Fixed Income Securities
Fin 284
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Drake Fin 284
DRAKE UNIVERSITY
Introduction
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US bond market
Bond Market Association estimate the total
market value of outstanding debt in the United
States in September of 2003 to be over
$22Trillon
Need to understand where fixed income fits in
the financial system
Background
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Financial Institutions channel funds from
individuals and institutions with a surplus of
funds to (suppliers) to those with a shortage
or funds (users of capital).
Banks
Credit Unions
Insurance Companies
Mutual Funds
Total assets 2000 = $14.75 trillion
Categories of FI’s
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Depository Institutions
Banks, Savings and loans, Thrifts, Credit
Unions
Nondepository Institutions
Insurance Co’s, Investment Banks, securities
firms, mutual funds and finance companies
Similar Risks and Rewards
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All Financial Institutions:
Hold Assets that are subject to default (or
credit) risk
Are exposed to interest rate risk based on
maturity of assets and liabilities
Exposed to liquidity (withdraw) risks
Face operational costs and risks
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Financial Intermediation
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At any point in time there are individuals in
the economy with both a surplus and
shortage of funds.
For the economy to function efficiently it
should be possible for those with a surplus to
lend to those with a deficit.
Bringing Together
Borrowers and Lenders
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Direct Financings vs. Indirect Financing
Funds are either exchanged between the
borrower and lender directly or via a financial
institution.
Direct Financing
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The direct exchange of money and financial
claims between individuals with excess funds
and individuals with a shortage of funds.
The participant with a deficit issues a financial
claim (a bond for example) purchased by the
participant with a surplus of funds.
Direct Financing
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Private Placement The entire claim is sold to an
individual investor or a small group of investors
Brokers and Dealers
Brokers – Serve as a matchmaker bringing together
the two sides – receive a commission for their efforts
(they do not actually buy or sell securities)
Dealers – Market Makers – Serve to both buy and sell
(at different prices) a given security. For example a
dealer might be willing to but shares at $80 (the bid
price) and sell shares at $81.50 (the ask price)
Direct Financing
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Investment Bankers
Main role is helping those seeking funds
market new claims.
May purchase a claim directly then sell it off in
pieces for a profit (close to intermediation).
The claim is still basically intact. The sold off
claim is still with the original issuer.
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Direct Financing
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Fin 284
Equity & Debt
Suppliers of
Funds
(net savers)
Users
of Funds
Cash
(net borrowers))
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Problems w/o
Financial Institutions
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Monitoring is costly
Exposes households to increased risk
Lack of Liquidity
Households may not be able to easily convert
claims to cash
Price Risks
Prices fluctuate
Indirect Financing
(Intermediation)
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An intermediary transforms assets acquired
through the market into a more widely
preferred asset (which becomes their liability).
The intermediary is then holding a direct
claim in terms of their assets The participants
holding the claims issued by the intermediary
are said to have an indirect claim.
Direct Financing
Surplus Funds
Households
Business
Government
Direct
Claims
Dollars
Indirect
Claims
Dollars
Private
Placement
Brokers &
Dealers
Investment
Bankers
Indirect Financing
(intermediaries)
Banks & Thrifts
Finance Companies
Insurance Firms
Pension Funds
Mutual Funds
Deficit Funds
Direct
Claims
Dollars
Households
Business
Government
Direct
Claims
Dollars
Examples
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Commercial Bank: Accept Deposits and use
the cash to make loans to other participants
(both households and businesses)
Mutual Fund Firm: Pooling Funds of
individuals and uses them to buy a portfolio
of securities
The roles of Financial
Intermediation
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Maturity and Denomination Intermediation
The intermediary can produce assets of varying
maturities. It transforms demand deposits
into long term commercial loans for example.
Similarly the intermediaries can produce a wide
variety of denominations in the new assets via
pooling and separating of funds
The Roles of Intermediation
Diversification
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The firm is able to change the risk characteristics
of the claims.
For example a mutual fund which takes a
relatively small sum of money form an individual
investor but invests in a portfolio of assets.
(Decreases Credit Risk).
The size of the firm allows it to be more cost
effective at producing this risk reduction . An
individual doing this alone, faces high costs.
(there is an economy of scale in the intermediaries
operations)
The Roles of Intermediation
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Information Cost Reduction
Specialization allows the intermediary to focus on
investment analysis. This is a costly process for the
individual. It also allows a reduction in loan
contracting costs.
Providing a payment mechanism
The firms provide a means of noncash payemt
(checks, debit card etc…). The intermediaries also
provide many claims that are highly liquid, allowing
individuals to invest in less liquid assets indirectly.
Roles played by FI’s
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Brokerage Function
Research and information provider (reduces information
costs such as agency costs)
Economies of Scale (decreases transaction costs and
information costs)
Asset – Transformation Function
Purchase primary claims and issue secondary claims
backed by the primary claims (reducing contracting
costs)
Allows for risk sharing via diversification (reduces price
and liquidity risk)
Roles played by FI’s
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Transmission of Monetary Policy
The liquid nature of depository institutions
make them the main way monetary policy is
transmitted to the public
Credit Allocation
Primary suppliers of capital to special sectors
of the economy (Residential lending for
example)
Intergenerational Transfer of Wealth
Insurance and pension funds allow transfer
across generations
Other Functions
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Maturity Intermediation
Provides households with maturities that match what
they desire
Intermediaries are willing to accept longer term risks and
finance them with short term deposits.
Denomination Intermediation
Commercial paper is issued in $250,000 units, too large
for most households
Payment Mechanism
Facilitate the payment of claims without the use of cash.
Regulation
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Given their vital role in the economy FI’s are
highly regulated. The goal of this regulation
is to protect against a disruption in the
services they offer.
Some segments of the population could be
discriminated against without regulation
(race, gender etc)
The difference the private benefits and private
costs of regulation are the net regulatory
burden.
Types of Regulation of FI’s
Safety and Soundness Regulation
Monetary Policy Regulation
Credit Allocation Regulation
Consumer Protection Regulation
Investor Protection Regulation
Entry Regulation
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Fixed Income Markets
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To provide the intermediary role, most of the
financial institutions become active
participants in the fixed income market.
The market provides a source of funds and
risk management
New products have been developed that
broaden the market, manage risk and provide
profit opportunities.
Trends in the Market
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Market Broadening Instruments
Increase liquidity of the market attracts new
investors and provides opportunities for
borrowers
Risk Management Instruments
Reallocate financial risks to those willing and
able to borrow them
Arbitraging Instruments
Allow investors and borrowers to take advantage
of differences between markets
Reasons for Innovation
Increased volatility of interest rates
Advances in Technology
Greater sophistication among
participants
Increased Competition
Globalization
Avoiding Regulation
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Types of Bonds Issued
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Treasury – Treasury Bonds, Bills and Notes
issued by the US government
Agency – Federal agencies such as FHLB,
FNMA, GNMA etc
Municipal – Issued by state and local
governments
Corporate - Used to Raise funds
Mortgage – Backed
Asset backed
Compostion of US Debt Market Sept
2003 (total value $22.6 Trillion)
Asset
Money Backed
Market, $1.68T
$2.526T
Federal
Agency
$2.636T
Corporate
$4.347T
Muni
1.883T
Treasury
$3.446T
Mortgage
Related
$5.129T
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Treasury Markets
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Types of Treasury Securities
Discount vs. Coupon
Bills, Notes and Bonds
Treasury Inflation Protection Securities
Coupon set at fixed rate by auction process (real rate above
inflation)
Both Principal and interest are adjusted for inflation
Example: Coupon = 3.5%, 100,000 Par Value 3% infl
End of 6 mos: Princ= 100,000(1.05) = 101,500
Int = 101,500(.0175) = $1776.25
End of 1 year 2% infl: Princ: 101,500(1.01) = 102,515
Int = 102,515(.0175) = 1794.01
Treasury Markets
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The Primary Market (the Auction Process)
The Treas announces $ amount to be
auctioned, date of auction and maturities
Deduct noncompetitive bidders and nonpublic
purchases the rest sent to competitive bidding
Starting from the lowest yield (highest price)
all bids are accepted until the total amount
allocated is reached
When total allocation is reached the “Stop
Yield” is hit, all accepted bids pay stop yield.
Auction Process continued
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Bidders at the stop yield awarded a % of the
amount desired, everyone else receives full
amount
Difference between the average yield bid and
the stop yield is referred to as the tail. The
lower the tail the “more successful” the
auction is considered.
The Secondary Market
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An OTC market with continuous bid and ask
on outstanding treasuries
The most recent issue auctioned is referred to
as the “on – the - run issue.”
Mortgage – Backed Sec.
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Securitization has created a large market in
mortgage backed securities
Securitization – The packaging and pooling of
assets so they have the characteristics of
security instruments that can allow them to
be resold.
Maturity Intermediation and denomination
intermediation
Securitization
Benefits to Issuers
Diversification – Broadens funding source
Ability to manage capital requirements
Provides Fee Income
Manage interest rate volatility
Benefits to investors
Increased Liquidity
Reduced Credit Risk
Benefits to Borrowers
Reduced spreads
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Corporate Markets
Commercial paper
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Unsecured short term borrowing – An alternative to
bank borrowing (less than 270 days)
millions of $
total outstanding total outstanding
non financial
financial
March 92
137,857.40
389,559.30
March 97
187,705.30
642,717.70
March 02
188,752.80
1,169,361.00
Often it is used as bridge financing.
Corp Medium Term Notes
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Offered on a continuous basis with the investor
having the ability to select maturity. Allowed under
the self registration rule (Rule 415).
Register with the SEC to sell a certain amount of a
certain class of securities one or more times within
the next two years.
Vast majority of MTN rated as investment grade.
MTN accounted for 13% of outstanding debt in 2000
with a total of $71 billion dollars filed for. This was
down from 150 billion in 98 and 135 billion in 99.
Agency Securities
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Issued by Federally related Institutions such
as Fannie Mae (Federal National mortgage
Association), Freddie Mac (Federal Home Loan
Bank Corp etc
Created by congress to reduce the cost of
capital for specific borrowing sectors of the
economy.
Many of their securities are asset backed and
mortgage backed
Municipal Securities
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Issued by state, and local government
Generally pay tax exempt interest, allowing a
lower interest rate to be paid.
Higher liquidity risk than other issuers.
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Municipal Issuers
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21%
38%
State Govt
State Author
2%
0%
8%
31%
Municipalities
Local
Authorites
Public
Colleges
Tribal Gov't
Use of Municipal Financing
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Development
4%
Eduction
24%
22%
Electric Power
Enviromental Factilites
Health Care
Housing
2%
Public Facitlites
8%
4%
Transportaion
Utilities
General Purpose
12%
10%
5%
9%
Municipal Securities
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General Obligation Debt
Unlimited: Secured by the issuers taxing power
Limited: Statutory limit on the tax rates and
types of taxes that can be levied to service the
debt
Appropriations Backed Debt
State tax revenue is a possible but unbinding
source of repayment. Appropriation must be
approved by a governing body
Municipals continued
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Revenue Bonds
Revenue produced from a specific project are
pledged (Toll roads, airports etc)
Private Activity Bonds
Similar to Revenue, but private entity is
partner
Tax reform act of 1986 limited tax exempt
status
10% of bond must be secured by private
entity
Bond Market Features
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Issuer – Entity raising funds in the primary market
Term to Maturity – Length of time before maturity of
the bond
Par Value – Amount to be repaid at maturity
Coupon Rate –The interest rate paid each year
Accrued Interest – Interest earned but not yet
distrbuted
Amortization Features – If and when interest payments
are made
Embedded Options – The ability of the issuer or holder
the right to take a given action
Covenants
Principal
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The amount that the issuer will repay upon
the maturity of the bond (also par value, face
value, maturity value and redemption value)
Coupon Rates
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Rate of interest paid during the life of the bond.
Determines the coupon payment
Zero Coupon Bonds – make no interest payment.
Sells at a discount below its par value with return
being earned by the increase in value.
Floating Rates – Coupon rate resets periodically
Deferred Coupon Bonds
Deferred interest
Step up bonds
Payment in kind
Types of Coupon Structures
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Zero coupon Bonds
Make no Interest payments, bond sells at a
price much lower than par value.
Step up Notes
Coupon increases over time.
Deferred Coupon Bonds
First Coupon may be deferred for a period of
time
Types of Coupon Structures
Continued
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Floating Rate Securities
Coupon resets periodically according to an
index or reference rate.
Usually the rate is equal to the reference (or index)
rate plus an additional margin (LIBOR + 1%). The
margin can be negative
Deleveraged Floater – coupon is a fraction of the
reference rate plus the quoted margin, for example
50% of LIBOR plus 1%
Caps and Floors
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A Cap keeps the coupon rate from increasing
so it is unattractive to the investor, increasing
the return the investor should require.
Similarly a Floor is an attractive feature for
the investor.
Collar – Floating rate bond with both a Cap
and Floor
Drop Lock Bond – the floating rate can
change to a fixed coupon under given
circumstances.
Types of Coupon Formulas
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Inverse Floaters – the coupon rate moves in the
opposite direction of the index
Generally the formula starts with a base rate then
subtracts a multiple of a reference rate. Coupon =
Base – L(Reference Rate)
Generally the coupon rate has a cap and floor to avoid
the possibility of a negative coupon rate
Dual Indexed Floater – the coupon is a function of
more than one reference rate
10 YR Treasury – 3 month LIBOR + margin
Types of Coupon Formulas
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Range Notes
Floating rate with a coupon equal to a set
amount as long as reference rate is within a
given range
Ratchet Bonds
Adjusts similar to a basic floater, except the
rate decreases when the reference rate
decreases and cannot be increased
Types of Coupon Structures
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Stepped Spread Floaters
The margin changes over the life of the bond
Reset Margin Determined at Issuer Discretion
The coupon rate is rest at a rate which keeps the price
of the bond at a predetermined price (often above
par)
Non interest Rate Indexes
The reference rate is something other than a base
interest rate for example Treasury Inflation Protection
Securities (TIPS) reset the coupon based upon the
level of inflation.
Accrued Interest
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Typically coupon payments are made every 6
months. If the bond is sold in between
interest payments the buyer will receive the
entire coupon payment, however the buyer
did not own the bond for the entire period.
Generally the cash price of the bond must
include any accrued interest that the seller
implicitly earned – we will calcualte this later.
Provisions for Retiring Bonds
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Basic bond calls for payment of principal at
maturity this is referred to as bullet maturity
May also pay principal over the life of the
bond based upon an amortization schedule, in
this case principal is repaid over the life of the
security.
Indexed Amortizing Notes – the principal
payments is indexed to a reference rate.
Repayment features
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Call and Refunding Provisions
Provide the issuer the right to retire the issue
prior to the stated maturity. This is a
disadvantage to the bondholder (lender) since
often the principal would be reinvested at a
lower rate. Therefore the issuer often must
compensate by offering a higher coupon rate.
Call – the right to retire the issue at a give
“call price”
Call Provision
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Generally the bond can be called based upon
a call schedule which specifies call prices at
different points in time. The call price
generally is set at a premium above the par
value and decreased toward the par value
over time.
Noncallable vs. NonRefundable
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Noncallable and Nonrefundable are often
confused. Noncallable is more absolute. For
example the bond may be callable , only if the
call is financed by debt having a higher
coupon (interest) rate.
Repayment Features
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Sinking Funds
Allows a given portion of the prinicipal to be retired
each year over a range of years.
Designed to reduce default risk
Balloon Maturity – only a portion is paid off prior to
maturity with a large portion or principal paid at
maturity
Accelerated Sinking Fund – Generally the portion paid
of is the same, however it may change over the life of
the bond.
Embedded Options
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Many of the provision we have discussed
allow either the issuer or bond holder to take
advantage of an option to change the
structure of the bond.
Examples of Embedded Options
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Call Features – Allows issuer to retire the debt
Put Features – Allows holder to resell to issuer
Convertible bonds – Can be converted to a
number of shares issued by the issuer
Exchangeable bonds – Can be exchanged for
a number of shares issued by a different firm
Embedded Options Granted to
Issuers
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Right to Call the issue
The right of underlying borrowers in a pool of
loans to prepay an amount in excess of
scheduled payments
Accelerated sinking funds
Interest rate caps
Embedded Options granted to
bondholders
Conversion privledeges
Put options
Interest rate floors
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Impact of Embedded Options
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When valuing debt with embedded options the
option provision creates difficulty in estimating the
future cash flow from owning the bond.
Need to model factors that influence the option being
exercised
Need to Model the factors that impact the issuers
desire to exercise option (revenue, cash flow etc)
Added difficulty causes modeling risk in determining
the bonds value.
Maturity Terminology
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Money Market – very short term – less than
one year
Short Term – Less than 5 years
Intermediate Term – 5 to 12 years
Long Term – Over 12 years
Risks Faced by Bondholders
Interest Rate Risk
Reinvestment Risk
Call Risk
Default Risk
Inflation Risk
Exchange – Rate risk
Modeling Risk
Liquidity Risk
Volatility Risk
Risk Risk
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