Debt Markets: Money Markets and Bond Markets

Debt Markets

• Companies may need short-term funds to cover costs such as raw materials or build new factories.
• These situations can be addressed through financial intermediaries like commercial banks.
• Short-term debt security issuances may provide funds in money markets.
• Cash can be raised by selling bonds to investors in the bond market for longer term projects.

Note on Market Context

• Slides may reference American markets.
• These references can is translated to European market equivalents as follows:
  • Replace '$' with '€', 'Federal Reserve' with 'ECB', and 'US Treasury Department' with 'National Treasuries'.

Course Content: Debt Market (Session 2)

• Money Markets are covered in Part 2.1
• Bond Markets are covered in Part 2.2

The Money Markets

• Apple had $74 billion in cash and short-term securities in 2017,
• Approximately $8 billion was deposited in banks.
• Around $12.3 billion was in cash equivalents.
• The term "money market" is misleading because money is not traded there.
• Securities traded have short terms, high liquidity, and low credit risk.
• Money market securities are sold in large denominations, typically $1,000,000 or more.
• Money market securities have low default risk.
• Money markets mature in one year or less, mostly in less than 120 days.
• Investors and lenders use money markets to warehouse excess funds for short periods to get a return.
• Borrowers sell money market securities for low-cost, temporary funds.
• Money markets address cash flow timing issues for institutions.

Example Of A Non-Financial Institution's Use Of Money Markets

• Firms first pay for inputs like raw materials, labor and storage
• Firms then get paid a few weeks after sales have been made.
• Money markets are utilized to settle cash flow shortages due to asynchronization.

Participants in the Money Markets

• U.S. Treasury Department sells securities to fund the national debt.
• The Federal Reserve System buys/sells securities to control interest rates.
• Commercial banks buy Treasury securities and sell certificates of deposit.
• They offer short-term loans.
• Commercial banks offer individual investor accounts for investing in money market securities
• Businesses buy and sell short-term securities for cash management.
• Investment companies trade on behalf of commercial accounts.
• Finance companies lend funds to individuals.
• Insurance companies maintain liquidity for unexpected demands.
• Pension funds use money markets for readiness to invest in stocks/bonds.
• Individuals buy money market mutual funds.
• Money market mutual funds allow small investors to participate via aggregated funds.
• They invest in large-denomination money market securities.
• Most participants use money market securities to get cash
• The Federal Reserve buys/sells securities for monetary policy, unlike most participants

Money Market Instruments

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

Treasury Bills

• Treasury Bills are issued by the US Treasury to cover budget deficits.

• Bills are sold at a discount from the par amount, the face value of the bill.

• Buying a $1,000 bill for $990 results in a $1,000 payment at maturity.

• Maturity terms include 4, 13, 26, and 52 weeks.

• Bills are auctioned regularly, every Thursday.

• Treasury bills have a very liquid secondary market and are virtually default-risk free.

• Information about T bills can be found at: https://www.treasurydirect.gov/indiv/research/indepth/tbills/res_tbill_faq.htm.

• Information about BTFs, the French equivalent, can be found at: https://www.aft.gouv.fr/en/btf-characteristics.

• They are officially quoted using a discount rate rather than interest. The increase in price at maturity provides a return.

• The formula for calculating the price P is: 𝑃 = 𝐹 (1 − 𝑖discount 𝑛/360) .

  • F = face value of bill, 𝑖discount = discount rate, n = days until the maturity

• Formula implies 𝑖discount = (𝐹 −𝑃)/𝐹 × ((360)/𝑛) .

• The formula understates the return due to calculating with face value.

• Yield is calculated using the face value in the denominator, which creates an understated return.

• A 360-day convention is used, this highlights that instruments have specific conventions.

• Debt securities follow specific interest rate and day-count conventions.

• Formula can also be expressed as: return = (100/99) − 1 = 1.01%.

• Investment rate is calculated as 𝑖investment = (𝐹 −𝑃)/𝑃 × (365/𝑛)

• Returns are more accurate when using price in the denominator and include the number of days per year.

• As an example, paying $996.37 for a 28-day T-bill worth $1,000 at maturity has:

• Discount rate (𝑖 discount ) = 4.67% .and,

• Investment rate (𝑖investmen ) = 4.75%.

Commercial Papers / Certificates of Deposit

• Commercial Paper is a note issued by an corporation.
• Commercial papers are typically issued with maturities of 270 days or less, averaging around 30 days.
• Use of commercial paper rose significantly in the early 1980s due to rising bank loan costs.
• The commercial paper market currently has an volume of over $0.85 trillion.
• When issued by a financial institution, these are Certificates of Deposit (CD).
• CDs can be longer in duration but should never exceed 3 years.
• CDs are often less risky than CPs and therefore have lower returns because financial institutions are severely regulated.

Repurchase Agreements (Repos)

• A form of collateralized short-term borrowing.
• A firm sells securities and agrees to buy them back at a specified date/price, usually after one day.
• An overnight repo means one party borrows cash while posting collateral (e.g., government securities).
• In no-default situations, the cash is gives back and collateral resold.
• On borrower defaults, the lender sells the high-quality securities
• Risk is reduced, a lower rate is paid by the loaner versus a classic loan.
• Borrowers get less than the market value of securities in case of default .
• Governments use haircut as goverment secured collatoral.
• Lenders perform with usually government high quaility securities.
• Done banks can borrow funds for 1 night
• Repo: companies with short liquidity gap dont have obligated to sell assets and reinvest later.

Interbank Market

• Transfers short-term funds transferred usually for one day
• Banks use the interbank market to meet short-term reservice equirements.
• Central Banks set minimum reserve requirements.
• Banks can lend overnight.
• In France the Interbank Market is called “marché interbancaire”, in USA: “Fed Funds”
• Fed Funds is misleading, as Fed funds are held at Federal Reserve bank
• The interbank rate is derived fro, the interest rate on interbank transactions.
• C.B.’s cannot control on interbank transactions
• If the Fed purchases securities from banks, the proceeds are deposited at the bank's account with the Fed.
• Level of reserves changes pushing the interbank rate down.
• This can favour start restart to economy.
• Conversely, C.B.’s can push it up by increasing the percentage of required reserves.

Bond Fundamentals

• Bonds are long-term debt, greater than 1 year.
• Issuers use these to raise funds to fincance long term investing.
• Investors buy portions of this debt and receive regular interest payments, a coupon.
• When bond matures issuer repays borrowed amount, known as nominal / principal / face value.
• Coupon and maturity are the two key bond characteristics.
• Issuers can be governments (US Treasury, UK Gilts , German Bund, France OAT, Japan JGB) , corporations or government agences.
• Governemnts issue Treasury notes and bonds.
• Corporations issue domestic, Eurobonds
• Bonds can be investment grade vs junk and are issued by government agences via Municipal bonds, local authorities.

Who invests in bonds

• Pension funds
• Life insurance companies
• Hedge funds
• Households mostly through funds and by governments
• E.g., Japan, China, most relevant in US government bonds.
• Coupon bonds pay annual or semi-annual payments.
• Issuers pay a par value at maturity
• Bonds can be a the par value and constant coupon rate is specified when the bond is first issued.
• Coupons can be very often constant with bonds.
• However, floating rate bonud are variable, with variable reates such as Euribor 3M is a given currency.
• Coupons are constant with bonds (the bond holder receives the same coupon every year or every six months).

Specific Bond Types:

• Perpetual bonds means the principal was never repaid and

• Variable rate , FRNs have coupon linked to rate interest rate

• Mortgage payments secured against property.

• Callable bonds give, Callable: issuer has the option to buy them back when rates decrease.

• Puttable: investor option to sell them back if rates increase

• Convertible bonds vestior has option convert into issuer equity after x years.

• Strucutred complex payment profiles: pay 3 spread notrd rate 20y - rate2y Ex: 3 times (rate 20Y – rate2Y)

• No coupons on zero coupon bonds with only payment of principal at maturity.

• Only those bonds are accepted in Islamic finance.

• Eurobonds are issued in currency different the currency issuers' country.

• "Green bonds" exclusively projects that have climate or environemtal benefits

• Market started 20 yerars ago, exponentially. Increasing due to investors demand)

US Treasury Bonds specifics

• The U.S. Treasury issues notes and bonds to finance operations.
• Treasury bill has less than 1 year maturity.
• Treasury note have have 1 to 10 years.
• Treasury bonds: 10 to 30 years.
• Treasury bonds is when the Treasury money can pay off debt
• It has very low rates, often considered the risk-free rate,
• There a low interest rate is still present and a very active secondary market.

Corporate Bonds

• They can issude semi-annual coupons is USA.
• Degree of risk varies with both band.
• The required interest rate varies with level of risk.
• The degree of risk ranges from AAA to BBB.
• Rated BBB any bonds and considered sub0investment gread debt.
• There are bond grades that indicate credit quality
• The bonds have higher credit quality and the are default
• There Standard, Poor’s, Moody’s and Fitch.

Bond Ratings

• Bond ratings indicate credit quality, with lower ratings signifying a higher chance of default.
• These are provided by independent rating services such as Standard & Poor's (S&P), Moody's, and Fitch.
• S&P defines a credit rating as "a forward-looking opinion about the creditworthiness of an obligor."

Bond Pricing

• In theory is that no diffren than pringany any set of flows

• The price of flows. bond today inequal

• Bond price are step like

• Identifify the cast bond

• Determing disocunt rates

• The bond calculated with with by descontrocing

• R is the disount rate

• I bond matirty - or yiled.

• N is the

• An exampl, the present bond

• Pay $1,00 at anan rate for the bond years im

The Price Yield Relationship

• Bonds have yield price relationship

• If the yeld the price goves down

• Sensitibty is goves duration.

• Bond can be also yield

• The bond also sells at par.

• Bond can be belove or above

Economics of the YTM

• Securities required investors bond - more yeld
• Required yield bonds ask liquidity
• Required the are Yied is ask matury
• Security bond of credit risk

Bond Risks

• Default bond
• Speread yield betweeen of credit quality
• Aond in matyriy
• Yield of the bond increases -The rate of interset

Bond Terminology

• Definition of :
  • Coupon interest rate the is.
  • Face amount the is.
• Maturity The is bond to. -Par value is also value the amount of maturity at face
• Yield to maturity The an to the bonds.