Debt Markets: Money and Bond Markets

Debt Markets

• Companies may need short-term funds to cover costs or long-term funds for expansion.
• Financial intermediaries like commercial banks can solve these situations.
• Short-term funding needs can be addressed by obtaining funds in the money market through short-term debt securities.
• Long-term projects can be financed by selling bonds in the bond market.
• Debt increases in both scenarios, but for different purposes.

Note on Market Translations

• Translate the following slides if dealing with European markets.
• Replace dollars with euros.
• Replace the Federal Reserve with the ECB/European Central Bank.
• Replace the US Treasury Department with National Treasuries.

Course Contents: Session 2 - The Debt Market

• Session 2 has two parts: Money Markets (2.1) and Bond Markets (2.2).

The Money Markets

• Apple's balance sheet shows large holdings of cash and short-term investments.
• Cash includes cash in transit, cash in banks, and petty cash.
• Cash equivalents include deposits with financial service companies (excluding commercial banks), short-term papers/CDs (maturity less than 3 months), money market funds, and highly liquid investments.
• As of 2017, Apple held $74 billion in cash and short-term securities.
• Around $8 billion was deposited in banks.
• Around $12.3 billion was held as cash equivalents.
• Money, or currency, is not actually traded in money markets, although it's often referred to as such
• Securities are short term, highly liquid, and low credit risk and very similar to actual money.

Money Markets Defined

• Money market instruments are usually sold in large denominations ($1,000,000+).
• Money market instruments have low default risk and mature in one year or less.
• Most mature within 120 days.

Purpose of the Money Markets

• Money markets allow investors/lenders to warehouse excess funds for short periods and earn a return.
• Borrowers can access a low-cost temporary source of funds.

Examples of Borrowers Needing Cash

• Cash flows are not perfectly synchronized, and money markets address cash problems stemming from asynchronization.
• A firm producing goods must pay for inputs, employees, and storage before being paid.
• Asynchronization generates a cash shortage that can be settled by borrowing from money markets.

Participants in the Money Markets

• U.S. Treasury Department sells securities to fund national debt.
• Federal Reserve buys/sells securities to control interest rates.
• Commercial banks buys Treasury securities, sells CDs, makes short-term loans, and offers money market accounts.
• Businesses buy/sell short-term securities for cash management.
• Investment firms trade on behalf of commercial accounts.
• Finance companies lend funds to individuals.
• Insurance firms maintain liquidity for unexpected demands.
• Pension funds maintain funds for investment in stocks/bonds.
• Individuals buy money market mutual funds.
• Money market mutual funds enable small investors to participate in the money market.
• Most participants sell money market securities to obtain cash, except the Federal Reserve.
• The Federal Reserve sells or buys securities (T bills) for monetary policy reasons.

Money Market Instruments

• Money market instruments include Treasury Bills, Commercial Papers/Certificates of Deposit, Repurchase Agreements, and the Interbank market.

Treasury Bills (T-Bills)

• These are debt securities issued by the US Treasury to cover government deficits, sold at a discount from par value (face value).
• An investor might pay $990 for a $1,000 bill and receive $1,000 at maturity.
• The difference between purchase price and face value represents implied interest and has no explicit interest rate.
• In France, treasury bills are known as "Bon du Trésor à taux fixe et à intérêt précompté" or BTF.
• Treasury bills are issued in terms of 4, 13, 26, and 52 week, and auctioned every Thursday.
• It has a liquid secondary market and are virtually default risk free.
• T-bills are officially quoted using a discount rate, not an actual interest rate.

  P = F(1 - (i_discount * n / 360))
  

  where:
  • P = price
  • F = face value
  • i_discount = discount rate
  • n = number of days until maturity.
• Debt securities follow specific interest rate and day-count conventions.
• A 360-day year convention is used, the formula understates the return because of the lower price paid.
• A better estimate of the yield of a treasury bill is the investment rate

  i_investment  = ((F − P) / P)  * (365/n)
  

• Investment rates are calculated using the actucal number of days per year (366 in leap years) and reflect the price in the denominator.
• Treasury Bill Interest Rate and the Inflation Rate are of note and trend year on year

Commercial Paper

• A commercial paper is a promissory note issued by creditworthy corporations with maturities up to 270 days (average around 30 days).
• Use of commercial paper increased significantly in the early 1980s because of the rising cost of bank loans.
• Volume of commercial paper has fallen significantly over the recent economic recession, with the annual rate being 0.85 trillion.
• Certificates of Deposit (CDs) are issued by financial institutions (bank, credit union).
• CDs should never exceed 3 years.
• Because of financial institutions being strictly regulated, they are less risky than corporations and give a lower return.
• A comparative return on Commercial Paper and the Prime Rate chart, taken from 1990-April 2016 indicates a trend.

Repurchase Agreements (Repos)

• Repos are form of collateralized short-term borrowing securities.
• A firm sells securities with an agreement to buy them back at a later date, usually after 1 day, to receive payment.
• In a no-default one-day repo, the borrower posts the collateral to borrow cash the cash lender gives back the collateral as the borrower repurchases.
• In the event of a borrower default, the lender liquidats the high quality securities.
• The borrower receives less than the market value of the securities, referring to a haircut, the difference between the loan amount and the value of the collateral in the form of government securities.
• If the borrower defaults and the lender sells the collateral, the operation can be performed by banks and non-banks.
• Companies with liquidity gaps frequently use repos where assets are not sold for re-investment.

Interbank Market

• Transfers short-term funds (loaned or borrowed without warranty) between institutions, typically one day.
• Used by banks to meet short-term reserve requirements.
• Central Banks set minimum reserve requirements institutions must maintain.
• Banks with excess reserves lend funds overnight to those in need.
• In France it's called "marché interbancaire" and “Fed Funds” in the USA.
• Funds are held in banks' accounts with the Federal Reserve bank, and are misleading as it has nothing to do with the federal government.
• The interest rate in these transactions is a benchmark called the interbank rate
• Factors of supply and demand set the rate.
• The Federal Reserve can influence the rate through it's adjustment.
• The Federal Reserve purchasing securities from banks increase reserves and push the rate down.
• The Federal Reserve can push the rate up through increasing the percentage of required reserves.

Bond Markets

• Part 2.2 is about Bond Markets.

What is a Bond?

• Bonds are debt securities with a maturity of over one year.
• Issuers use them to borrow funds for long-term financing.
• Investors purchase portions of the debt.
• Issuers provides coupon regularly until reimbursed when the bonds matures.
• Coupon and maturity are key.
• A bond may provide an annual or semi-annual interest through coupons.
• Bond issuers repays par value or face value of a bond at maturity.
• For a coupon bond, the par value and coupon rate are set are issuance.
• Typically the coupon is a constant, and the bondholders receives a regular coupon every year or set period of time.
• Some bonds have coupons which are variable-rate coupons that are floating-rate bond.
• Euribor can set the interest rate in a given currency.

Who Issues Bonds?

• Governments including treasury notes and bonds in the US.
• The UK issues Gilts, Germany issues Bund, France issues OAT, and Japan issues JGB.
• Corporations issue domestic and Eurobonds for investment grade vs junk.
• Government agencies issue municipal bonds, local authorities, etc.

Who Buys Bonds?

• Pension funds, life insurance companies, and hedge funds invest in bonds.
• Households invest mostly through funds.
• Governments, namely Japan and China, are relevant investors in US government bonds.

Specific Bond Types

• Perpetual bonds never have their principal repaid and to recover it, they must be sold on the secondary market
• Variable rate, or floating-rate notes (FRNs), have coupons linked to an interest rate.
• Payments of mortgage bonds are secured against property.
• Callable bonds can be bought back if rates decrease.
• Puttable bonds can be sold back if rates increase.
• convertible bonds can be converted into issuer equity after x years but risk is higher
• Structured bonds' payments form complex profiles, for "spread notes" that pay 3 times (rate20Y-rate2y).
• Zero coupon bonds only pay principal at maturity, and adhere to Islamic finance.
• Eurobonds are bonds that is issued in foreign currency.
• Green bonds fund projects that have environmental climates

US Treasury Bonds

• The U.S. Treasury issues notes and bonds to finance its operations.
• Types and maturities vary. Treasury bills mature in less than 1 year.
• Treasury notes mature in 1 to 10 years.
• Treasury bonds mature in 10 to 30 years.
• Treasury can print money, therefore, it is assumed to have no default risk with their bonds
• Treasury Bonds have low interest, but are considered risk-free because of it's very active, and consistent secondary market.

Corporate Bonds

• Corporations generally issue these and typically offer semi-annual coupons in the USA, but offer annual coupons in Europe.
• Risk varies with each bond.
• Risk and interest ranges come from low-risk bonds with good ratings (AAA) to higher-risk bonds with bad rating(BBB).
• Anything lower BBB is considered sub-investment grade debt.

Bond Ratings

• Ratings indicate a bond's credit quality
• The lower the risk of default, the higher the credit quality.
• Ratings are provided by independent rating services like Standard & Poor's, Moody's, and Fitch.
• S&P defines a credit rating as "a forward-looking opinion about the creditworthiness of an obligor" on financial obligations.

Bond Pricing

• In theory, it's like pricing and cash flow.
• Bond Prices measure today's, equal value or future cash flows
• For Bond pricing, it involves identifying cash flows, determining appropriate discount rates, calculating present value cash flow
• Formula to calculate PB of coupon bonds paying annual payments is:

       𝑃𝑟𝑖𝑐𝑒 𝑃 = 𝑃𝑉 = 𝐶/(1 + 𝑖) + 𝐶/(1 + 𝑖)^2 + 𝐶/(1 + 𝑖)^3 + ⋯+ 𝐶/(1 + 𝑖)^n + 𝑅/(1 + 𝑖)^n

• Variables:
  • C = Cashflows
  • PV = Value of bonds
  • P = Price
  • Reimbursement Price
  • i = yield to maturity referred to also as internal rates
  • n = maturity of bond

Bond Pricing Variants

• If the reimbursement rate is 102%, the reimbursement price is 102% of $1,000, to $1.020

Bond Pricing Annuity Rates

• When payments are an annuity, values are different.
• Formula for PV of bond is:

                       𝑃𝑉 = (𝐶/𝑖) * [1 − 1/(1 + 𝑖)^n] + F/(1 + 𝑖)^n        

PV Formula Adjustment

• Payments occur annually in the bond world, however, it needs to be adjusted to compensate
• A change from a yearly cash flows to an annual amount for each investment must occur by dividing half

          𝑃𝑉𝑠𝑒𝑚𝑖 = 𝐶/2/(1 + 𝑖/2) + 𝐶/2/(1 + 𝑖/2)² + 𝐶/2/(1 + 𝑖/2)³ + ⋯+ 𝐶/2/(1 + 𝑖/2)²ⁿ + F/(1 + 𝑖/2)²ⁿ

Interbank Market

• For annual bonds, bond price and yield to maturity share an inverse relationship which is non-linear.
• If the yield goes up, the price goes down and vice-versa.
• The risk measure is known as duration, which is the sensitivity of the changes in yield, which dictates the bond's duration

The Relationship Between Coupon Rate and YTM

• Selling of Bonds falls into three categories:
  • Discount rate: YTM > Coupon Rate
  • At Par: YTM = Coupon Rate
  • Premium-Bond relationship

Bond Price

• Changes in market rates means investor requires higher YTM
• Bonds that are sold after the change in market rates, have a lower rate and decrease in bond prices because investors require a higher YTM

Economics of the YTM

• The riskier the security, the higher the yield (YTM) required by investors
• The more liquid the market, the lower the yield asked investors for that security.
• The longer the maturity, the higher the yield required by investors.