Debt Markets Explained

Debt Markets

• A company producing electric cars may need short-term funds to cover raw materials, production costs, and employees' salaries during the 65 days it takes, on average, to receive payment after selling a car.
• A company planning to build a new factory for $200 million to double production within 10 years may need to borrow funds if it lacks the necessary cash.
• Both scenarios can be addressed theoretically through a financial intermediary like a commercial bank.
• In practice, the first scenario is usually solved using the money market by issuing a short-term debt security.
• To build the factory, the company could raise cash by selling a bond to investors in the bond market.
• In both scenarios, the company's debt increases, but in very different ways, and for very different purposes.
• These slides often deal with American markets, but can be translated for European markets by replacing "$ "with "€", "Fed or Federal Reserve" with "ECB or European Central Bank", and "US Treasury Department" with "National Treasuries."

Course Contents

• Session 2 focuses on the debt market with two parts: money markets and the bond markets.

The Money Markets

• Apple's Balance sheet includes : -Assets like Cash and Short Term Investments
  • Which is comprised of Cash, Cash Equivalents, and Short Term Investments
• The definition of "Cash" includes cash in transit, cash in banks, and petty cash.
• The meaning of "Cash Equivalents" includes deposits with financial service companies other than commercial banks, short-term paper and CDs (maturity less than 3 months), money market funds, and cash combined with highly liquid investments.
• A data point notes Apple had $74 billion in cash and short-term securities as of 2017.
• Almost $8 billion was in the form of deposited cash at banks.
• $12.3 billion was in "cash equivalents."
• The term "money market" can be considered a misnomer, as money (currency) is not actually traded in the money markets.
• Securities in this arena are short term with high liquidity and very low credit risk, and therefore close to being money.
• Money market instruments mature in one year or less (most mature in less than 120 days) and are usually sold in large denominations ( $1,000,000 or more) with low default risk.
• Investors/lenders buy money market securities providing them a place to warehouse excess funds for short periods of time and get a return, rather than keeping surpluses of cash with no return.
• Money Markets provide a way to solve the cash timing problems for institutions faced with asynchronization of cash flow.
• Borrowers sell money market securities, which provides them a temporary source of funds.
• Cash outflows (payments) and cash inflows (income) are not perfectly synchronized which may imply to cash shortages.
• An example is a firm that produces a good will first pay for inputs, employees, and storage of inputs but will be paid weeks after the sale; such asynchronization of cash flow can be settled by borrowing in Money Markets.

Participants

• The U.S. Treasury Department sells U.S. Treasury securities to fund the national debt.
• The Federal Reserve System buys and sells U.S. Treasury securities to control interest rates.
• Commercial banks purchase U.S. Treasury securities, sell certificates of deposit, make short-term loans, and offer money market investment accounts.
• Businesses buy and sell short-term securities to manage cash.
• Investment companies trade on behalf of commercial accounts.
• Finance companies lend funds to individuals.
• Insurance companies maintain liquidity for unexpected demands.
• Pension funds maintain funds in readiness for investment in stocks and bonds.
• Individuals sometimes buy money market mutual funds.
• Mutual funds allow small investors to participate by pooling funds to invest in large-denomination securities
• Except for the Federal Reserve, participants sell securities to obtain cash, while Federal Reserve sells or buys money market securities (T-bills) for monetary policy.

Money Market Instruments

• Specific instruments will be examined further: treasury bills, commercial papers/certificates of deposit, repurchase agreements, and the interbank market.

Treasury Bills

• They comprise debt securities issued by the U.S. Treasury to cover federal budget deficits that trade at a discount from their par value, representing implied interest without an explicit rate, and are called "Bon du Trésor à taux fixe et à intérêt précompté" or BTF in France
• Treasury bills are issued for 4, 13, 26, and 52 weeks with regular auctions usually occurring each Thursday and virtually default risk free given the liquid secondary market
• The formula for determining the cost of an interest-free money market security is: P = F(1 - idiscount * (n / 360)).
• Terminology: F = Face Value, idiscount = Discount Rate, and n = Days Until Maturity
• To calculate the discount rate: idiscount = (F - P)/ F x 360/n
• Key Concept highlight the fact that debt securities have specific interest rate and day-count conventions which one needs to understand the underlying instrument.
• The formula understates the return on T Bills; For example, paying 99 to receive 100 in one year: idiscount = ((100-99) / 100) X (360/360) = 1%.
• The return is more accurately computed as: F=PX(1+returnXduration) = 100 = 99 X(1+ return X1) so return= (100 / 99) -1 = 1.01%
• The investment rate is: i investment = (F - P / P) x 365 / n.
• It better reflects actual returns, using price in the denominator (366 days are used for leap years).
• Example: a 28-day T-bill selling for $996.37 with a $1,000 maturity value: idscount = (1,000-996.37/1000) * 360/28 = 4.67% i investment = (1,000 - 996.37/996.37) * 365/28 = 4.75%, this reflects the true return as 996.37 * (1+ 4.75 * 28/365) = 1,000

Commercial Paper and Certificates of Deposit

• Commercial paper is a note issued by a liquid company that has a maturity of up to 270 days, and the use of commercial paper increased in the 1980s due to the rising cost of bank loans but has decreased due to recent economic events; the market is still estimated to be over $0.85 trillion.
• Certificates of deposit share those concepts but are issued by financial institutions (banks, credit unions) and may rarely exceed 3 years; they also are generally less risky due to regulation and have lower returns due to the lower risk profile.

Repurchase Agreements (Repos)

• A form of collateralized short-term borrowing, a firm sells securities and agrees to buy them back a specified date (1 day) for a specified price.
• A firm borrows cash from the other and posts collateral against the performance of the loan.
• On day one the borrower gives back the cash repurchase of securities that the lender returns.
• Should the borrower default, the lender sells the securities, reducing risk and decreasing the rates (compared to classic loans).
• There is the fact that the borrower receives value below market, creating a spread with the difference between the amount loaned and the value declared as the haircut.
• While the most frequent transactions are for government securities, they can apply to all securities.
• Repo transactions exist via banks, non-banks, or traders. They are frequently used by companies that have limited liquidity needs, allowing them not to obligate assets.

Interbank Market

• Short-term funds (loaned or borrowed without question marks) between financial institutions usually exist for one day to meet reserve requirements as determined by central banks.
• Banks exceeding reserve requirements can frequently loan to those needing funds overnight.
• While these requirements set minimums that banks must maintain, the name "Fed Funds" is misleading as they (The funds) do not exist governmentally (federal), and are instead tied to holdings at the Federal Reserve Bank.
• Interest on these interbank transactions is a benchmark called the interbank rate.
• This rate is set by the supply between private banks (not controlled by Central Banks).
• Central Banks can manipulate this interest rate; for example, If the Fed buys bonds from banks, it may increase the supply of reserves and push down interest rates. They can conversely increase it through increased percentages.

Bond Market

• Bonds are essentially long-term (>1 year) debt securities.
• Used by issuers to borrow funds for long-term financing/investments and are purchased in parts.
• Issuers give regular interest payments, or coupons, and when a bond matures, issuers pay back the borrowed amount.
• Characteristics include a bond's coupon and maturity.
• Governments issue U.S. Treasury Notes and Bonds, UK Gilts, German Bunds, French Obligations Assimilables du Trésor (OATs), and Japanese Government Bonds (JGBs), while corporations issue domestic or eurobonds (investment grade or junk).
• These types of bonds are bought as instruments, in whole, by Pension funds, Insurance Companies, Hedge Funds and Households, but are often taken by countries too like Japan and China to invest in US Government bonds.
• -A typical coupon bond has annual or semi-annual interest payments in the form of coupons; the price of the bond is equal to the present value of the bond discounted at a discount rate which takes into account the riskiness of the bond.
• At maturity, the issuer pays par value to the bondholder. Bonds do have coupons with variable rates, such as Euribor 3M.

Specific Bond Types

• Perpetual bond are bonds where the principal is never repaid, making them sellable on the secondary market.
• Variable rate bonds or floating rate notes/FRN's have a coupon with interest rates such that at the start of each year the value can be determined.
• Mortgage Bonds have payments secured in the form of properties.
• There exist Callable bonds where the issuer can buy back (if rates decrease) and Puttable bonds where investors can sell back if they wish (if rates increase).
• Convertible Bond have an investor option to convert into issuer equity after a given period, creating an extra risk.
• Structured Bonds, which are complex financial profiles based on how things are going, such as "spread notes," which pay 3 times (rate20Y-rate2Y)
• There are also zero Coupons, which do not contain periodic payments, only a single principal paid at Maturity which tends to be in accordance with principles of finance as practiced by the religion of Islam.
• Eurobonds are issued in dollar denomination in euro markets that would rather have a dollar based bond.
• Green Bonds, on the other hand, consist of projects exclusively dedicated to climate, environment, or ecological programs which are generally increasing in demand (20 years old but exponentially improving due to investment demands and investor driven forces).

US Treasury Bonds

• The U.S. Treasury issues them to finance operations and has durations based on their designation (Treasury bills - less than one year, Treasury notes - 1- 10 years; Treasury bonds - 10 -30 years)
• The risk-free status is dependent on the Treasury having the ability to print money and low interest, along with an active secondary market although there is risk for inflation.

Corporate Bonds

• Issued by corporations can have semi-annual or annual coupons, and suite of potential interest that varies on the credit ratings.
• Rating Agencies (such as S&P, Moody's, and Fitch) grade and rate these bonds from high potential to low.
• The better the rating, the better the quality and rating of the bond.
• S&P defines this rating as a "forward-looking opinion about the creditworthiness of an obligor" with an underlying class.

Bond Ratings

• AAA/Aaa is the best quality with strong repayment capabilities. Grade differences begin to fall sharply as one goes further down the scale.
• BBB / Baa is a medium-grade potential, being neither well secured/protected and lacking long-term protections.
• At B, assurances in interest/principal payments decline, likely impairing financial obligations.
• CC is the class where they are speculatively speculative with higher risk, and C is the bottom of the bond scales where they are seen as almost certainly destined for bankruptcy.
• D grades imply "income bonds", with the presence of ratings designated by"+" / "-".

Bond Interest Rates and Junk Bonds

• Corporate Bond Interest Rates are influenced by the rating of the bond, meaning a bond will vary on the quality of the bonds.
• Corporate Debt rated below BBB (Baa) is referred to as ‘Junk’ and is only normally issued by potentially difficult financials not allowed for use by all investors, and it is a higher risk proposition to be a part of such a bond.

Bond Pricing

• This is no different from pricing other sets in today as pricing those cashflows relies on using the value of future worth using cashflow discounting:

  1. to identify flows,
  2. the "best" appropriate value for them,
  3. the discount of value of the rate. P= coupon/ (1+i) + coupon/(1+i) sq+ coupon(1+i) Cubed

  With (1+ i) as interest with coupon = (bond x rate x % )

• A formula that represents this calculation is = PV = nΣt=1 C / (1 + i)t + F / (1 + i)n Where the formula for PV bond can be simplified into: PV =( (I / i 1) ) + I / (1 + i) n

• An example of Bond Yield is as follows for a 1000 dollar potential with a yearly rate of 10.5, but with "only" 3 years to maturity, one must be very high and the rate (annual coupon rate) must equal 12 percent: 10* $100/ 1+1.2+ 2. * 1( 0^2 + 3. 3* 1/ . (0^3 1. Then the present rate can be (100 + 1000) is 951.96.

• Re-imagine; what would it be with the reimbursement of 102 potential of $1 +1,2 = 1 and what is the difference?

• Next, calculate what the differences might be 966.1.

• In conclusion, if the is 9%, it will be 1025.

• A semi-annual bond price needs the coupon by 2 since only half is paid at max, and the number is " n " and can be presented with a different equation: PVsemi = (1/i) + ( +)/ semi (1 +/ 2(

• But in the yearly payments the price is now different. 1/4 +2 )+ .

The Price/Yield relationship

• An increase negatively impacts the prices of the bond, such as when an investor may potentially sell what they got at that increase.

Coupon Rate and relationship to YTM

• Bonds pay when the rate is equal to the YTM. Discounting occurs when the bonds pay less than the YTM, and it becomes a premium when payments are higher than the YTM.
• The formula for yield to maturity YTM =C + (FV-CV) / N / ) / N FV +CV / 2( ) where:
• C means periodic coupon payment
• FV means face value.
• CV is current value.
• N means the number of years to maturity.
• Bonds rely on various outside interests as it attempts to gain more of a yield to maturity by its quality of both issuers + the market (liquidity) which can all be done through both interest + the quality of both issuers + the market, creating a very high bond potential that does pay if any rates change, or increase in yields through change + increase which can damage.

Bond Risks

• While yields are similar to credit risks, their main credit risk is the potential of defaulting due to no payment in a rate or in principle can be solved, for "some" by comparison of potential with the potential + risk found at Brazilian government bonds when issued

Bond Terminology

• Coupon Interest rate as a stated annual rate on the bond as designed.
• Face Value as having reached full potential for being both a potential "holder" in addition to being synonymous with the part sold.
• A Maturity comes when 2 things occur: the original number has reached its fullest, and a holder gets the potential face potential. Par is when the values align.
• YTM Yield in this case exists at fully held prices set to be as close to perfection as potential