The Fixed Income Market

Session One
Content

Issuers and investors – why fixed income??

Government bond markets

Yield curves

Macroeconomics and bond issuance

Issuers and Investors – why fixed income?
Raising finance
Companies have a choice in raising finance, either equity or debt
The features of debt investments for the issuer are:
 Will be cheaper than equity due to higher rank in repayment order – less risk for the investor
 Have compulsory payments – coupons and principal payments must be made
 Interest payments are tax deductible – further reducing the cost of debt
 Issuers can target different maturities of debt to give financing for a given period of time
In comparison, equity investments
 Are more expensive
 Have non-compulsory dividends
 Never have to be redeemed!
The value of an entity will be a function of their future cashflows, but also their
debt/equity mix as this will drive their WACC
Fixed income market products
Term and revolving loans
 Bilateral or syndicated loans arranged with banks
 Much less liquidity and secondary market trading
Bonds
 Government (relatively risk free)
 Corporate (credit risky bonds)
Treasury bills and commercial paper
Asset Backed Securities
Hybrid instruments
 Convertible bonds
 CoCos
Investing
From the investors perspective, why pick fixed income over equity
The risk is lower – due to the higher seniority of the claim over assets
The cash flows – relatively certain future cash flows match their liabilities
 The coupons from a bond may match a liability stream
 The maturity of a bond gives a known date for redemption of the investment
Interest rate risk management
 Bonds have interest rate risk, but so might the liabilities of an institutional investor, like for
example a pension fund
 So the manager can tailor their desired exposure to interest rates using fixed income
Features of bonds
Bonds are securities – they give investors the right to cashflows in the future
Bonds have three key features:
A par value (or redemption, or nominal) – the amount paid back to the investor
at maturity, normally $1000, or £100
A maturity or redemption date – the day the par value is paid back
A coupon – the annual amount of interest paid to the investor
 The coupon is normally a percentage of par value, and will always be quoted annually but is
usually paid semi annually
Global bond markets

Source: SIFMA
USD market in more detail

Source: SIFMA
Last 12 months of USD Issuance

Source: SIFMA
Government Bond Markets
Government bonds
Governments borrow money in order to fund the spending relative to their
taxation, known as a deficit or in the UK the Public Sector Net Cash Requirement
(PSNCR)
There is a distinction between net borrowing (to fund a deficit) and gross
borrowing (borrowing to repay previous borrowing)
All governments can borrow money, under different names:
 UK – Treasury bills, Gilts and Index Linked Gilts
 USA – T-bills, T-Notes, T-Bonds amd TIPS
 Japan – Japanese Government Bonds
 Germany – Bubills, Schatze and Bunds
 Italy – BOTs, BTPs, CCTs
Inflation linked bonds
The problem with fixed income investing is that if interest rates or inflation are
not what you expect, then you have risk
Due to very high inflation levels in the 60s and 70s, more investors moved away
from bonds to reduce the inflation risk – leading to the UK government starting
issuing Index Linked Gilts in 1981, the US government started issuing them in
1997
In the UK they make up 25% of all gilt stock in issue
Due to how they work, traditionally had a 8 month lag on inflation, but since
2005 a new issue method results in a 3 month lag
World bond markets

Source: Bloomberg
Issuance timelines
The Debt Management Office
in the UK issues:
Treasury Bills – a discount
instrument issued on the last
working day each week,
maturities 1, 3, 6 and 12
month – the 12 month has
never been issued
Gilts – Interest bearing
instruments issued continually
as per schedule to the right
This information available at
www.dmo.gov.uk
Issuance timelines
US instruments are issued in a more structured manner:
Treasury bills are issued once a week, 4 & 8 week auctioned Tuesday, 13 & 26
week auctioned Mondays, and 52 week auctioned every 4th Thursday, all of these
settle on the next Thursday
Treasury notes (2, 3, 5, 7, 10 year) are issued monthly, the 3, 10 year in the first
week of the month and the 2, 5, 7 year in the third week of the month
20 year Treasury bonds are issued monthly in the third week of the month
Treasury bonds (30 year) are issued quarterly in the February cycle, in the first
week of the month
TIPS are issued in 5, 10 and 30 year maturities, issued monthly alternative for
each month (so each maturity is issued quarterly.
Long term US Treasury issuance

Source: SIFMA
All US Treasury Issuance

Source: SIFMA
Trading
The government bond market, in particular the US Treasuries market is hugely
liquid
Over $500bn of trading per day spread out over the different maturities, in
particular on the short maturities, which is why these securities are described
sometimes as near-cash instruments
The most liquid issues are generally the most recently issued ones
Trading in USD bonds

Source: SIFMA
Trading in US Treasuries

Source: SIFMA
Yield curves
A government bond market has a benchmark yield curve, displaying the yield of
it’s securities over different maturities
The ‘benchmark curve’ is so called as it normally includes only the most recently
issued securities, so called the ‘on the run’ securities
Movements in the curve tell us about changes in expectations for the markets, or
about the issuance of securities, and help us form macroeconomic views
 Expectations theory
 Liquidity preference theory
 Market segmentation theory
Yield curves theories
Expectations tells us that we can infer future movements in interest rates from
the curves, as investors naturally buy and sell to reflect their ideas of what a
Central Bank may or may not do in the future
Expectations tells us a lot about the front end of the yield curve
Liquidity preference covers that fact that the yield curve is most often upward
sloping – given the choice ALL investors would rather their money back sooner
than later, and therefore would require more return per year for investing for
longer
Preferred habitat (or market segmentation) theory outlines investor behaviour,
the types of institutions that invest in the curve, where and why they invest
Yield curves

Source Statista
Yield curves

Source: Bloomberg
Yield curves

Source: Bloomberg
Yield curves

Source: Bloomberg
Macroeconomics 1 - fiscal policy
International governments are huge borrowers (in the main), and so fiscal policy
is going to have a massive effect on bond markets
Fiscal policy is the adjustment of government spending and taxation to try and
alter the growth rate of an economy, and meet the governments social objectives
regarding employment and inflation
If the government spends more than it taxes, then it has to fund this by
borrowing money, and the issuance of bonds is the easiest, cheapest way of
doing so
Macroeconomics 2 – monetary policy
The Central Bank has defined objectives other than just managing currency like
notes and coins
Maintain long term growth
 Consistent, sustainable growth in GDP
 What is a target number?
 What is real GDP or GDP per capita?
Maintain maximum or full employment
 What is the target number?
 How is this calculated?
Keep prices stable
 What is a goal for inflation?
 Is it the same in every country?
The Federal Reserves mandate
Traditional monetary policy to achieve these goals include:
 Open market operations
 Reserve requirements
 Discount window lending – but a lender of last resort

In addition the Fed uses non-traditional monetary policy

 Large scale outright asset purchases
• Buying government bonds – quantitative easing
• Buying credit risky bonds – qualitative easing
 Forward guidance
Rates

Source: SIFMA
Central Banks and Government Bonds
In order to enact monetary policy, the central bank is a large purchaser of
government debt

After the financial crisis of 2008, and during the current Covid pandemic, the
central banks have purchased huge amounts of government securities to try
to stimulate the economy and keep the markets liquid
Federal Reserve Total Assets
Federal Reserve Selected Assets
Bank of England Balance Sheet
Unwinding the balance sheet
The big long term question is how the central bank goes about removing the
assets from their balance sheet
This could be achieved by selling bonds they own
Or naturally over time, just allowing bonds they own to mature and they
disappear
The question is when is it the right time for the economy for this to happen, as
that would result in effectively reducing the money supply, and could harm
economic growth