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 80s/90s 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 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

BIS Data on Bonds The Bank for International Settlements compiles quarterly statistics on securities markets, including fixed income securities. 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, 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? 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 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 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 Bond Price Web Resources

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