Debt Markets: Money Markets and Bond Markets

Debt Markets

• Situations needing financial solutions can involve short-term or long-term funding.
• Short-term needs are often met through the money market via short-term debt securities.
• Long-term needs, like building a factory for $200 million, can be addressed by selling bonds in the bond market.
• Both approaches increase the company's debt, but serve different purposes.

Adapting to European Markets

• Convert dollar ($) references to euro (€) when considering European markets.
• Replace the Federal Reserve with the European Central Bank (ECB).
• Replace the US Treasury Department with National Treasuries.

Course Content: Debt Market

• Session 2 focuses on the debt market.
• Includes money markets (Part 2.1).
• Includes bond markets (Part 2.2).

Apple's Balance Sheet Example

• Apple had $74 billion in cash and short-term securities in 2017.
• Almost $8 billion of this was in cash deposits.
• $12.3 billion was in "cash equivalents".
• Cash includes things like cash in transit, cash in banks and petty cash.
• Cash equivalents include deposits with financial service companies (not commercial banks), short-term papers and CDs (with maturity in less than 3 months), as well as money market funds.

Money Markets Overview

• The term "money market" can be misleading
• Money (currency) isn't traded there.
• Securities in the money market are short term, highly liquid, with very low credit risk.
• Money market securities are sold in large denominations, such as $1,000,000.
• They mature in a year or less with most maturing in less than 120 days.

Money Market Function

• Investors/lenders utilize money market securities for short-term warehousing of excess funds to earn a return.
• Borrowers use them for a low-cost, temporary fundraising solution.
• Money markets help managing cash flow timing issues for institutions.
• A non-financial institution has to pay the inputs, employees, and stockage of inputs before its products are sold.
• This creates a cash shortage that can be counteracted by borrowing from the money markets.

Money Market Participants

• U.S. Treasury sells securities to fund national debt.
• Federal Reserve buys and sells securities to control interest rates.
• Commercial banks buy Treasury securities, sell CDs, make short-term loans, and offer money market accounts.
• Businesses buy/sell short-term securities for cash management.
• Investment companies trade for commercial accounts.
• Finance companies lend to individuals.
• Insurance companies maintain liquidity for unexpected demands.
• Pension funds maintain funds for investment in stocks and bonds.
• Individuals buy money market mutual funds.
• Money market mutual funds let small investors participate in high-value money market securities.
• Most participants use these to obtain cash.
• The Federal Reserve is an exception of this because they sell or buy T-bills for monetary policy.

Money Market Instruments

• Treasury Bills
• Commercial Papers
• Certificates of Deposit
• Repurchase Agreements
• Interbank market

Treasury Bills

• T-bills are debt securities issued by the U.S. Treasury to cover shortfalls and are sold at a discount to par.
• Paying $990 might get you a $1,000 bill that pays $1,000 at maturity.
• The implicit interest is the difference between purchase price and face value.
• In France, a Treasury Bill is called "Bon du Trésor à taux fixe et à intérêt précompté", or BTF.
• T-bills have are issued for terms of 4, 13, 26, and 52 weeks and auctioned every Thursday.
• Secondary market is very liquid.
• It's virtually default-risk-free.
• Treasury bills are priced using a discount rate.
• The formula for the price P is: P = F(1 - (i_discount * n / 360)).
  • F is the bill's par value.
  • i_discount is the discount rate.
  • n is the number of days until maturity.
• The discount rate is calculated by: i_discount = (F - P) / F * 360 / n.
• A 360-day year convention (30 x 12) is used.
• Debt securities have specific interest rate and day-count conventions.
• A simple example is, if you invest 99 to receive 100 in one year, 𝑃 = 99, 𝐹 = 100, 𝑖𝑑𝑖𝑠𝑐𝑜𝑢𝑛𝑡 = 1%.
• The return equation is, 𝐹 = 𝑃 × (1 + 𝑟𝑒𝑡𝑢𝑟𝑛 × 𝑑𝑢𝑟𝑎𝑡𝑖𝑜𝑛).
• Thus for the example above; return = 1.01%.
• The investment rate is, 𝑖𝑖𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡 = (𝐹 − 𝑃) / 𝑃 × 365 / 𝑛.
• Investment rates use price in the denominator, and use the day count is 366 in leap years.
• If you pay $996.37 for a 28-day T-bill worth $1,000, discount rate is 4.67%, and investment rate is 4.75%.

Commercial Paper and Certificates of Deposit

• Commercial paper is a note issued by creditworthy corporations, with maturities up to 270 days.
• Utilisation of commercial paper rose in the early 1980s due to rising bank loan costs.
• Commercial paper volume fell during the 2008 recession, but the annual market is still over $0.85 trillion.
• The prime rate is the interest rate that commercial banks charge creditworthy customers.
• A Certificate of Deposit (CD) is issued by financial institutions.
• CDs have longer duration, but never exceed 3 years.
• CDs are lower risk than commercial paper, which leads to a lower rate of return than commercial paper.

Repurchase Agreements (Repos)

• Repos are a form of collateralized short-term borrowing
• A firm sells securities and agrees to buy them back at a later date for a certain price.
• In an overnight repo, a party borrows cash and posts collateral (like government securities).
• In a no-default situation, the borrower repurchases the securities and the lender returns the collateral the next day.
• If default occurs, the lender can sell the securities, this reduced risk results in lower rates.
• The borrower receives less than the market value of the securities.
• The difference between borrowed amount and collateral value is the "haircut.”
• Can be done by banks and non-banks, usually large dealers, for liquidity gaps of a very short period.

Interbank Market

• Concerns Loaned or borrowed short-term funds between financial institutions, typically for one day at a time.
• It assists banks in meeting short-term requirements.
• Central Banks set reserve requirements that banks must maintain.
• Those with excess reserves lend to banks needing reserves, these are generally overnight loans.
• In France this is called the “marché interbancaire", but in the USA it is called "Fed Funds".
• Fed Funds are funds held at banks' account with the Federal Reserve bank
• The rate of interest on these transactions is a benchmark interest rate called the interbank rate.
• Interbank rates follow the forces of supply and demand.
• The Central Bank indirectly influencing the rate, this is done by purchases of securities, from banks.
• Proceeds are deposited, increase supply of reserves, which then pushes interbank rate down.

Bond Fundamentals

• Key characteristics are coupon and maturity.
• There many types of bonds; however, most are long-term (> 1 year) debt securities.
• Issuers use them to issue funds for long-term financing or investments.
• Investors, in buying this portion of debt, receive regular interest payments (coupons).
• When the bond matures, the issuer pays back its borrowed amount, known as nominal/principal/face value.

Who Issues Bonds?

• Governments such as, US Treasury notes and bonds, UK Gilts, German Bunds, France OATs and Japan JGBs.
• Domestic and Eurobond coorporations.
• Investment grade vs junk sector.
• Government agencies issue Municipal bonds and local authorities bonds.

Who Buys Bonds?

• Pension funds
• Life insurance companies
• Hedge funds
• Households (mostly through funds)
• Governments (Japan and China are the most relevant investors in US government bonds)

Coupon Bonds

• A typical coupon bond's features are annual or semi-annual interest payments.
• At maturity the issuer pays the par value (face value, nominal or principal).
• the coupon rate and par value are specified when the bond is issued.
• The coupon is often constant, but some bonds have variable rates like Euribor 3M in a currency.

Specific Bond Types

• Perpetual - principal never repaid and must be sold on the secondary market to get money back.
• Variable Rate (FRNs) - A variable rate bond's coupon is linked to interest rate and is determined at the start of periods.
• Mortgage - payments secured against property.
• Callable - Issuer has the option to buy them back, generally if rates are decreased.
• Putable - Investor option to sell bonds back, typically if rates are increased.
• Convertible - investor option to convert to issuer equity under agreed terms under high risk.
• Structured bonds - complex payment profiles like “spread notes which pay 3 times (rate20Y – rate2Y).
• Zero Coupon - no coupons, the single payment of principle is at maturity, in Islamic finance.
• Eurobonds- issued in currency different from the currency of the issuer’s country, mostly in dollars.
• Green bonds - used exclusively to finance projects that positively affect the environment/climate.

Treasury Bonds

• The U.S. Treasury issues for notes & bonds to finance operations
  • Treasury bills: less than 1 year maturity
  • Treasury notes: 1 to 10 years maturity
  • Treasury bonds: 10 to 30 years maturity
• There negligible default risk
• Very low interest rates may have some present though limited present inflation risk.
• The secondary market is active.

Corporate Bonds

• Issued by corporations.
• Pay semi-annual coupons in US, but annual in Europe.
• Risk varies, interest rate varies with level of risk.
• The range of risk runs from very low-risk (AAA) to higher risk (BBB), and below BBB is sub-investment grade debt.

Defining Bond Ratings

• Grades assigned to bonds that identify their credit quality.
• Quality and rating go up with decrease in chance of default.
• Standard and Poor's, Moody's, and Fitch are major rating services.
• "A forward-looking opinion about the creditworthiness of an obligor", as S&P defines it.

Junk Bonds

• Rated below BBB, normally issued by new companies or ones with recent financial difficulties,.
• Trusts and insurer funds will not invest.
• They have higher returns and and higher risk.

Bond Pricing

• Theory treats bond pricing as pricing any known cash flows; equal to the flow’s PV, discounted at a rate that reflects risk, and bond pricing involves:
  • Identifying the cash flows.
  • Determining the discount rate.
  • Discounting the set flows.
• Recalling how to treat coupon bonds, paying annual fixed flows ,we get:
  • 𝑃𝑟𝑖𝑐𝑒 𝑃 = 𝑃𝑉 = 𝐶 / (1 + 𝑖) + 𝐶 / (1 + 𝑖)^2 + C / (1 + 𝑖)^3 + …+ C / (1 + 𝑖)^𝑛 + 𝑅 / (1 + 𝑖)^𝑛
    • Where R is the reimbursement price.
    • C is the coupon value.
    • i is the yield to maturity (discount rate, IRR).
    • n is years to maturity.
    • PV is the present value of the bond payment.

Examples of Bond Pricing

• To compute the flow of of a $1,000 face value bond.
• With annual 10% coupon and exactly 3 years to maturity.
• Reimbursement occurs at 100%, yield-to-maturity (YTM) is 12% means;
  • Yearly coupon flows 𝐶 = $1,000 × 10% i.e $100.
  • The reimbursement is 100% that is $1,000:
    • PV is $100 / (1 + 12%) + $100 / (1 + 12%)2+ $100 + $1,000 / (1 + 12%)3 or , $951.96.

Variations

• If there's 102% reimbursement: Reimbursed flow $1,020 and thus 𝑃𝑉 = $966.20.
• But with 9% YTM, 𝑃𝑉 is $1,025.31.

Simplify flows Of A Bond

• PV sums for bond coupon follow annuity formula:

  • 𝑃𝑉 = Σ [n t=1] C / (1 + 𝑖)>t + 𝐹 / (1 + 𝑖)^𝑛
    • = C / i * 1 -[1 + i ]^-n + 𝐹 / (1 + 𝑖)^𝑛

• A bond with $1,000 face value has annual coupon is set at 6.5% and a time to maturity of 40 years with a YTM of 5.5% results in a PV:

• With discount rate known to be 6% - PV : 65 / (1 + 5.5%) + 65 / (1 + 5.5%)^ 2 +···+ 65 /(1 + 5.5%)^10+ 1,000 / (1 + 5.5%)^40 = : 65 : 5 . 5 %(1− [(1/ + 5.5%) *40+ 1,000 /(1 + 1 + 5.5%( 1−.5%)^40 =1,160.46 , 1/ (1 /+ 5. 5 %) 40 + 1,000 /(15

PV Semi Formula

• Semi-annual bonds require flow and returns to be half the annual rates and twice the years to maturity; n:
  • 𝑃𝑉 semi = 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. .
• With an example of a 2-year 10% $1,000 face value bond requires rate is known to be at 12%
  • Thus 𝐶 = $1,000 × 10% i.e $50 is semi.
  • 𝑃𝑉 semi = $50 /( 1 + 0 .6) +.... + 1,050/ (1 + 0,6 )^4 i.e; $965 . 35.
    • Note: with yearly coupon payments, the price is: 𝑃𝑉 = $100 /(1 +0,6 ) +. + 100/ (1 + 0,6 )^2= $966 20

Yield/Price Correlation of Annual Bonds

• 𝑃 = (Σ [tn =]) 𝐶 /( 1 + 𝑖) t + F/ (1 /+I )n
• there is a non-linear and inverse correlation to it and price, so as it grows, prices diminish and vise versa,.
• This reaction (sensitivity) is referred to duration, or rate.

Relations between coupon rate and YTM and par

_ Relation set:

• Bond selling at PAR = Coupon rate == YTM. - Bond trading aatDiscount (coupon rate is < YTM. - Bond listed as Premium) the former is more YTM. - It's why it leads he will pay for it, when high, because high values for i indicate an price drop. _ Investors requires higher is for increase of rates as and hence lowering of price

Bond Rate and Price

  BONDs is and the spread between price and 76the two.