Debt Markets: Money Market & Bond Market

Debt Markets

• Companies need debt markets for short-term and long-term financial needs, to cover costs like raw materials or to expand production.
• Both short-term and long-term financial needs can be addressed through financial intermediaries like commercial banks.

Money Market

• Short-term financial gaps can be closed using the money market, using short-term debt securities.
• The bond market can be used to raise cash by selling bonds to investors to finance long-term projects such as building a new factory.
• Issuing debt increases a company's debt, but for distinct reasons

Note for European Markets:

• Convert dollar ($) to Euro (€), and the Federal Reserve/Federal Reserve to the European Central Bank (ECB)
• Convert US Treasury Department to National Treasuries.

Course Contents

• Session 2 covers the debt market.
• Part 2.1 is about Money Markets.
• Part 2.2 is about Bond Markets.

Apple's Balance Sheet (example)

• In 2017, Apple had $74 billion in cash and short-term securities, approximately $8 billion deposited in banks, and $12.3 billion in "cash equivalents".
• Apple does not keep funds in its local bank.

Characteristics of the Money Market

• The "money market" term is a misnomer because money (currency) is not actively traded within money markets.
• Instruments are short term with high liquidity and very low credit risk.
• Usually sold in large denominations of $1,000,000 or more, with low default risk.
• Securities mature in one year or less from their issuance, most commonly within 120 days.

Purpose of the Money Market

• Designed for investors/lenders to warehouse excess funds for short periods, generating a return on surplus cash.
• Offers entities secure, temporary, and cheap funds.

Cash Needs in the Money Market

• Solves timing issues when cash inflows and outflows are not synchronized, leading to occasional shortfalls for firms.
• Firms can use short term borrowing in the money market to meet operational costs if payments are delayed

Money Market Participants

• U.S. Treasury Department: Sells U.S. Treasury securities to fund the national debt.
• Federal Reserve System: Controls interest rates by trading in U.S. Treasury securities.
• Commercial banks: Buy U.S. Treasury securities, sell certificates of deposit, make short-term loans, and offer money market investment accounts.
• Businesses: Manage cash by buying and selling short-term securities.
• Investment companies: Facilitate trades on behalf of commercial accounts.
• Finance companies: Lend funds to individuals.
• Insurance companies: Maintain liquid assets to meet unexpected demands.
• Pension Funds: Maintain readiness for investment in stocks and bonds via money market instruments.
• Individuals: They invest in money market mutual funds.
• Money market mutual funds: Aggregate funds from small investors to invest in larger-denomination securities.
• Most participants sell money market securities to gain cash.
• The Federal Reserve is the exception, engaging for monetary policy reasons.

Key Money Market Instruments

• Treasury Bills
• Commercial Paper/Certificates of Deposit
• Repurchase Agreements
• Interbank Market

Treasury Bills

• These are short-term debt securities issued by the U.S. Treasury to cover government budget deficits sold at a discount from their par value.
• Implied interest is the difference between the purchase price and face value.
• In France, they are called "Bon du Trésor à taux fixe et à intérêt précompté" (BTF).
• Treasury bills are offered in terms of 4, 13, 26, and 52 weeks.
• Bills are sold by auction every Thursday.
• Secondary market is very liquid due to the low risk of default.
• Bills are priced using a discount rate instead of paying separate interest.

Treasury Bill Pricing Formula

• P = F[1-(i_discount)(n/360)], used to determine price P, with F, the bills face value, i_discount, the discount rate, and n is the number of days until maturity.
• This equation is used to determine the discount rates for the securities
• Debt securities come with interest rate and conventions that you need to be aware of
• A 360-day year is an example of one such convention
• i_discount understates the return in this calculation
• A more accurate calculation is F = P x (1 + return x duration)

More Accurate Estimate of Yield

• Calculated as i_investment = (F-P)/P x 365/n
• Reflects the actual return better, and assumes 366 days in leap years.

Example rates

• You pay $996.37 for a 28 day T-Bill, worth $1,000 when you cash, here are the rates:
• i_discount = (1,000-996.37)/1,000 x 360/28 = 4.67%
• i_investment = (1,000 - 996.37)/ 996.37 x 365/28 = 4.75%
• i_investment shows the true return at 996.37 * (1 + 4.75% * 28/365)

Treasury bill and inflation rate

• Treasury bill interest rates are directly linked to inflation rates

Commercial Paper & Certificates of Deposit (CDs)

• The commercial paper is a note, issued by creditable corporation,
• Maturities occur up to 270 days, with an average of 30.
• Commercial paper use increased in the 1980s because of the increasing costs of bank loans.
• Commercial paper market large at well over $0.85 trillion outstanding, although, significantly affected by recession.

CDs notes

• These are issued by financial institution (bank, credit union),
• Their durations never exceed 3 years.
• Financial institutions are more regulated; CDs are lower risk but also lower return than commercial paper

Repurchase Agreements (Repos)

• Repos are collateralized short term borrowing, A firm sells securities and buys them back at an agreed time, usually after 1 day with an agreed price.
• Borrowers post collateral in exchange for cash.
• Lender returns the collateral to the borrower after the cash has been returned.
• A 'haircut' is the difference between the borrowed value and the securities market value.
• Collateral is usually high-quality government securities, it can include other varieties.
• Repos allows large dealers from banks/non-banks to borrow.
• Repos are heavily used by institutions with short-term liquidity gaps, so they don't have to sell assets/re-invest.

Interbank Market

• Concerns short-term funds (loaned/borrowed) between financial institutions, typically for one day without warranty).
• Used by banks to meet reserve requirements within their countries.
• Central banks, like the Federal Reserve or European Central Bank, set minimum bank reserve requirements using a % of deposits.

"Fed Funds"

• If a Bank has excess reserves, they can lend them to banks that don't.
• In France, the interbank market is called "marché interbancaire", in USA: “Fed Funds”.
• The term Fed Funds is misleading, as Fed funds don't really have anything to do with the federal government. The name comes from the fact that the funds are held at the banks' accounts with the Federal Reserve bank.
• Interbank rate, the rate of interest, is a benchmark interest rate, it is the cost to borrow these funds
• Rate in interbank market depends on supply and demand which means C.B.'s cannot directly control this rate
• However, C.B.'s indirectly manipulate, by adjusting the level of reserves.
• If the Fed purchases securities from banks, this pushes proceeds to the bank’s account/the supply of reserves up/the interbank rate down: which restarts the economy.
• C.B.'s also can increase the percentage of required reserves.

What is a Bond?

• Long-term debt security of > 1 year.
• Issuers use it to borrow for long-term investments.
• Investors can buy a slice of this debt.
• Issuers make interest payments to the investors (coupon).
• When the bond is over, they repay with the nominal, principal, or face value.
• Its two key features are the coupon and maturity.

Bond Issuers

• Governments: Issue Treasury notes and bonds in the U.S., Gilts in the U.K., Bunds in Germany, OATs In France, and JGBs in Japan.
• Corporations: Issue Domestic and Eurobonds with either an investment grade or junk rating.
• Government agencies: Issue municipal bonds, local authorities.

Bond Investors

• Primarily pension funds and life insurance companies, there are:
• Hedge funds
• Households (mostly through fund investments)
• Governments, examples, are Japan and China, specifically relevant with US government bonds.

Typical Coupon Bond

• These entail annual or semi-annual payments, called coupons.
• At bond maturity, the issuer pays the bond's par value to the bond holder
• the par value and rate are present when the bonds issue out.
• Bondholder receive the same rate for the bond lifetime, either yearly or bi-annually
• Some coupon bonds are variably-rate coupons i.e floating rate bonds to match interest rate like Euribor 3M.

Bonds With Special Attributes

• Perpetual: the principal never repaid.
• Variable rate (FRNs): coupons linked to interest rate
• Mortgage: payments secured against property.
• Callable: buyer can buy back at the set rate, usually if rates dropped.
• Puttable: investor sell back to the investor, commonly if rates going up.

Bonds-Further Attributes

• Convertible: buyer converts into issuer equity if/when risk increasing.
• Structured: includes complex attributes
• Zero Coupon: has those with no payment apart from final payment. only those bonds are accepted in Islamic finance.
• Eurobonds: issued in other nation's currency. mainly issues out in dollars as opposed to euros.
• Green: invested solely in projects that generate positive environmental/positive climate outcomes. market started 20 years prior and growing heavily.

US Treasury Bonds

• Used by U.S. Treasury issues notes and bonds.

Three Types

• Treasury bills: for less then one year
• Treasury notes: 1- 10 years
• Treasury bond 10- to 30 years.
• Low risks are associated with treasury bills as the treasury prints money to pay off issues.
• Low interest rates but that can often be considered risk-free, although inflation risk is still present
• Active in secondary market

Corporate Bonds

• They are issued by those, that offer semi-annual coupons in US, and annual in Europe.
• A bond grade impacts its interest rate.
• AAA are of low risk while BBB are of higher risk.
• All bonds rated below BBB are considered sub-investment grade debt.

Bond Ratings

• Ratings indicate credit quality by independent rating services like Standard & Poor’s, Moody’s, and Fitch who grade bonds and their qualities
• High ratings/the lower chance for default, create higher credit quality.
• The forward-looking opinion about the trustworthiness and commitment regarding specific monetary duties.
• Each of these agencies rate bonds, below is Standard & Poor/Moodys

Three A /Aaa

• Both are the respective agencies best quality and the highest rating. Capacity to pay interest and repay principal is extremely strong/has the smallest degree of investment risk.

Two A /Aa

• Both are the respective agencies high quality, they signify Very strong capacity to pay interest and repay principal however differs from AAA/Aaa in a small degree.

a

• Both agency respectively Strong capacity to pay interest and repay principal. Possess many favorable investment attributes and are considered upper-medium-grade obligations. Somewhat more susceptible to the adverse effects of changes in circumstances and economic conditions.

BBB /Baa

• Neither agency rated very high/low. An Adequate capacity to pay interest and repay principal is presented, may lack Long-term reliability and protective elements to secure interest and principal payments. BB/Ba Moderate:
• Ability to pay interest and repay principal which has Adverse business, economic, and financial conditions leading to a potential with financial obligations.

Bond Ratings Scale B to D

• B bonds lack desirable investment traits and has a high chance to cause impairment of finances.
• CCC/Caa bonds have Poor standing; a high vulnerability to default, thus the bond must depends on favorable business conditions.
• CC/Ca bonds represent high degrees of speculations, usually default, and have shortcomings.
• C bonds have lower class with poor prospects of obtaining any real form of investment level. It may be needed in situations of bankruptcy where service payments are continuous

Bond Ratings Cl/D/NR bonds

• Cl has bonds in situations where there is little to no income bonds on which no interest exists
• D bonds present a situation when there are Payment defaults
• NR stands for No public rating, that means there wasn't a request for grading. AA to CCC can be modified with rating to have + or -.

Graphs

• Lower graded Corporate Bonds Have Greater Interest Rates That Lower End

Junk Bonds

• Bonds Are rated below BBB (BBB and higher = investment grade)
• Normal bonds are issued by companies normally relatively very new, or have had financial issues to note.
• Not permitted to invest in junks for Trusts/insurance companies often.
• The upside is higher return but there are High amount of risks involved.

Bond Prices

• Requires finding Identify the cash flows
• Determinates discount price, the the future cash payments of bond value
• Bond price are calculated like any other cash flow
• Are linked to the its riskiness of the bond

More in-depth Bond Pricing

• Take a coupon bond that pays set returns, where all of the returns of bonds have that amount
• Price P = PV = C/(1 + i) + C/(1 + i)2 + C/(1 + i)3 … + C/(1 + i)ni + F/(1 + i)n
• C is the value to a coupon, and I bonds to maturity
• This equation has R the amount for the price for that bond
• C is the value for the total for any bonds
• I Is return or what the market deems at any potential point, that are also a the bonds total with the value from there

Example Bond Pricing Numbers

• bond with $1,000 with face value $1,000, with yearly 10% with those number payments:
• C = $1,000 with 10% value = 100*
• Discount the return on the bond, and its total for any bond values within the project
• Here is an example price for total
• $100/(1 + 12) + $100/(1 + 12)2 + $100/(1 + 12)3 Is calculated to 966.20$ worth of the bond prices all together

Example Bond Reimbursement Price

• Here's how the process affects numbers the bond that is a number in total prices for amount.
• A bond with face value $1,000, paying 12% will have:
• (C/2) = 10% ($1,000) = (100/year = (50 dollar per month
• *So i/2 = 6% each annual and annual value payment * Total Price to make up for numbers For each years, the price is 965.35$ worth on numbers All totals and the price totals out to an annual of nearly

Quick Bond Facts

• The more long-term a bond is, the higher its yield generally become

Price-Yield Relationship

• The sensitivity of the returns can influence the yield and the influence on the bond.
• The* bond is a bond when it changes has had as higher influence bonds that change due to the yield for the higher potential to a total that bonds will influence.

Bond Risk

• They are influenced and made for that potential that make it that it is the value you have been looking it influences the bond and it influence its higher potential.
• It shows that when the rate goes, down they have a good bond.

Coupon Rate and YTM

• The total between Coupon rate and Yield amounts are made to calculate on numbers.
• Relationship Between Price, Face and Returns
• -Bond Price is lower if P (price )< face, (discount)*
• Yield to maturity is that any returns made at the rates for the bond (If bond is held until maturity)

Factors

• Bond prices fluctuate for changes in interest rates or perceptions of credit quality, and these impact both discount returns, face returns, and at premium yields
• The higher the risk to the credit or the maturity can influences prices but it can also create higher chances
• As security, the price and yield relationship change
• Returns decrease can lead to any maturity and lower risk is also why all of this is important
• Returns will more then that rate may be potentially worth the effort if potentially well in control.