Fixed Income (1)

R43. Fixed-Income Markets:

Issuance, Trading, and Funding
Fixed-Income Classifications
Type of issuer – Households, governments,
financial institutions, nonfinancial corporations
Credit quality – Investment grade, high yield
Maturities – Money market, capital market
Coupon structure – Fixed-rate, floating-rate
 Fixed-Income Classifications
Geographic market – Developed, emerging
Currency denomination – Primarily USD and EUR
Index linking – Inflation, equities, commodities
 Primary Market for Bonds
Public offering: Register issue with securities
regulators
Private placement: Sold only to qualified
investors
Shelf registration: Register entire issue with
regulators, issue bonds over time
 Primary Market for Bonds
Underwritten offerings
Investment bank or bank syndicate buys entire
issue, resells to dealers and investors.
Bonds sometimes trade for forward delivery in
the “when-issued” or “grey” market.
 Primary Market for Bonds

Best-efforts offerings
Investment banks sell bonds on commission basis.

Auctions
Often used for government bonds (primary dealers)
 Secondary Market for Bonds
Primarily over-the-counter trading (dealer markets)
Bid-ask spread depends on issue’s liquidity

Trade settlement
▪ Typically T + 2 or T + 3 for corporate bonds
▪ T + 1 for government, quasi-government bonds
▪ Same day (cash settlement) for many money
market securities and some government bonds
 Government Debt
Sovereign bonds: Issued by national governments
▪ Issued in local currency or foreign currency
▪ Higher credit rating for local currency debt than for
developed country currency debt
 Government Debt
Nonsovereign government bonds
States, provinces, counties, cities
May be paid from taxes, fees, or project revenues
 Agency Debt
Quasi-government bonds or agency bonds:
Issued by government-sponsored entities
▪ Example: Fannie Mae (U.S.)
▪ May be guaranteed by national government

Supranational bonds: Issued by multilateral

agencies (Examples: IMF, World Bank)
 Corporate Debt
Bank borrowing
▪ Bilateral loan: Single bank
▪ Syndicated loan: Multiple banks
Commercial paper (working capital, bridge financing)
▪ U.S. commercial paper: Maturities up to 270 days, sold
on a discount interest basis, settles T + 0
▪ Eurocommercial paper: Maturities up to 364 days, sold
on discount or add-on interest basis, settles T + 2
 Corporate Debt
Commercial paper (cont.)
Rollover risk: The risk that new paper cannot be
issued to pay for maturing paper
▪ Deterioration of credit
▪ Systemic failure
Firms have backup lines of credit to get acceptable
credit ratings; funds available unless there is a
material adverse change.
 Add-on vs. Discount Yield
Consider 240-day commercial paper with holding
period yield of 1.35%
Discount yield: Priced at 100 / 1.0135 = 98.668
Pay 100 at maturity
Discount from par = 100 – 98.668 =
1.332%
Add-on yield: Priced at 100, pays 101.35 at maturity
 Corporate Debt
Corporate bonds
Term maturity structure: Entire issue matures on same
date
Serial bond issue: Multiple maturity dates

Medium-term Notes (MTNs)

▪ Issuer provides range of maturities, buyer specifies
desired amount and maturity
▪ Continuous offering by issuer’s agent
Structured Financial Instruments

Designed to change the risk profile of an

underlying debt security
Examples: Asset-backed securities
Collateralized debt obligations
May combine a debt security with a derivative
Structured Financial Instruments
Capital protected instrument
▪ Guaranteed minimum value at maturity
▪ Potential upside gains based on return of other asset
▪ Guarantee certificate if guaranteed maturity value
equals original cost

Example: zero-coupon sovereign bond that matures at

$50,000 in two years combined with S&P call options,
prepackaged as structured instrument
Structured Financial Instruments
Credit-linked note:
Receives extra yield (yield enhanced)

Pays less than face value if credit event occurs for

reference security

Equivalent to purchasing bond and selling credit

default swap (receive payments, pay if default occurs)
Structured Financial Instruments
Participation instrument
Payments based on underlying instrument (e.g.,
interest rate, stock index return)
No guaranteed payment amount at maturity
Includes floating-rate notes, payments based on a
reference rate
Structured Financial Instruments
Leveraged instruments include inverse floaters:
Coupon rate = fixed rate – (L × reference rate)

Leveraged inverse floater, L > 1, example:

coupon rate = 6% - (1.2 × 90-day LIBOR)

Deleveraged inverse floater, L < 1, example:

coupon rate = 7% - (0.5 × 180-day LIBOR)
Short-term Funding for Banks

▪ Customer deposits
▪ Certificates of deposit (CDs)
▪ Negotiable CDs
▪ Central bank funds market
▪ Interbank funds
 Repurchase Agreements
▪ Source of short-term funding for bond dealers
▪ Sell bond to counterparty and agree to repurchase
it on repo date at a slightly higher price
▪ 1 day = overnight repo, > 1 day = term repo

Reverse repo: Dealer acts as lender, buys bond

 Repurchase Agreements
Repo rate is percentage difference between sale price
and repurchase price.
Repo margin (haircut) is percentage difference
between sale price and value of bond.
Risks: Both parties have counterparty risk
Security lender may experience financial stress
Security may decline in value
 Repurchase Agreements
Repo rate and repo margin both:
▪ Decrease with higher credit quality of collateral
▪ Increase with the term of the repo (maturity)
▪ Decrease when security is in greater demand