Fixed%20Income%20Market%20(1)

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Fixed Income Market (1)

• Week 13 November 9, 2005

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Fixed Income Markets
Source Flow of Funds 1995-2004
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Fixed Income Markets

• Government Debt
• U.S. Treasury
• Sponsored agencies
• State and local government debt
• Sovereign debt

4
Overview of Financial System
Money Markets
Various Financial Claims
Debt Markets
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U. S. Treasury Debt

• Treasury debt outstanding in June 2005
• Total outstanding 7.860 trillion
• Held by government 3.309
• Held by public 4.551
• Publicly held
• Marketable 4.013
• Non-marketable .515
• Savings bonds .204

Largely social security trust fund
Including Federal Reserve
Source Treasury Bulletin, Tables FD-1 to FD-4
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Marketable U.S. Debt June 2005

• Of the total 3.519 trillion
• T-Bills are 920 billion
• Notes are 2.272 trillion
• Bonds are 530 billion
• TIPS are 291 billion
• Treasury will begin seeling 30-year Treasury bond
  again

Source Treasury Bulletin, Tables FD-1 to FD-4
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Issues in Government Debt

• Does government borrowing cause inflation?
• Depends on central bank policy (monetizing the
  debt or printing money)
• One-time deficit produces one-time price
  increase, inflation requires sustained debt
  monetization
• Is total government liability reflected in debt?
  Unfunded pension liability and government
  guarantees are also liabilities

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Ricardian Equivalence

• Is government debt wealth?
• Private claim on public sector does it cancel
  out when sectors are aggregated (see previous
  slide)?
• What is the source of the value of government
  debt future taxes
• Ricardian Equivalence (named after David
  Ricardo) argues that public recognizes that
  future taxes will increase if government debt
  increases and hence government debt is not wealth
  and does not influence the level of interest rates

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Agency Bonds

• Budget agencies, e.g. Tennessee Valley Authority
  (TVA)
• Government-sponsored enterprises (Federal
  National Mortgage Association, FNMA, and Federal
  Home Loan Bank, FHLB)
• Mortgage-backed securities issued by FNMA, FHLB,
  and Federal Home Loan Mortgage Corporation
  (FHLMC), and Farmers Home Administration

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History of FNMA and FHLMC

• Federal Housing Administration (1934) and
  Veterans Administration (1944) provided
  government-guaranteed mortgages following certain
  standards (called FHA-VA or guaranteed or
  conforming loans)
• FNMA and guarantor General National Mortgage
  Association (GNMA or Ginnie Mae) functions were
  separated in 1968 and FNMA became private firm

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Agencies

• FNMA Fannie Mae is a stockholder owned
  corporation trading on the NYSE
• FHLB system is member-owned, before 1989
  predominantly lent to savings and loans in the
  form of advances, and now open to all financial
  institutions
• FHLMC Freddie Mac established (1970) as a
  non-guaranteed (conventional) mortgage
  counterpart to FNMA

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Agency Issues

• Direct borrowings from capital markets, like FHLB
  issues used for advances to members
• Government guaranteed pools of mortgages like
  GNMA and FNMA issues
• The extent of the U.S. government commitment to
  make payments of agencies is not backed by the
  full faith and credit of the Treasury, hence
  there is default risk

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Agency Market since 1968
Source Flow of Funds 1995-2004
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Sponsored Agency Controversy

• FNMA, FHLBB and FHLMC borrow at the agency rate
  which is only slightly higher than the Treasury
  rate
• Agencies compete with private firms in financing
  home mortgages
• Agencies are not subjected to same regulatory and
  capital review as private financial institutions

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Agency Controversy (continued)

• Balance sheets of FNMA, FHLMC, and FHLB reflect
  agency debt used to invest in loans and
  mortgages, implying a valuable government
  guarantee on borrowings
• Agencies and GNMA also guarantee loans
• The implicit government liability is estimated in
  the trillions of dollars
• Agencies accused of accounting irregularities
  (associate with hedging activities) and with
  having too little capital

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Role of Agencies

• Huge organizations have been able to establish
  standards and possibly realize economies of scale
• Agencies have been very innovative
• Trade mortgages and form pools
• Make loan commitments
• Would private sector have been as innovative?

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Taxation

• U.S. debt is taxed at both state and federal
  level
• Debt of state and local governments is not taxed
  at the federal level and may not be taxed at the
  state level (depends on state)
• Qualifying debt of state and local governments
  (municipalities) are therefore called tax-exempt
  issues or municipal bonds

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Tax-Exempts After-Tax Yield

• Two ways to look at the impact of municipal debt
  tax treatment
• Example, 39 tax rate tax-exempt yield of 4.93
  (26-year CA InfrEconDevBayAr quoted November 6,
  2003)

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Implicit Tax Rate

• Compare the before-tax yield equivalent of 8.08
  in the previous example to the 26-year Treasury
  on the same date, 5.36
• The tax rate which makes taxable Treasury yields
  equal to the tax-exempt rate is called the
  implicit tax rate, calculated
• Investors with tax rates higher than the implicit
  rate earn higher after-tax returns

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Types of Municipals

• Short-maturity municipals
• Tax anticipation notes and bond anticipation
  notes are short term and will be repaid out of
  the next tax collection cycle or financing
• Municipal bonds can have legal restrictions like
  not being used to finance long-term deficits
• Long-maturity municipals
• General obligation (GOs) are secured by the
  overall taxing authority of the issuer
• Revenue bonds are paid out of specific revenues
  streams, like toll roads, dormitories, etc.

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Banks and Municipals

• Even prior to GLB Act of 1999, banks could
  underwrite and make markets in general
  obligations bonds (GOs) and banks were major
  players
• Until the Tax Reform Act of 1986, banks also
  could deduct all interest on deposits and
  borrowed funds even though some funds were
  invested in tax-exempts, a tax arbitrage, and
  other corporations could not

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Municipal Market before 1986

• Tax arbitrage by municipalities borrowing and
  investing proceeds in U.S. Treasuries (for
  construction accounts, etc.)
• Tax arbitrage by municipalities financing
  industrial development using industrial
  development bonds
• Federal subsidies through allowance of pollution
  control bond financing of investments in
  pollution control equipment

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Tax Reform Act of 1986

• Motivation simplify tax code and reduce hidden
  subsidies and tax breaks
• Removed many advantages of investment in
  municipal bonds for banks (allocate interest
  expense to tax-exempt investments)
• Strictly limited opportunities for tax arbitrage
• Effects of tax changes on municipal market

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Municipal Market 1982-2004
Source Flow of Funds Includes loans
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Sovereign (Foreign) Debt

• Foreign government debt
• Most countries issue more debt as percent of GDP
  than United States
• Markets for major countries are well developed
  (e.g. Japan, Germany, United Kingdom)
• Emerging markets may be less well developed
• Latin America and monetization of debt
• Low deficits and undeveloped debt markets in Asia
• Domestic policies and regulations
• Currency denomination

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International Organizations

• International Bank for Reconstruction and
  Development (IBRD or World Bank) borrows
  billions, innovates in debt markets
• 17 billion in 2001 (232 deals in 9 currencies,
  with maturities of 1 to 30 years and average of
  6.5 years)
• 65 billion in 1998 to 2000 in total borrowings
• Backed by IBRDs 183 sovereign shareholders
• Other regional development banks

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Next Week Nov. 16, 2005

• Read Chapter 21 and 22 for next week
• Remember due date on group project is November 30
  
• Final is scheduled on December 7, 2005 700 to
  900pm
• Review text readings, but also my objectives,
  vocabulary, and slides, they reflect my emphasis
  in course materials