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
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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
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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
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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
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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
A US T-Bond Description on Bloomberg
yield
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
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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
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
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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
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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
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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
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
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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
BIS Data on Bonds
• The Bank for International Settlements
compiles quarterly statistics on securities
markets, including fixed income securities.
• http://www.bis.org/statistics/secstats.htm
Issuers of Bonds
Government Securities
• Treasury Bills
– Pure discount securities placed through auction
– Maturity 13, 26 and 52 weeks
• Treasury Notes and Bonds
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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
Agency Securities
• Issued by different organizations
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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)
• 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: backed 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
Corporate Bonds
• Bonds issued by a corporation
• Typically pay semi-annual coupons
• 3 Sources of Risk
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Interest Rate Risk
Default Risk
Liquidity Risk
• Bond indenture contracts stipulate collateral and
specify terms
• Different “seniority” classes
– Secured Bonds
– Subordinated debentures
– Debentures (Unsecured)
• 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
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 $250,000
• 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
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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…