Bonds and MoneyMarket Instruments

1

FIXED-INCOME SECURITIES

• Chapter 1
• Bonds and Money-Market Instruments

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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

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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 80s/90s led to
  engineering of interest-rate contingent claims
• Zeroes
• Adjustable rate bonds
• Bonds with embedded options
• Foreign currency bonds, etc.

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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

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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

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Bond Markets A US T-Bond Description on Bloomberg
price
coupon rate
maturity date
yield
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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 (j2)
• For week-ends and holydays following day,
  preceding day, following day if same
  month, preceding day if same month

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Bond Markets Basis Computing the Rate

• Conversion formulas

• 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

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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

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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.

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Bond Markets A Corporate Bond Description on
Bloomberg
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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

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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

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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

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Issuers of BondsVarious Issuers

• US Treasury
• T-Bill (maturity lt 1 year)
• T-Notes (maturity 2, 3, 5, 7 and 10 year)
• T-Bonds (gt10 years)
• Municipalities
• Corporations
• International Governments and Corporations

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Issuers of Bonds Size of Fixed Income Markets

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Issuers of Bonds Sector Breakdown (June 30,
2001)
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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

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Issuers of Bonds Country breakdown of the JP
Morgan Global Government Bond Index
Market Weights
Market Weights
Weights' evolution
as of 06/01/01
as of 09/01/97
between 09/97 and 06/01
land
33.24
30.94
7.43
Japan
30.27
14.72
105.67
US
25.37
39.84
-36.32
UK
-13.87
5.80
6.73
Canada
3.12
3.11
Denmark
1.14
1.80
Sweden
0.68
1.74
Australia
0.38
1.12
Belgium, France, Germany, Italy, Netherlands,
Spain
Source JP Morgan
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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

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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.)

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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

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Issuers of Bonds Bond Quality

• Standard Poor, Moodys and other firms score
  the probability of continued uninterrupted
  streams of interest principal payments to
  investors
• Classes of grades
• Moodys Investment Grades Aaa,Aa,A,Baa
• Moodys Speculative Grades Ba, B, Caa, Ca, C
• Moodys Default Class D
• Are ratings agencies better able to discern
  default risk or simply react to events?

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Issuers of Bonds Size of the Corporate Bond
Markets - US and Europe
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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

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Money MarketsMoney Markets Instruments

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

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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

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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
• Bankers Acceptances
• Bank guarantees payment
• Replaces firms credit with banks
• Repurchase Agreements (Repos)
• Effectively an overnight, collateralized loan
• Sell government securities, with promise to
  repurchase at slightly higher price tomorrow

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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

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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
• (104.115x160/360)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

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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

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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

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Bond Price Web Resources

• http//www.savingsbonds.gov/
• http//www.zionsbank.com/zd_bonds_less.jsp
• http//www.forbes.com/1998/02/24/feat.html