unit .pdf

Introduction to Financial Markets Unit 3 Fixed Income Markets - Institutional Aspects Prof. Dr. M. De Ceuster Prof. Dr. M. De Ceuster Introduction to Financial Markets 1 / 44  Ratings...

Introduction to Financial Markets Unit 3 Fixed Income Markets - Institutional Aspects Prof. Dr. M. De Ceuster Prof. Dr. M. De Ceuster Introduction to Financial Markets 1 / 44  Ratings Section 1 Ratings Prof. Dr. M. De Ceuster Introduction to Financial Markets 2 / 44  Ratings The Economic Problem A-symmetric information Prof. Dr. M. De Ceuster Introduction to Financial Markets 3 / 44  Ratings Ratings Prof. Dr. M. De Ceuster Introduction to Financial Markets 4 / 44  Ratings Terminology Modifiers High grade or investment grade, Speculative grade, Split rating, Credit watch and potential rating migration, Downgrade or upgrade, Fallen angel. Prof. Dr. M. De Ceuster Introduction to Financial Markets 5 / 44  The Instruments Section 2 The Instruments Prof. Dr. M. De Ceuster Introduction to Financial Markets 6 / 44  The Instruments Market Taxonomy Maturity at issuance Money markets are markets where instruments are being traded with a maturity at issuance of at most 1 year. Capital markets group instruments with a maturity at issuance of more than 1 year. Nature of the debt instrument Loans are contracts with two parties. Loans are transferable but the correct legal procedures have to be followed. Bonds are securities which are issued by 1 borrower and are being bought by many investors. They can easily be transferred. Prof. Dr. M. De Ceuster Introduction to Financial Markets 7 / 44  The Instruments Market Taxonomy Geographical span National/Domestic markets (i.e. transactions in local currency under supervision of local central bank) International markets Nature of the counterparties Wholesale market (institutional investors) Retail market (retail investors) Prof. Dr. M. De Ceuster Introduction to Financial Markets 8 / 44  The Instruments Money Market Instruments (Wholesale) Private money market instruments are instruments issued by non- governmental entities (financial and nonfinancial corporations). Call money Unsecured loans made between banks, Repurchase agreements, Commercial paper (CP), Large-denomination negotiable certificates of deposit, Money market funds. Public money market instruments are instruments issued by gov- ernmental entities. T-bills / CP Prof. Dr. M. De Ceuster Introduction to Financial Markets 9 / 44  The Instruments Call Money Very short period borrowing between banks. Overnight (O/N) transactions Spot next (S/N) transactions Spot next week transactions EONIA, SONIA,... serve as benchmark interest rates. Prof. Dr. M. De Ceuster Introduction to Financial Markets 10 / 44  The Instruments Unsecured Interbank Funding/Lending market Loans between banks maturing from 1 week to 1 year. International banking facility (onshore and offshore (in eurocurrency) transactions). In the US the interbank market is the called the Federal funds market [at the Federal funds rate]. EURIBOR serves as a benchmark interest rate. LIBOR-scandal had serious consequences. Prof. Dr. M. De Ceuster Introduction to Financial Markets 11 / 44  The Instruments Secured Lending using Repurchase Agreements A repo consists out of the sale of a security with a commitment by the seller to buy the security back from the purchaser at a specific price at a designated future date. Terminology Repo rate (simple interest; often ACT/360 quotation), General collateral and specific (hot) collateral, Haircut, Reverse repo, Overnight repo, term repo, open repo Tri-partite repo. Prof. Dr. M. De Ceuster Introduction to Financial Markets 12 / 44  The Instruments Commercial Paper CP is a short term unsecured promissory note issued in the open market that represents the obligation of the issuing company. Used for seasonal financing of working capital, bridge financing,... Primary market based on best effort arrangements (i.e. no guaranteed placement) Hardly any secondary trading. Short term. In the US typically 90 days paper (Eligibility requirement). The term rarely exceeds 270 days. Yields can be quoted on discount basis or in interest bearing form. Prof. Dr. M. De Ceuster Introduction to Financial Markets 13 / 44  The Instruments Simplified (Short Term) C P Ratings Prof. Dr. M. De Ceuster Introduction to Financial Markets 14 / 44  The Instruments CDs A certificate of deposit represents a financial obligation issued by a depository institution that indicates a specific sum of money deposited at the issuing depository institution for a specific time period. Deposit insurance applies for small denominations. Any denomination can be issued. Can be negotiable or non-negotiable (i.e. not resellable in the market and can be redeemed at an early withdrawal penalty). Large-denomination negotiable CDs have denominations of 10 million USD and more. Prof. Dr. M. De Ceuster Introduction to Financial Markets 15 / 44  The Instruments Other Money Market Instruments Household debt instruments Consumer loans Corporate debt instruments Intercompany loans Trade credit Straight loans Overdrafts Factoring and forfaiting Prof. Dr. M. De Ceuster Introduction to Financial Markets 16 / 44  Public Money Market Instruments Section 3 Public Money Market Instruments Prof. Dr. M. De Ceuster Introduction to Financial Markets 17 / 44  Public Money Market Instruments Treasuries Names In the US these instruments are known as Treasury Bills or simply T-Bills. In Europe these instruments carry a variety of names: T-bill (UK), schatkistcertificaat (BE), Bon du Trésor (FR), Schatzwechsel (GE),... The most recently issued are the on-the-run issues, the older ones are the off-the-run issues. Typically off-the-run-issues are less liquid. Maturities at issuance 3, 6 12 months fungibility Prof. Dr. M. De Ceuster Introduction to Financial Markets 18 / 44  Public Money Market Instruments Treasuries Primary market Auctions (aka tenders) American tender principle i.e. bid price auction (and hence not a uniform price auction (Dutch style)). On the money market treasuries are discount securities. Prof. Dr. M. De Ceuster Introduction to Financial Markets 19 / 44  Capital Market Instruments Section 4 Capital Market Instruments Prof. Dr. M. De Ceuster Introduction to Financial Markets 20 / 44  Capital Market Instruments Long Term Loans Household debt Mortgage loans Corporate debt Credit lines Investment credit Revolving credits Leasing Prof. Dr. M. De Ceuster Introduction to Financial Markets 21 / 44  Capital Market Instruments Debt Securities Debt securities are issued by borrowers to obtain liquidity for their short-term or long-term needs. embed the obligation of issuers-borrowers to make a certain promised stream of cash flows in the future. This does not imply that the size of the cash flows, nor the timing of the cash flows are always known at the issuance of the bond. The cash flows are at least determinable (at some point in time) based on a function the borrower and issuer agreed upon. Debt markets (a.k.a. fixed-income markets) are markets where debt securities trade. Some equity instruments such as preferred stock may be considered as well as a fixed income instrument. (but nobody would call them bonds.) P rof. D r. M. D e Ceuster Introduction to Financial M arkets 22 / 44  Capital Market Instruments Debt Securities The repayment of debt securities takes precedence over the payment streams to residual cash flow instruments. Secured debt is backed by tangible assets (often called senior debt). Unsecured debt (debentures (US)). Debt contracts specify events that precipitate default. Non payment of promised coupons. Non payment of the balloon payment. In case of default, bondholders Have the right to take over the firm. Can re-negotiate the contract. Prof. Dr. M. De Ceuster Introduction to Financial Markets 23 / 44  Capital Market Instruments Debt Securities Old Dutch Bond (1648) It was a bearer bond, meaning anyone who presents the addendum to the issuing authority can collect the interest. The water board (i.e. the issuer of this bond) kept no register of ownership of the bond. Prof. Dr. M. De Ceuster Introduction to Financial Markets 24 / 44  Capital Market Instruments Debt Securities Traditional Bond Although bonds have been dematerialized, it is good to visualize a bond in its traditional form. Prof. Dr. M. De Ceuster Introduction to Financial Markets 25 / 44  Capital Market Instruments Characteristics Source: Sundaresan, S. (2009), Fixed Income Markets and Their Derivatives, 3rd ed., Academic Press. Prof. Dr. M. De Ceuster Introduction to Financial Markets 26 / 44  Capital Market Instruments Characteristics Identifiers: CUSIP-code or ISIN-code The name: issuer of the bond Coupon style Zero coupon Fixed coupon Floating (i.e. a reference rate + quoted margin/spread) Multicoupon (e.g. step-up coupon bond) Linkers (TIPS i.e. treasury inflation protected securities) Coupon frequency Annual (Eurozone) Semi-annual (US, UK, Japan, Italy) Prof. Dr. M. De Ceuster Introduction to Financial Markets 27 / 44  Capital Market Instruments Characteristics: A Myriad of Dates Announcement date: date on which the bond is announced and offered to the public. Maturity date: date on which the principal amount is due. Issue date: the day on which the security is issued. Dated date: the day from which the first coupon starts to accrue interest (a.k.a. interest accrual date). Settlement day: the day on which the parties will exchange cash and securities (important for valuation!). In general the trade day plus a number of working days. Prof. Dr. M. De Ceuster Introduction to Financial Markets 28 / 44  Capital Market Instruments Characteristics Maturity Treasury (discount) bills (money market so maturity at issuance Æ 1 year) Treasury (coupon) notes (used in the US for maturities between 1 and 8-10 years) Treasury (coupon) bonds (used in the US for maturities more than 8-10 years; used in other countries for all debt securities with maturities > 1 year) Perpetual or undated bonds Terminology is not consistent over countries and markets! Prof. Dr. M. De Ceuster Introduction to Financial Markets 29 / 44  Capital Market Instruments Characteristics Issued amount When a very large amount is issued, we refer to the bond as a jumbo bond. The size will vary from market to market. In some emerging markets it will be in the hundreds of million of dollars, in developed markets it will be in the billions. The outstanding amount can be lower due to buy backs, calling of bonds, stripping,... Issue price (percentage paid at issuance) or spread at issuance (i.e. the spread in basis points over a benchmark Treasury Bond). Prof. Dr. M. De Ceuster Introduction to Financial Markets 30 / 44  Capital Market Instruments Characteristics: Redemption Value Par amount, nominal amount or principal amount Face value of the bond Used to calculate the coupon Redemption value Expressed in percentage of the nominal amount. Price at which the bond is redeemed on the maturity date. Most of the time equal to the nominal amount. Prof. Dr. M. De Ceuster Introduction to Financial Markets 31 / 44  Capital Market Instruments Players Sovereign bonds are issued by the highest level of government in a country. Subnational government debt a.k.a. municipal debt is issued by states, regions, provinces, counties, municipalities even local utility companies. Supranationals (multilateral financial institutions) such as IMF, World Bank, EBRD, Asian Development Bank. Especially for infrastructure (when municipals are not allowed to issue bonds.) Corporates issue corporate bonds and Medium Term Notes (MTNs), Prof. Dr. M. De Ceuster Introduction to Financial Markets 32 / 44  Capital Market Instruments Corporate bonds General classification Public utilities Transportation economics Banks and finance companies Industrials Bond indentures = promises of the issuer and rights of the investors. Covenants = restrictions imposed on management. Prof. Dr. M. De Ceuster Introduction to Financial Markets 33 / 44  Capital Market Instruments Corporate Bonds & Security A pledge of a real property is a mortgage. In a mortgage bond the mortgage grants the bond holders a lien against the pledged assets. A pledge of personal property is collateral. A debenture bond is not secured by a specific pledge of property. A guaranteed bond is a bond of which the cash flows are guaranteed by a third party. Prof. Dr. M. De Ceuster Introduction to Financial Markets 34 / 44  Capital Market Instruments Terminology Convertible bond Exchangeable bond High yield bond Prof. Dr. M. De Ceuster Introduction to Financial Markets 35 / 44  Capital Market Instruments Medium Term Notes Offered continuously. Maturities from 9 months to 30 years. Best effort basis. Shelf registration. Often structured (e.g. inverse floaters,...) Prof. Dr. M. De Ceuster Introduction to Financial Markets 36 / 44  Primary Market Section 5 Primary Market Prof. Dr. M. De Ceuster Introduction to Financial Markets 37 / 44  Primary Market Objectives (According to the World Bank) Ensure cost effectiveness, Encourage participation from a large range of investors, Maximize competition, Minimize placement risk, Foster transparency. Prof. Dr. M. De Ceuster Introduction to Financial Markets 38 / 44  Primary Market Distribution Methods 1 Auctions with a stop yield (transparent and cost effective) Single price auction (to broaden participation and to reduce concentration in ownership) Multiple price auction (i.e. price discriminatory auction with winner’s curse) 2 Syndication (reduce placement risk, but less transparent) 3 Tap sales (of existing bonds) Primary dealers are active market makers. Prof. Dr. M. De Ceuster Introduction to Financial Markets 39 / 44  Secondary Markets Section 6 Secondary Markets Prof. Dr. M. De Ceuster Introduction to Financial Markets 40 / 44  Secondary Markets Objectives (According to the World Bank) Low transaction costs, Continuous and wide disseminated price information, Immediate execution of trades, Safe and rapid settlement, Efficient custodial and safekeeping services. Prof. Dr. M. De Ceuster Introduction to Financial Markets 41 / 44  Secondary Markets Trading (see Unit 4 - Equity) Order driven markets Quote driven markets Prof. Dr. M. De Ceuster Introduction to Financial Markets 42 / 44  Secondary Markets Stripping Stripping and reconstitution Creation of coupon and principal strips: IO and PO strips. Prof. Dr. M. De Ceuster Introduction to Financial Markets 43 / 44  Secondary Markets Bond Indices Bond indices are much more difficult to create than equity indices: There is a larger number of bonds than stocks, There is more variety in features, The universe of bonds is constantly changing (bonds mature!), Duration (interest rate risk) changes over the life of the bond, Some bonds are difficult to price. Prof. Dr. M. De Ceuster Introduction to Financial Markets 44 / 44