Debt Markets: Short and Long Term Funding

Debt Markets

• Companies may require short-term funds for raw materials, production costs, and employee salaries
• Companies borrow funds for long-term investments like building a factory costing $200 million to double production in 10 years

Short and Long Term Funding Scenarios

• Companies can solve funding issues through a financial intermediary like a commercial bank
• Short-term situations can be addressed through the money market by issuing a short-term debt security
• Long-term situations, like building a new factory, can be addressed by raising cash through selling bonds in the bond market
• In both short and long term situations, company debt increases but in different ways and for different purposes

Note on Market References

• The information is explained with a focus on American markets, but can be used in the European context
• The dollar sign ($) can be replaced with the euro (€)
• The Federal Reserve (Fed) can be replaced with the European Central Bank (ECB)
• The US Treasury Department can be replaced with National Treasuries

Course Content Overview

• Session 2 focuses on the debt market
• It includes topics on Money Markets (Part 2.1) and Bond Markets (Part 2.2)

The Money Markets

• Apple had $74 billion in cash and short-term securities as of 2017
• About $8 billion was in cash (deposited in banks) and $12.3 billion in "cash equivalents"

Money Market Defined

• Despite the name, money (currency) is not traded in the money markets
• Securities in the money market are short-term with high liquidity and very low credit risk

Money Market Characteristics

• Money market securities are generally sold in large denominations (one million dollars or more)
• They have low default risk
• They mature in one year or less from their issue date, with most maturing in less than 120 days

Purpose of Money Markets

• Money markets provide investors/lenders a place to warehouse excess funds for short periods of time and get a return instead of keeping surpluses of cash
• Borrowers can sell money market securities, providing a low-cost temporary source of funds

Institutions Cash Problems

• Cash outflows (payments) and cash inflows (income) do not always happen at the same time
• Asynchronization of cash flow implies possible cash shortages
• Money markets can solve these cash timing problems for institutions faced with asynchronization of cash flow

Example: Cashflow For Non-financial Institutions

• A firm producing goods must pay for inputs, employees, and stockpiling
• Firms are generally paid a few weeks after the sale
• This asynchronization of cash flow generates a cash shortage
• Companies settle shortages by borrowing in the money market

Participants in the Money Markets

• Participants inclide:
• US Treasury Department sells U.S. Treasury securities to fund the national debt
• The Federal Reserve buys and sells U.S. Treasury securities to control interest rates
• Commercial banks buy U.S. Treasury securities, sell certificates of deposit, make short-term loans, and offer individual investors accounts that invest in money market securities
• Businesses buy and sell short-term securities for cash management
• Investment companies trade on behalf of commercial accounts
• Financial Companies lend funds to individuals
• Insurance companies maintain liquidity to meet unexpected demands
• Pension funds maintain funds in money market instruments for investment in stocks and bonds
• Individuals buy money market mutual funds
• Money market mutual funds allow small investors to participate in the money market by aggregating their funds to invest in large-denomination money market securities

Key Players in Money Market

• Most participants (US Treasury Department, corporations, financial institutions, etc.) sell money market securities to obtain cash
• The Federal Reserve is an exception, buying or selling specific money market securities (T-bills) for monetary policy reasons

Money Market Instruments

• Types include:
• Treasury Bills
• Commercial Papers / Certificates of Deposit
• Repurchase Agreements
• Interbank market.

Treasury Bills

• US treasury department issues treasury bills to cover budget deficits. They are typically sold at a discount from the par amount, also called face value
• As an example, a person might pay $990 for a $1000 bill
• Upon maturity, the bill would be paid for $1000
• The difference between purchase and sell price makes up interest earned. There are no interest rates on the bill contract

Treasury Bills (France)

• In France, Treasury Bills are called "Bon du Trésor à taux fixe et à intérêt précompté", abbreviated as BTF.
• Treasury bills have maturities of 4, 13, 26, and 52 weeks are sold every Thursday
• Are very liquid and have low risk of default

Treasury Bill Rates and The Formula

• Treasury bills are quoted using a discount rate
• The price P formula:
  • P = F(1-i_{discount}*n/360) where:
  • F is the face value
  • i_{discount} is the discount rate
  • N is number of days until maturity

Understanding Yield Understatement and Day Conventions

• i_{discount} = (F-P)/F * 360/n
• This yield is calculated using the face value, therefore, it understates the return
• A 360-day year (30 x 12) convention is used

Debt Securities - Interest Rate and Day Count Conventions

• Debt securities have specific interest rate and day-count conventions and it is important to know which convention is applicable for each instrument
• As an example, an investment of 99 to receive 100, then P = 99 and F = 100 discount = F - P/ F * 360/N which equals 1%

Return Computations

• F = P x (1 + return x duration)
• 100 = 99 x (1 + return x 1) can also be expressed as return = (100/99) - 1 = 1.01%

Estimating Investment Yield

• A better estimate of the yield on treasury bills is the investment rate, which can be calculated as I investement = F - P / P * 365/ N
• The investment yield is calculated using price

Treasury Bills - Real World Example

• Buying $996.37 on a 28-day T-bill that matures to $1,000 has discount and investment rates of
• Discounted rate = 1000 - 996.37 / 1000 * 360 / 28 = 4.67%
• Investment rate = 1000 - 996.37 / 996.37 * 365 / 28 = 4.75%
• iinvestment reflects true value as 996.37 * (1 + 4.75% * 28 / 365) ≈ 1,000

Treasury Bills - Real World Interest Rates

• A graph shows Treasury Bill Interest Rates against Inflation Rates from 1973 to 2016.

Commercial Paper and Certificates of Deposit

• Commercial paper is a note issued by a creditworthy corporation and issued by corporations with maturities of up to 270 days (average around 30)
• The use of Commercial Paper increased in the early 1980’s due to the higher cost of bank loans
• Commercial paper volume fell after the recent recession, but is still well over $0.085 Trillion
• When issued by a financial institution (bank, credit union), it’s called a Certificate of Deposit (CD).

Certificates and CD Duration

• CD’s do not exceed 3 years.
• Financial institutions are more regulated and are less risky. As such, returns from CD’s are lower than CP’s.

Short-Term Borrowing: Repurchase Agreements (Repos)

• Essentially a Collateralized short term borrowing action.
• A firm will sell securities but agrees to buy them back at a later date at a certain price.

How Repos Work

• On day 0, cash is borrowed against collateral (government securities).
• On day 1, the borrower repurchases these, then the lender sells them

Overnight Repos

• Collateral must be posted proportional to the load in order for security.
• “Reduced risk” and “lower rate to be paid by the loaner” if the borrower goes bankrupt.

Repo Interest and Rates

• Borrowers receive less than market value, and that difference is called "haircut"
• Collateral is government securities, and can be done by entities like banks or trading desks.
• Repo is used by companies with a liquidity gap who don't want to sell or reinvest assets.

Short Term Fund Transfer: Interbank Market

• Deals with short-term funds transferred between financial institutions, warrantied for a period for one day.
• Used by banks to cover short-term needs that meet reserve requirements, and set by central entities as they may see fit
• Banks that have more reserves than required lend funds to the entities that need them, typically overnight
• In France they are known as marché interbancaire and in the US "Fed Funds"

Federal Funds (USA) - Interest Rates

• Don't involve federal government, rather comes from fact funds held at accounts with the Federal Reserve
• Transactions create benchmark called "interbank rate"
• Not directly controlled be central bank authority.

Federal Manipulation

• CB’s can manipulate it by adjusting what the level of reserves are in the system.
• For example, securities from banks can be processed through the fed, which raises reserves and lowers the Interbank rate.

Bonds: Governments

• Us treasury bonds are known notes, while the UK ones are known as gilts.
• German bonds are bunds, France are OATs, and Japan are JGBs.

Bonds: Other Entities

• Can be domestic or eurobonds
• Grades can be investment grade vs junk rated

Who Invests In Bonds

• Pension funds, Life insurance Hedge funds, and general Households
• Governments from Japan and China are the most relevant to US bonds

What a Bond Is

• It has set interest payments or Coupons.
• After a bond matures, the par value is paid to the holder.

Two Key Bond Characteristics

• The two key considerations for any bond investment is the coupon and maturity date
• If there are annual or semi-annual interest payments to coupons, they are issues at par
• Most issuer pay "par value" to the bond holder in nominal amount
• Each bond will both have both a coupon and par value when initially issued

Variable Interest Rate (FRNs or Zero-Interest)

• Some bonds have variable coupons that float, and are determined at the beginning of the period -Some bonds are Mortgages which require a premium to payments secured against property

Options And Actions With Bonds

• "Callable" gives the issuer right buy back at a date rate decreases vs market rate
• "Puttable" is when investor sell them back if the rate changes

Other Types Of Bonds

• “Convertible” bonds give holders option to convert to equity if risk is higher
• "Structured bonds" have complex payment profiles like “spread notes,” which pays 3x the rate of some benchmark return
• • Zero Coupon bonds have "no coupon" but are only paid out at maturity, can have benefits within "Islamic finance"
• Eurobonds involve dollar denomination for European economies, and are used by EU, not just euro economies Environmental protection "green bonds" saw their market debut two decades ago, now see big potential

Treasury Bonds (In The United States)

• Used to finance treasury operation through selling bills or notes.
• Treasury Bills last less than a year, Treasury Notes last one to ten years, and Treasury Bonds last 20 to 30 years