FIXED-INCOME SECURITIES

Chapter 1

Bonds and Money-Market

Instruments
 Outline

• Overview of Bond Markets

– Bond Characteristics
– Floating-Rate Notes
– Inflation-indexed bonds

• Issuers of Bonds
– Size of fixed-income markets
– Government Bonds
– Municipal Bonds
– Mortgage-Backed Securities
– Corporate Bonds

• Money-Markets
• Other Fixed-Income Markets
 Bond Markets
Overview

• Bonds are claims to a specified stream of income

– Typically stream is ‘fixed’ (principal plus interest at an annual
coupon rate)
– Some ‘floating rate streams’

• Volatile interest rates in 80’s/90’s led to engineering

of interest-rate contingent claims
– Zeroes
– Adjustable rate bonds
– Bonds with embedded options
– Foreign currency bonds, etc.
 Bond Markets
Bond Characteristics

• A debt security (or a bond) is a financial claim by

which
– The issuer (or the borrower) is committed ….
– … to paying back to the bondholder (or the lender) …
– … the cash amount borrowed (called the principal) …
– … plus periodic interests calculated on this amount during a given
period of time
 Bond Markets
Bond Characteristics: Indenture
• Bond Indenture
– Coupon rate
– # payments per year
– Maturity
– Face Value
• Example
– A US Treasury bond with coupon 3.5%, maturity date 11/15/2006
and a nominal issued amount of $18.8 billion …
– … pays a semi-annual interest of $329 million ($18.8 billion times
3.5%/2)
– … every six months until 11/15/2006 included, as well as $18.8
billion on the maturity date
coupon rate price maturity date

Bond Markets yield

A US T-Bond Description on Bloomberg
 Bond Markets
Basis – Computing the # of Days

• Convention 1
– Actual /360 basis: exact # of days divided by 360
– Used on the money market
– Example 764 days between 08/01/1999 and 09/03/2001
• Convention 2
– Actual/Actual basis: exact # of days divided by 365 or 366
– Used for computing accrued interest
– Example: from 08/01/1999 to 09/03/2001, 152/365 + 1 + 246/365 = 2.0904
• Convention 3
– 30/360 basis : year divided into12 30-days month
– Used on swap market
– Example: from 01/01/2001 to 03/25/2001 : 2 x 30 + 24 = 84 days
• Convention on starting/end dates
– Most deals start spot (j+2)
– For week-ends and holydays: following day, preceding day, following day if
same month, preceding day if same month
 Bond Markets
Basis – Computing the Rate

• Conversion formulas
 360 
r360  r365   
 365 
 365 
r365  r360   
 360 

• Examples
– r365 = 10% corresponds to r360 = 9.86%
– r365 = 5% corresponds to r360 = 4.93%
– r365 = 20% corresponds to r360 = 19.73%
– Difference increases with rate
 Bond Markets
Settlement Date

• The settlement date is the date on which

payment is due in exchange for the bond
(used for interest computations)
• It is generally equal to the trade date plus a
number of working days
• Examples:
 Bond Markets
Settlement Date - Examples
– In the US, the settlement date for Treasury bonds and T-bills is
equal to the trade date plus 1 working day

– In the Euro zone, the settlement date for Treasury bonds is equal
to the trade date plus 3 working days as it can be 1, 2 or 3
workings days for T-bills depending on the country under
consideration

– In the UK, the settlement date for Treasury bonds and T-bills is
equal to the trade date plus 1 and 2 working days respectively

– In Japan, the settlement date for Treasury bonds and T-bills is

equal to the trade date plus 3 working days.
 Bond Markets
A Corporate Bond Description on Bloomberg
 Bond Markets
Floating Rate Notes

• Floating-Rate Notes are bonds that bear floating coupon rates

– Floating-rate bonds : bonds with a coupon rate indexed on a short-term reference with
a maturity inferior to one year (e.g., 3-month Libor rate)
– Variable-rate bonds or adjustable-rate bonds : bonds with a coupon rate indexed on a
longer-term reference with a maturity superior to one year
• Coupon rates can be determined in three ways
– As the product of the last reference index value and a multiplicative margin
– As the sum of the last reference index value and an additive margin
– As a mix of the two previous indexations
• Example
– An investor buying a floating-rate bond whose coupon rate is equal to three-month
Libor + 20bp is entitled to receiving, every period determined in the contract (usually
every three months), a coupon payment
– The coupon rate will be reset every three months in order to reflect the new level of the
three-month Libor
– Usually, the reset frequency is equal to the coupon payment frequency
 Bond Markets
Inverse Floaters

• When the sign of the additive margin is negative, the

bond is called an inverse floater
– The coupon rate moves in the opposite direction to the reference index
– So as to prevent it from becoming negative, a floor is determined that is
usually equal to zero
– Such bonds have become fairly popular under a context of decreasing
interest rates

• Example
– An investor buying an inverse floater whose coupon rate is equal to 16%-2
times 2-year T-Bond yield is entitled to receiving, every period determined in
the contract (usually every year), a coupon payment
– The coupon rate will be reset every two years in order to reflect the new
level of the two-year bond yield
 Bond Markets
Inflation-Indexed Bonds

• Inflation-indexed bonds deliver coupons and principal that are

indexed on the future inflation rates
• They are structured so as to protect and increase an investor's
purchasing power
• They are mainly issued by governments to make it clear they
are willing to maintain a low inflation level
• They are more developed in the UK where they represent more
than 20% of outstanding government bonds, versus only 7% in
the US (1999)
• An inflation-indexed bond can be used to
– hedge a portfolio against a rise in the inflation rate
– diversify a portfolio based on low correlation with stocks, fixed-coupon bonds and cash
 Issuers of Bonds
Various Issuers

• US Treasury

– T-Bill (maturity < 1 year)

– T-Notes (maturity 2, 3, 5, 7 and 10 year)
– T-Bonds (>10 years)

• Municipalities

• Corporations

• International Governments and Corporations

 Issuers of Bonds
Size of Fixed Income Markets

Security Type Market Value

($Bill, 1999Q1)

Treasury Securities $3759.7

U.S. Agencies $1349.9

Bank Loans $1,270.3

Mortgages $5,780.5
Consumer Credit $1,318.6

State/Local Govt $1481.6

Corporate & Foreign Bonds $3627.7

Mortgage-Backed Pools $2111.4

Asset-Backed Pools $1464.2

TOTAL FIXED INCOME $22163.9

Source: April 1999, Federal Reserve Bulletin
 Issuers of Bonds
Sector Breakdown (June 30, 2001)

M a r k e t w e ig h t
T re a s u ry 2 5 .8 1 %
G o v e rn m e n t S p o n s o re d 1 2 .0 6 %
* Agency 1 1 .0 6 %
* S u p r a n a t io n a l 1 .0 0 %
C o lla t e r a liz e d 3 6 .9 6 %
* M o rtg a g e 3 6 .1 3 %
* A s s e t-B a c k e d 0 .8 3 %
C r e d it 2 5 .1 6 %
* A A A /A A 4 .9 3 %
* A 1 1 .4 8 %
* BBB 8 .7 4 %

S o u r c e : S a lo m o n S m it h B a r n e y
 Issuers of Bonds
Government Securities

• Treasury Bills
– Pure discount securities placed through auction
– Maturity 13, 26 and 52 weeks
• Treasury Notes and Bonds
– Half coupon paid semi-annually
– Maturity 2, 3, 5, 7, 10 (notes) and 30 years (bonds)
– Sold in denominations of $1,000
– Bonds may be callable
 Issuers of Bonds
Country breakdown of the JP Morgan Global
Government Bond Index

Market Weights Market Weights Weights' evolution

as of 06/01/01 as of 09/01/97 between 09/97 and 06/01
€land * 33.24% 30.94% +7.43%
Japan 30.27% 14.72% +105.67%
US 25.37% 39.84% -36.32%
UK 5.80% 6.73% -13.87%
Canada 3.12% 3.11%
Denmark 1.14% 1.80%
Sweden 0.68% 1.74%
Australia 0.38% 1.12%

* Belgium, France, Germany, Italy, Netherlands, Spain

Source : JP Morgan
 Issuers of Bonds
Agency Securities

• Issued by different organizations

– Federal National Mortgage Association (Fannie Mae)
– Federal Home Loan Bank System (FHLBS),
– Federal Home Loan Mortgage Corporation (Freddie Mac)
– Farm Credit System (FCS)
– Student Loan Marketing association (Sallie Mae)
– Resolution Funding Corporation (REFCO)
– Tennessee Valley Authority (TVA)
• Agencies have at least two common features
– First, they were created to fulfill a public purpose.
– Second, the debt of most agencies is not guaranteed by the US
government
 Issuers of Bonds
Municipal Bonds

• Issued by state and local governments

– Exempt from federal income tax
– Exempt from (issuing) state local tax

• Types of ‘munis’
– General obligation bonds: baked by the ‘full faith of credit’ of the
issuer (taxing power)
– Revenue bonds (riskier): issued to finance specific projects
(airports, hospital, etc.)
 Issuers of Bonds
Municipal Bonds (continued)

• Who purchases municipal bonds?

– T-bond pays 5% and municipal bond 3.8%
– If (marginal) tax rate is 20%? 35%?

• After-tax return
– MTR = 20%: (.05)x(.8) = .04 > .038
– MTR = 35%: (.05)x(.65) = .0325 < .038

• What MTR is indifferent (‘cutoff rate’)?

(.05)x(1 - t) = .038 => t = .24 = 24%
 Issuers of Bonds
Corporate Bonds

• Bonds issued by a corporation

• Typically pay semi-annual coupons
• 3 Sources of Risk
– Interest Rate Risk
– Default Risk
– Liquidity Risk

• Bond indenture contracts stipulate collateral and

specify terms
• Different “seniority” classes
– Secured Bonds
– Subordinated debentures
– Debentures
• Preferred stocks
– ‘Promises’ fixed dividend = coupon rate
– Cannot force bankruptcy if no dividend paid
 Issuers of Bonds
Bond Quality

• Standard & Poor, Moody’s and other firms score ‘the

probability of continued & uninterrupted streams of
interest & principal payments to investors’

• Classes of grades
– Moody’s Investment Grades: Aaa,Aa,A,Baa
– Moody’s Speculative Grades: Ba, B, Caa, Ca, C
– Moody’s Default Class: D

• Are ratings agencies better able to discern default

risk or simply react to events?
 Issuers of Bonds
Size of the Corporate Bond Markets - US and Europe

Description Par Amount Weight

(in billion USD) (in %)
USD Broad Investment Grade bond market 6,110.51 100.00
USD Govt./Govt. Sponsored 2,498.23 40.88
USD Collateralized 2,216.73 36.28
USD Corporate 1,395.56 22.84
USD Corporate (Large Capitalizations) 869.96 14.24
USD Corporate 1,395.56 100.00
AAA 35.33 2.53
AA 200.81 14.39
A 653.76 46.90
BBB 505.65 36.23
Description Par Amount Weight
(in billion USD) (in %)
EUR Broad Investment Grade bond market 3,740.77 100.00
EUR Govt./Govt. Sponsored 2,455.24 65.63
EUR Collateralized 685.78 18.33
EUR Corporate 599.75 16.03
EUR Corporate (Large Capitalizations) 416.96 11.15
EUR Corporate 599.75 100.00
AAA 143.10 23.86
AA 151.55 25.27
A 220.36 36.74
BBB 84.74 14.13
 Issuers of Bonds
Strips

• Initially created by investment banks

• Coupons are detached and principal and coupons

sold individually
– It used to imply a tax break
– Not anymore, the law has changed
– Even after the law changed, great success

• The government has its own program

 Money Markets
Money Markets Instruments

• Markets for short term debt

• Highly marketable (liquid)

• Low risk

• Very large denominations

• MM mutual funds accessible

 Money Markets
T-bills

• Treasury bills: short term gov. debt

• Primary market: auction

– Competitive bid: specify quantity and price (hope to bid low, not get
‘shut-out’)
– Non-competitive bid: specify quantity (receive quantity at ‘average
price’)

• Secondary market
– Very liquid (low transactions costs)
– Denomination = $10,000
 Money Markets
CDs and CPs

• Certificate of Deposit (CD)

– Time deposit (penalty for early withdrawal)
– Insured by Federal Deposit Insurance Corporation (FDIC) for $100,000
• Commercial Paper
– Company borrows from public
– Short term, unsecured
• Banker’s Acceptances
– Bank guarantees payment
– Replaces firm’s credit with bank’s
• Repurchase Agreements (Repo’s)
– Effectively an overnight, collateralized loan
– Sell government securities, with promise to repurchase at slightly higher
price tomorrow
 Money Markets
Repurchase Agreements

• A repo is a way for an investor to borrow money

– A commitment by the seller of a security (usually gvt security) to buy it back
from the buyer at a specified price and at a given future date
– Can be viewed as a collateralized loan, the collateral being the security
• Repo maturity
– When repo maturity is one day, called overnight repo
– When repo maturity exceeds one day, called term repo
• A reverse repo is a way for an investor to lend
money
– A reverse repo agreement is the same transaction viewed from the buyer's
perspective
– The repo desk acts as the intermediary between investors who want to
borrow cash and lend securities and investors who want to lend cash and
borrow securities
– The repo rate is computed on an Actual/360 day-count basis
 Money Markets
Repo - Example

• A German investor needs to borrow € 1 million

– He lends € 1 million …
– … of the 10-year Bund benchmark bond (i.e., the Bund 5% 07/04/2011 with
a quoted price of 104.11, on 10/29/2001) …
– … over 1 month at a repo rate of 4%
– There is 160 days' accrued interest as of the starting date of the
transaction
• Cash payments
– At the beginning of the transaction, investor receives an amount of cash
equal to the gross price of the bond times the nominal of the loan, that is
(104.11+5x160/360)x1,000,000/100= € 1,063,322
– At the end of the transaction, in order to repurchase the securities he will
pay the amount of cash borrowed plus the repo interest due over the
period, that is
1,063,322 + 1,063,322 x 4 x 30/360= € 1,066,866
 Money Markets
Repo - Examples

• Financing a long position

– An investor wants to finance a long position of € 1 million Bund with
coupon 5% and maturity date 07/04/2011
– Can purchase these securities and then lend them (repo transaction)
– He will gain the coupon income of the securities he owns, that is
€ 1,000,000 x 5%/360 = € 138.89 a day
– He will lose the repo rate, that is
€ 1,063,322 x 4%/360 = € 118.15 a day
– His net gain per day equals $138.89 - 118.15 = € 20.74
• Financing a short position
– An investor has to make a delivery of € 1 million Bund on his short sale
position
– He can borrow the securities through a reverse repo transaction, and then
lend the money resulting from the short sale to the repo desk as collateral
– Suppose the reverse repo rate is 4%, his net loss per day amounts to €
20.74
 Other Fixed-Income Securities

• Swaps (Chapter 10)

• Futures and forwards (Chapter 11)
• Bonds with embedded options (Chapter 14)
• Options (Chapter 14)
• Swaptions (Chapter 15)
• Caps, floors, collars (Chapter 15)
• Exotic options (Chapter 16)
• Credit derivatives (Chapter 16)
• Mortgage-Backed Securities (Chapter 17)
• etc…