Chapter 3 debt markets

3.2.2 Treasury bills T-bills Estimating the Yield  The yield is influenced by the difference between the selling price and the purchase price.. 3.3 Treasury bond markets Bonds are oft

Financial Markets

and Institutions

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Chapter 3 Debt (fixed-income

sercurity) market

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 Debt securities market preview.

 Debt market Instruments: Treasury Bills, Commercial papers, (Negotiable Certificates of Deposit – NCDs, Repurchase Agreements, Banker’s Acceptance, Euro dollars

 Treasury Bonds market.

 Municipal Bonds market.

 Corporation Bonds market.

Institutions; Jeff Madura; South-Western Cengage Learning (2010).

Institutions- Federic S Mishkin, Stanley G Eakins; Pearson (2012).

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3.1 Debt security overview

 Debt security markets create profitableenvironment

 Debt security markets help institutions adjustingtheir payable balances

 Central Bank makes trading of open marketinstruments

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3.1 Debt security overview

 Debt securities transactions are made by:

3.2 Money market securities

3.2.1 Money market securities characters

 Money market securities are debt securities

with a maturity of one year or less.

 Issued by the Treasury, corporations, and

financial intermediaries that wish to obtain

short-term financing.

 High liquidity

 Popular money market securities: T-bills,

commercial paper, negotiable certificates of

deposit, repurchase agreements, Federal funds,

banker’s acceptances

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3.2 Money market securities

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3.2.2 Treasury bills (T-bills)

 Short-term securities, issued by the Treasury

 T-bills can be issued with 4-week, week, 26-week, or one-year maturities.

13- Virtually free of credit (default) risk

 Highly liquid

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3.2.2 Treasury bills (T-bills)

 Pricing Treasury Bills

 T-bills do not pay interest so they are sold at adiscount from their par value

 The price of a T-bill is the present value of thepar value that investors will receive in thefuture

 Investors are willing to pay a price for a T-billthat ensure that the amount they receive laterwill generate their desired return

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3.2.2 Treasury bills (T-bills)

 Pricing Treasury Bills

Example: If investors require a 7% annualized return on a one-year T-bill with a $10,000 par value, the price that they are willing to pay is

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79.345,

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$07

.1/000,

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3.2.2 Treasury bills (T-bills)

 Treasury Bill auction

 Primary T-bill market is an auction

 At the auction, investors have the option of biddingcompetitively or noncompetitively

 After accounting for non-competitive bids, theTreasury accepts the highest interest competitive bidsfirst and works it way down until it has generated theamount of funds from competitive bids that it needs

 The Treasury applies the lowest accepted bid price

to all competitive and non-competitive bids

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3.2.2 Treasury bills (T-bills)

 Estimating the Yield

 The yield is influenced by the difference between the selling price and the purchase price.

 If the investors hold the T-bills until maturity, the selling price is par value If not, the selling price is determined in the secondary market.

 Example: Assume an investor purchased a six-month T-bill with a $10,000 par value for $9000 and sold it 90 days later for $9,100 What is the yield? 13

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3.2.2 Treasury bills (T-bills)

 Estimating the T-bill discount

 Some business periodical quote the T-billdiscount along with the T-bill yield The T-billdiscount represents the percent discount of thepurchase price from par value for newly issuedT-bills and is computed as

 Example: newly issued three-month T-billswith a par value of $10,000 sold for $9,700.Compute the T-bill discount 14

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x Par

PP

Par discount

bill

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

3.2.3 Commercial paper (CP)

 CP is a short-term debt instrument issued only bywell-known, creditworthy firms and is typicallyunsecured

 Financing a firm’s investment in inventory andaccounts receivable

 The minimum denomination of CP is usually

$100,000 The typical denominations are inmultiples of $1 million

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3.2.3 Commercial paper (CP)

 Maturities are normally between 20 and 45 days

but can be as short as one day or as long as 270

days

 An active secondary market for CP is vey limited

However, it is sometimes possible to sell the paper

back to the deals who initially helped to place it

 Commercial paper is subject to credit risk

 Direct placement or through dealers

 Can be backed by assets or obtaining credit

guarantees from a sponsoring institution 16

3.2.3 Commercial paper (CP)

 Estimating the Yield

 Like T-bill, CP does not pay interest and is priced at a

discount from par value.

 At a given point time, the yield on CP is slightly higher

than the yield on T-bill with the same maturity Why?

 The nominal return to investors who retain the paper

until maturity is difference between the price paid for

the paper and the par value.

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3.2.4 Negotiable Certificates of

deposit (NCDs)

 NCDs are certificates that are issued by large

commercial banks and other institutions as a

short-term source of funds.

 The minimum denomination is $100,000, although a

$1 million denomination is more common.

 Maturities on NCDs normally range from 2 weeks to

one year.

 A secondary market for NCDs exists.

 Placement: directly; using a correspondent institution

that specializes in placing NCDs; or through

3.2.4 Negotiable Certificates of

deposit (NCDs)

 NCDs provide a return in the form of interest alongwith the difference between the price at which theNCD is redeemed (or sold in the secondary market)and purchase price

 Example: Investors purchased an NCD a year ago inthe secondary market for $990,000 He redeems ittoday upon maturity and receives $1,000,000 He alsoreceives interest of $40,000 His annualised yield on

3.2.5 Repurchase Agreement (Repo)

 With a Repo, one party sells securities to another with an

agreement to repurchase the securities at a specified date and price.

 A reverse repo refers to the purchase of securities by one

party from another with an agreement to sell them.

 The Repo transaction represents a loan backed by the securities.

 Most Repo transaction use government securities, although some involve other securities such as CP or NCDs.

 If the borrower defaults on the loan, the lender has claim to

3.2.5 Repurchase Agreement (Repo)

 The repo rate is determined by the difference

between the initial selling price of the securitiesand the agree-on repurchase price, annualized with

a 360-days year

 Example: An investor initially purchasedsecurities at a price of $992,000 while agreeing tosell them back at a price of $1,000,000 at the end

of a 60-day period What is the repo rate? 21

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x PP

PP

rate Repo  

3.2.6 Federal funds

 The Federal funds market enables depository institutions to lend or borrow short-term funds from each other at the so- called federal funds rate.

 This rate is influenced by the supply of and the demand for funds in the federal funds market.

 The federal funds rate is normally slightly higher than the T-bill rate at any given time.

 Most loan transactions are for $5 million or more and usually have a maturity of one to seven days.

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3.2.6 Banker’s acceptance (BA)

 A banker’s acceptance indicate that a bank acceptsresponsibility for a future payment

 An exporter that is selling goods to an importer whose credit rating is not known will often prefer that a bank act as a guarantor The bank therefore

facilitates the transaction by stampingACCEPTED on a draft, which obligates payment

at a specified point in time

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3.2.6 Banker’s acceptance (BA)

 Exporter can hold a banker’s acceptance until thedate at which payment is made, but theyfrequently sell BA before then at a discount toobtain cash immediately

 The investor who purchase BA the receives thepayment guaranteed by the bank in the future

 The investor’s return is derived from thedifference between the discounted price paid for

BA and the amount to be received in the future

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3.2.6 Banker’s acceptance (BA)

 Maturities on BA often range from 30 to 270 days

 BA’s return is above T-bill yield because the bankcan default on payment

 An active secondary market exists

 Steps involved in Banker’s Acceptances (Nextslide)

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Summary of commonly issued Money Market Securities

3.3 Treasury bond markets

 Bonds are often classified according to the type of issuer: Treasury bonds, federal agency bonds, municipal bonds, corporation bonds.

 Most bonds have maturities of between 10 and 30 years.

 Bonds are classified by ownership structure as either

bearer bonds or registered bonds.

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3.3 Treasury bond markets

Background on bonds

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3.3 Treasury bond markets

Bond yields

 Bond yields depend on whether it is viewed from the perspective of issuer of the bond or from the perspective of the investors.

 Yield from the Issuer’s Perspective: The issuer’s cost of

financing with bonds is commonly measured by the yield

to maturity, which reflects the annualized yield that is paid

by the issuer over the life of the bond.

 Yield from the Investor’s Perspective: Many investors

do not hold the bond a maturity and therefore focus on

their holding period returns.

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3.3 Treasury bond markets

 U.S Treasury commonly issues Treasury Notesand Treasury Bonds to finance federal governmentexpenditures

 The minimum denomination for Treasury notes orbonds is $100

 Note maturities are less than 10 years, whereasbond maturities are 10 years or more

 An active OTC secondary market

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3.3 Treasury bond markets

 The yield from holding a Treasury Bond, as withother bonds, depends on the coupon rate and on thedifference between the purchase price and theselling price

 Investors in Treasury Notes and Bonds receivesemiannual interest payments from the Treasury.The interest is taxed by federal government asordinal income, it is exempt from state and localtaxes, if any exist

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3.3 Treasury bond markets

Treasury bond auctions

 Bond offerings are conducted through periodicauctions

 Financial institutions submit bids (either competitive

or non-competitive bids)

 Treasury ranks the competitive bids in descendingorder All competitive bids are accepted until thedesired amount of funding is achieved

 Treasury has used the lowest accepted bid price asthe price applied to all accepted competitive bids andall noncompetitive bids

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3.3 Treasury bond markets

Special types of Treasury bonds

 Stripped Treasury bonds: Cash flows of bonds

are commonly transformed (stripped) by securitiesfirms to create two separate types of securities

 In these Stripped securities:

 One security represents the principal payment only (PO security).

 The second security represents the interest payments only (IO Security) or several IO securities that one IO security represents one interest payment only.

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3.3 Treasury bond markets

Special types of Treasury bonds

 InflationIndexed Treasury Bonds (or TIPS

-Treasury Inflation Protected Securities)

 Provide returns tied to the inflation rate

 The coupon rate offered on TIPS is lower than

the rate on typical Treasury bonds, but the

principal value is increased by the amount of the

U.S inflation rate every six months

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3.3 Treasury bond markets

Special types of Treasury bonds

 Example: Consider a 10-year inflation-indexed

bond that has a par value of $10,000 and couponrate of 4 percent Assume that during first sixmonths since the bond was issued, the inflationrate was 1%

The principal of the bond is increased by $100 (1%x$10,000) Thus, the coupon payment after 6 months will be 2% (half of yearly coupon rate) of new par value, or 2%x$10,100 = $202.

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3.3 Treasury bond markets

Special types of Treasury bonds

 The interest accumulates monthly and add value tothe amount received at the time of redemption 36

3.3 Treasury bond markets

Federal Agency bonds

 Federal Agency Bonds are issued by federal

agencies

 The Federal National Mortgage Association(Fannie Mae) and the Federal Home LoanMortgage Association (Freddie Mac) issue bondsand use the proceeds to purchase mortgages in thesecondary market

 These bonds are mortgage-backed securities(MBS)

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3.4 Municipal bond

 Issued by state & local government

 Classified as either General obligation Bonds or

Revenue Bonds.

 The minimum denomination is typically $5,000

 Their secondary market exists, but it is less activethan the one of Treasury bonds

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3.4 Municipal bond

Call provision

 Most municipal bonds contain a call provision,

which allows the issuer to repurchase the bonds at

a specified price before the bonds mature

 A municipality may exercise its option torepurchase the bonds if interest rate declinesubstantially because it can reissue bonds at thelower interest rate and reduce its cost of financing

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3.4 Municipal bonds

Variable-rate municipal bonds

 Variable-rate municipal bonds have a floatinginterest rate

 Some variable-rate municipal bonds are converted

to a fixed rate until maturity under specifiedconditions

 Benefit to the investors when the interest raterises, but disadvantage when the interest ratedeclines

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3.4 Municipal bond markets

Yield on Municipal bonds

 The yield differs from the yield on Treasury bondwith the same maturity for three reasons

 pay a risk premium to compensate for the possibility of default risk.

 Municipal bond must pay a slight premium to compensate for being less liquid than Treasury bond.

 Interest income earned from a municipal bond is exempt from federal taxes.

 Municipal bonds offer a lower yield thanTreasury bonds

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3.5 Corporate bond markets

 Corporate bonds are long-term debt securities issued by corporations.

 The minimum denomination is $1,000.

 Their maturity is typically between 10 and 30 years or even 100 years (Disney, AT&T and the Coca–Cola)

 Interest paid by company is tax-deductible to corporation, which reduces the cost of financing with bonds.

 The interest income earned on corporate bonds represents ordinary income and is therefore subject to federal taxes and to state taxes.

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3.5 Corporate bond markets

Characteristics of Corporate bonds

 Corporate bonds can be described according to avariety of characteristics

 The bond indenture is a legal documentspecifying the rights and obligations of both theissuing firm and the bondholders

 Bond are not as standardized as stocks with manydifferent maturities and payment terms

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3.5 Corporate bond markets

Characteristics of Corporate bonds

 Sinking-Fund provision: A requirement that the

firm retire a certain amount of the bond issue eachyear

 This provision is considered to be an advantage tothe remaining bondholders because it reduces thepayments necessary at maturity

 Example: A bond with 20 years until maturitycould have a provision to retire 5% of the bondissue each year

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3.5 Corporate bond markets

Characteristics of Corporate bonds

 Protective Covenants: restrictions on the issuing

firm that are designed to protect bondholders frombeing exposed to increasing risk during theinvestment period

 Frequently limit the amount of dividends andcorporate officers’ salaries the firm can pay andalso restrict the amount of additional debt the firmcan issue

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3.5 Corporate bond markets

Characteristics of Corporate bonds

 Call provision normally requires the firm to pay a

price above par value when it calls its bonds (callpremium) Call provisions have TWO principaluses

 First, the firm might end up paying a high rate of interest by selling a new issue of bonds when market interest rates decline.

 Second, a call provision may be used to retire bonds

as a required by a sinking-fund provision.

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