CHAPTER 8
FIXED - INCOME MARKETS
Overview of the Money Market
• Short-term debt market -- most under
120 days.
• A few high quality borrowers.
• Many diverse investors.
• Informal market centered in New York
City.
• Standardized securities -- one security is
a close substitute for another.
Overview of the Money Market
(concluded)
• Good marketability -- secondary market.
• Large, wholesale open-market transactions.
• Many brokers and dealers are competitively
involved in the money market.
• Payment in Federal Funds -- immediately
available funds.
• Physical possession of securities seldom made -centralized safekeeping.
Economic Role of
Money Market (MM)
• The money market is a market for
liquidity
– Liquidity is stored in MM by investing in
MM securities.
– Liquidity is bought in MM by issuing
securities (borrowing).
Characteristics of Money
Market Instruments
• Low default risk.
• Short maturity.
• High marketability.
Money Market Balance Sheet
Position of Major Participants
FEDERAL
RESERVE
SYSTEM
COMMERCIAL
TREASURY
DEALERS
BANKS
DEPARTMENT
AND BROKERS
INSTRUMENT
A
L
A
L
A
L
A
L
Treasury Bills




Agency securities



Negotiable CDs


Commercial paper


Banker's acceptances



Federal Funds


Repurchase agreements 


Note: A = Assets, L = Liabilities.
Commercial banks are both important investors in and issuers of money market instruments.
CORPORATIONS
A
L






Commercial Banks -- Most
Important Participant in the MM
• Bank assets or investments
–
–
–
–
–
Treasury bills.
Agency securities.
Bankers' acceptances (from other banks).
Federal Funds sold.
Repurchase agreements (securities
purchased under agreements to resell).
Commercial Banks -- Most
Important Participant in the MM (concluded)
• Bank liabilities or borrowing
–
–
–
–
–
Negotiable CDs.
Commercial paper.
Bankers' acceptances.
Federal Funds purchased.
Repurchase agreements (securities sold under
agreements to repurchase).
• MM securities provides sources and uses of
liquidity due to wide fluctuations in loans and
deposits.
The Federal Reserve
in the Money Markets
• Money market securities is the major
asset category of the Fed.
• Open-market operations (buying and
selling of MM securities by Fed) is the
primary tool for implementing monetary
policy.
– Purchase -- increases member bank reserves.
– Sale -- decreases member bank reserves.
Dealers in U.S. Securities -- Involved in
both primary and secondary markets.
• Purchases new treasury debt and resells
it (primary).
• "Makes a market" by buying/selling
(dealer) securities (bid/ask).
• Purchases are financed by repurchase
agreements or fed funds.
Treasury Bills -- Ideal Money
Market Instrument
• Characteristics
– Sold on discount basis.
– Maturities up to one year.
– Denominations are in multiples of $1000.
• Pricing Treasury Bills
– Treasury bills are priced on a bank discount
rate basis, a traditional yield calculation.
– The bank discount rate, rd, is:
rd 
Face Value  Price
360
x
 100%
Face Value
Days to Maturity
Treasury Bills -- Ideal Money
Market Instrument (concluded)
– The Wall Journal lists T-Bill yields on a bond
equivalent basis where the discounted price is the
denominator and 365 days is used as the annualizer.
Bond Equivalen t Yield 
Face Value  Price
365
x
 100%
Price
Days to Maturity
– The effective annual yield assuming compounding a
year is:
Effective Yield = [(Face Value/Price)365/D -1] x 100%.
Auctioning New Bills
• Weekly sale by U. S. Treasury of three- and sixmonth maturities; longer-term bills, monthly or
quarterly.
• Competitive vs. noncompetitive bid: states both
the quantity of bills and bid price. Large bids.
Multiple bids.
• Noncompetitive bid: states only the quantity of
bills requested at weighted average price.
Smaller bids.
Book-entry Securities
• No physical securities: only record
entries.
• Book-entry record keeping only since
1976.
• Most of marketable Treasury debt is now
in book- entry form.
Types of Federal Agencies
• Farm credit agencies -- loans to farmers.
• Housing credit agencies -- loans and
secondary market support for mortgage
market.
• Other agencies – (SBA)special purposes.
• Federal financing bank -- purchases
securities of agencies and issues its own
obligations (clearinghouse).
Characteristics of Agency Debt
• Most are not guaranteed by federal
government; federal guarantee implied,
not explicit.
• Marketability varies with the
development of the secondary market.
• Yields are higher than T-Bills.
– Slightly greater default risk.
– Slightly lower marketability.
Negotiable Certificates of Deposit – Major
Source of Funds for Large Money Center Banks
• Characteristics of Negotiable CDs
– Large denomination time deposit, less than six
month's maturity.
– Negotiable -- may be sold and traded before
maturity.
– Issued at face value with coupon rate.
• Development of the CD Market
– Issued by Citibank in 1961.
– Offset declining demand deposits as a source of
funds.
Negotiable Certificates of Deposit
(concluded)
• The CD Market
– Rate negotiated between buyer and seller.
– Market is sensitive to rates above or below
the market rates.
– Rates are lower for money center banks and
are tiered upward for regional banks.
– Purchased mainly by corporate businesses.
Characteristics of Commercial Paper
•
•
•
•
•
Short term -- one to 270 days.
Unsecured.
Large denominations -- $100,000 and up.
Issued by high-quality borrowers (GMAC).
A wholesale money market instrument -- few
personal investors.
• Sold at a discount from par.
• Directly or dealer sold.
• Backed by bank lines of credit.
The Commercial Paper Market
• Major investors
–
–
–
–
–
Commercial banks.
Insurance companies.
Nonfinancial business firms.
Bank trust departments.
State and local pension funds.
• Banks are involved
–
–
–
–
Backup lines of credit.
Act as agents in issuance.
Hold notes in safekeeping.
Facilitate payment in Federal Funds.
The Commercial Paper Market
(concluded)
• Credit ratings are available for
commercial paper.
• Backup lines of credit from banks
support or guarantee quality.
• Placement
– Directly by a sales force of the borrowing
firm.
– Indirectly through dealers.
Characteristics of Bankers‘ Acceptances
• Time draft -- order to pay in future.
• Drafts are drawn on and/or accepted by
commercial bank.
• Direct liability of bank.
• Mostly relate to international trade.
• Secondary market -- dealer market.
• Discounted in market to reflect yield.
• Standard maturities of 30, 60, or 90 days -- max
of 180.
Creating a Banker's Acceptance
• Importer initiates purchase from foreign
exporter, payable in future.
• Importer needs financing; exporter needs
assurance of payment in future.
• Importer's bank writes irrevocable letter of
credit for exporter
– Specifies purchase order.
– Authorizes exporter to draw time draft on bank.
Creating a Banker's Acceptance
(concluded)
• Importer's bank accepts draft (liability to
pay) and creates a banker's acceptance.
• Advantage of a banker's acceptance (BA)
– Exporter receives funds by selling BA in the
market.
– Exporter eliminates foreign exchange risk.
– Importer's bank guarantees payment of
draft in future.
Federal Funds
• Characteristics of Federal Funds
– Market for depository institutions.
– Most liquid of all financial assets.
– Related to monetary policy implementation.
• Yields related to the level of excess bank
reserves.
• Originally a market for excess reserves -- Now
a source of investment (federal funds sold) and
continued financing (federal funds purchased).
Federal Funds (concluded)
• Most Are One-day, Unsecured Loans.
• Bookkeeping Entry, Interest Paid
Separately.
• Traded in Fed Funds or Immediately
Available Funds.
Repurchase Agreements (Repo)
• Financing -- Source of funds
– Security sold under agreement to repurchase at
given price in future.
– Way to include corporate business in Federal Funds
market.
– Negotiated market rate.
• Investment -- Use of Funds (Asset)
– Security purchased under agreement to resell at
given price in future.
– Smaller banks are able to invest excess liquidity in a
secured investment.
Repurchase Agreements (Repo)
(concluded)
• Repos are used by the Federal Reserve in
open market operations.
Interrelationship of Money
Market Interest Rates
• Various MM instruments are close
substitutes in investment portfolios.
• Interest rates move together over time.
• Deviations from traditional spreads are
quickly eliminated by interest rate
arbitrage.
Capital Markets
• Economic purpose -- brings together long-term
(over 1 year) borrowers and long-term
investors.
• Major Issuers (borrowers)
– Households - mortgages.
– Business.
– Governments -- federal, state, and local.
• Major Investors
– Households (directly or through Financial
Intermediary).
– Foreign Investors.
Types of Capital Market Claims
• corporate stock -- studied in Chapter 9.
• bonds -- studied here in this chapter.
• mortgages -- studied in Chapter 10.
U.S. Government and
Agency Securities
• U.S. Government Issues -- Notes and
Bonds
–
–
–
–
Coupon issues.
Notes -- one to ten-year maturity.
Bonds -- over ten-year maturity.
Sold by auction by the Federal Reserve
banks.
– Trend is toward more money market
financing and less capital market financing.
Corporate Bonds
• Debt contracts (indenture) requiring borrower
to make periodic payments of interest and
repay principal, usually $1,000, at maturity
date.
• Types of ownership record
– Bearer bonds -- coupon bond owned by bearer.
– Registered bonds -- owner noted by records.
• Maturity
– Term bonds -- all bonds mature at future date.
– Serial bonds -- bonds mature at varying future
dates. Municipals
The Bond Indenture (or Contract)
• Collateral
– Mortgage bond -- real assets pledged.
– Equipment trust certificates -- specific, titled, or
identifiable equipment.
– Collateral bonds -- secured by financial assets.
– Debentures -- unsecured bonds.
• Claim on assets
– Senior debt -- first priority to general assets.
– Subordinated -- asset claim ranking of unsecured
debentures below senior or specific creditors.
The Bond Indenture (concluded)
• Means of principal payment
– Sinking fund -- building a sum for
retirement or the periodic retirement of a
number of bonds selected randomly.
– Call provision -- borrower right to retire
bond before maturity.
Investors in Corporate Bonds
• Major investors include:
–
–
–
–
life insurance companies.
pension funds.
households.
Foreign Investors.
• Investor requirements:
–
–
–
–
long-term investment horizon.
liquidity not always needed -- hold to maturity.
safety -- investment grade.
tax considerations.
The Market for Corporate
Bonds
• Public sale -- open to all interested buyers.
– Competitive sale -- public auction among
underwriters.
– Negotiated sale -- underwriting contract signed with
specific underwriters.
• Private placement -- sold to limited number of
sophisticated buyers, avoiding SEC
registration.
– private placements have increased relative to public
sale.
– when interest rates are high and/or when capital
market conditions are unstable, private placements
increase.
The Market for Corporate Bonds
(concluded)
– SEC Rule 144a (1990) liberalized the regulation of
private placements. It allows secondary market
trading of private placements.
• Most secondary trading of corporate bonds
occurs through dealers vs. exchanges.
– the volume of trading is low--a thin market, thus
there is a wide bid/ask differential in the market.
– corporate bonds are less marketable than money
market instruments.
Junk bond issuance was very
popular in the 1980s
• Junk bonds are low rated (high default risk)
corporate bonds.
• Development of the junk bond primary market
was enhanced by the secondary market
maintained by Drexel, Burnham and Lambert
in the early 1980s. Increased Liquidity.
• Higher risk firms found they could issue longer
term, more flexible securities in the high-yield
market rather than borrowing from
commercial banks.
Junk bond issuance was very
popular in the 1980s (concluded)
• Many financial institutions, such as
S&L's and life insurance companies, with
high cost sources of funds, became major
junk bond investors.
• Junk bonds fueled the merger mania of
the 1980s.
State and Local Government
Bonds -- Municipal Bonds
• Types of Municipal Bonds
– General obligation -- backed by taxing
power of political entity.
– Revenue -- financed and paid back from a
specific project.
– Industrial development bonds (IDB) -public financing of private business.
State and Local Government
Bonds -- Municipal Bonds (continued)
• The Relation between Municipals and Taxable
Yields
– Interest on municipal bonds is exempt from federal
tax on coupon interest payments.
– Muni bonds and taxable corporates are similar
except for the taxation of interest.
– The yield on municipals equals the yield on taxables
times one minus the marginal tax rate.
im = it (1-T).
State and Local Government
Bonds -- Municipal Bonds (continued)
• Three groups of investors in municipal bonds
whose demands are affected by their high
federal tax exposure are:
– Commercial banks -- the Tax Reform Act of 1986
ended the tax deductibility of interest expense
incurred on borrowing for the purchase of tax
exempt securities.
– Households -- affected by income level and marginal
tax rates.
– Casualty insurance companies -- investment
determined by industry profitability.
State and Local Government Bonds -Municipal Bonds (concluded)
• The Market for Municipal Bonds
– Primary market.
• Many individual smaller issuers.
• Underwritten by investment bankers--from local
to national markets.
– Secondary market not well-developed -OTC market made by dealers.
The Role of Financial
Guarantees
• Cover the payment of principal and interest in
the event of default.
• Substitutes the credit standing of the guarantor
for that of the security issuer.
• Provided for a fee by
– Commercial banks - letters of credit to back
commercial paper or swaps.
– Insurance companies - insurance policies to back
bond issues.