US T-Bond Description on Bloomberg yield

7. Bond MarketsBasis – 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

8. Bond Markets Basis – Computing the Rate • 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 • Conversion formulas

9. 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

10. Bond MarketsSettlement 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.

11. Bond Markets A Corporate Bond Description on Bloomberg

12. Bond Markets Floating Rate Notes • Floating-Rate Notes are bonds that bear floating coupon rates • 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 • Coupon rates can be determined in three ways • 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

13. 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

14. 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. • 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

15. Issuers of BondsVarious 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

16. BIS Data on Bonds • The Bank for International Settlements compiles quarterly statistics on securities markets, including fixed income securities. • http://www.bis.org/statistics/secstats.htm

17. 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

18. 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) • 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

19. 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: backed by the ‘full faith of credit’ of the issuer (taxing power) • Revenue bonds (riskier): issued to finance specific projects (airports, hospital, etc.)

20. Issuers of BondsCorporate 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 (Unsecured) • Preferred stocks • ‘Promises’ fixed dividend = coupon rate • Cannot force bankruptcy if no dividend paid

21. 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 discerndefault risk or simply react to events?

22. 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

23. Money MarketsMoney MarketsInstruments • Markets for short term debt • Highly marketable (liquid) • Low risk • Very large denominations • MM mutual funds accessible

24. 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

25. Money Markets CDs and CPs • Certificate of Deposit (CD) • Time deposit (penalty for early withdrawal) • Insured by Federal Deposit Insurance Corporation (FDIC) for $250,000 • 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

26. Money MarketsRepurchase 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

27. Money MarketsRepo -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

28. Money MarketsRepo -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

29. 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…