Content

							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         yield
                 A US T-Bond Description on Bloomberg
                                               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
                                          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
   –   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
                                                        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
                       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
                                        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
                                            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
                                       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.)
                                              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 (Unsecured)
• 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
                                                 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 $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
                                              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…