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EFB201 Lecture 5 – Public Debt Markets Reading – Viney chapters 2 and 6 Tutorial Questions –

EFB201 Lecture 5 – Public Debt Markets Reading – Viney chapters 2 and 6 Tutorial Questions – Viney chapter 6 Essay Questions 8-12 Additional Questions on Blackboard Site. Outline Short Term Instruments Background Commercial Bills Promissory Notes Negotiable Certificates of Deposit

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EFB201 Lecture 5 – Public Debt Markets Reading – Viney chapters 2 and 6 Tutorial Questions –

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  1. EFB201 Lecture 5 – Public Debt Markets Reading – Viney chapters 2 and 6 Tutorial Questions – Viney chapter 6 Essay Questions 8-12 Additional Questions on Blackboard Site

  2. Outline Short Term Instruments Background Commercial Bills Promissory Notes Negotiable Certificates of Deposit Valuation of Securities Long Term Instruments Background Valuation

  3. Corporate debt instruments can be broadly split into two categories :- Short Term – less than one year to maturity Long Term – greater than one year to maturity Key characteristics in both markets are creditworthiness and liquidity

  4. Short Term Instruments – Background Bills of Exchange A bill of exchange is a short-term money market security that pays the face value at maturity. It may be categorised as a trade bill which is used to finance specific international trade transactions or a commercial bill which is a method of borrowing.

  5. Commercial Bills • Bank-accepted bills where a bank places its name • on the face of the bill which will increase the bill’s • credit worthiness • Bank-endorsed bills where the bank, as a previous • owner of the bill, signs (endorses) the reverse of the • bill when selling it. These days endorsements are by • way of electronic record of transactions which • creates a legal chain of ownership • Anon-bank bill

  6. A commercial bill is a discount security as it is issued • at a price less than its face value. There are several • parties involved in the issue: • The drawer is the issuer. With a bank-accepted • bill the drawer has a liability to repay the face • value to the bank acceptor. • The acceptor is the party to whom the bill is • addressed and who undertakes to pay the bill’s • face value to the person presenting the bill at the • maturity date. They will charge the borrower fees • for doing this.

  7. The payee is the party to whom the bill is specified • to be paid. The payee is typically the drawer • although the drawer can specify some other entity • as the payee. • The discounter (lender) is the party that discounts • the bill’s face value and purchases the bill.

  8. Repay acceptor ($100,000 plus fee and margin) Drawer (borrower) Borrowing Corporation Ltd Drawer Bill accepted Bill discounted Funds lent ($95,800) Present mature bill Acceptor Acceptor ABC Bank Ltd Discounter Discounter (current holder of bill) Bill discharged (holder receives $100,000) On the issue date a discount price will be paid: At the maturity date the face value will be paid:

  9. The primary liability to exchange the bill at maturity falls on the acceptor, not the drawer. In the short-term money market there is an active market in bank-accepted bills. In an efficient market transactions will be recorded electronically through an authorised central securities depository. Austraclear, which is part of the Australian Securities Exchange, is the main central securities depository in Australia. Once a bill is drawn and discounted, the bill is physically lodged with the depository and each successive rediscounting and change of ownership is recorded electronically by the depository.

  10. Commercial bills typically have a maximum maturity of up to 180 days and a minimum face value of $100,000. In reality a business may require funding for a longer period of time. A bank-accepted bill facility can be set up to extend the overall term of a bill financing arrangement. This involves a rollover facility being set up with the bank. Under this facility the bank agrees to accept and discount new commercial bills for the borrower at each maturity date.

  11. On each rollover date the borrower will pay the bank the difference between the face value on the maturing bill and the discount price of the new bill.

  12. Promissory Notes Promissory notes (P-notes) are discount securities normally with a minimum face value of $100,000 and a term to maturity of up to 180 days. The cost to the borrower is the difference between the amount raised on the issue date and the face value payable at maturity.

  13. It is market convention to refer to the P-notes as commercial paper. P-notes are similar to bills of exchange except there is no acceptor involved. There is also no need for the seller to endorse the bill. Typically, only large companies with excellent credit reputations in the market are able to attract investors willing to discount P-notes.

  14. Negotiable Certificate of Deposit (CD) A CD is short-term discount security issued by a bank, typically with an initial maturity of up to 180 days. CDs are an investment product offered by banks in the money market to attract institutional investors. Banks issue CDs, in part, to manage their liabilities and liquidity. Within the money market there is an active secondary market in CDs.

  15. Valuation PRICE = PRESENT VALUE OF FUTURE CASH FLOWS REMEMBER IF INTEREST RATES RISE, PV FALLS IF INTEREST RATES FALL, PV RISES

  16. Discount securities are sold at a price that represents • a discount from the face value. Their price can be • calculated using: • P = FV/(1 + (yield × DTM/365)) • where • P = price • FV = face value • DTM = days to maturity

  17. Example One An investor buys a 180-day commercial bill with a face value of $100,000 yielding 8.75%pa. They decide to sell the bill 90 days later at a market yield of 7.8%pa. Price paid for the 180-day commercial bill: $95,864=$100,000/(1+0.0875×180/365) Price received when the bill is sold 90 days later: $98,113=$100,000/(1+0.078×90/365)

  18. Calculating Face Value In many instances a company needs to raise a specific amount of funds, the issue price, from a bill issue. As the issue price and yield are known the face value can be calculated using: FV = P × (1 + (yield × DTM/365)) For example, a company issues a 60 day bank accepted bill to raise $500,000. The bank agrees to discount the bill at 8.75%pa so the bill’s face value will be: $507,192 = 500,000 ×(1 + 0.0875 × 60/365)

  19. Calculating Yield The yield is the rate of interest, expressed as per cent per annum, on the amount outlaid to purchase the discount security. The yield can be calculated using: (sell price – buy price)/buy price × (365/DTM) At the maturity date the sell price will be the face value. If the security is sold prior to the maturity date, then DTM is replaced by days held.

  20. For example, an investor plans to purchase a 180-day bill with a face value of $100,000 and a price of $95,000. The yield on the investment will be: ($100,000 – $95,000)/$95,000 × 365/180 = 0.1067 = 10.67%pa

  21. Reconsider example 1 and calculate the Holding Period Yield (HPY) (sell price – buy price)/buy price × (365/Days Held) HPY = ($98,113 – $95,864)/$95,864 × 365/90 = $2,249/$95864 x 365/90 = 0.02346 x 365/90 = 0.0951 = 9.51%pa

  22. Long Term Instruments Background The major long-term debt market in developed countries is the bond market. Again the key factors in the market are 1. Default Risk (Creditworthiness) and 2. Liquidity of the market

  23. The Australian bond market consists of: 1. Treasury bonds issued by the Commonwealth Government 2. Semi-government bonds issued by state government borrowing authorities 3. Corporate bonds issued by financial institutions and other large listed corporations 4. Asset-backed securities 5. Australian-dollar-denominated bonds issued in Australia by non-resident borrowers (known as Kangaroo bonds).

  24. A bond pays a specified periodic interest rate for the term of the bond and the principal is repaid at maturity. The periodic interest payment made by a bond is normally referred to as a coupon. Typically the coupon is a fixed percentage of the face value, but floating rate coupon bonds also exist. It is cheaper for corporations to raise debt funds directly from capital markets as it removes the cost of the financial intermediary, such as a bank.

  25. Investors can obtain a higher return, although at a higher risk, from buying corporate bonds than if they placed their funds with a financial institution. A credit rating agency such as Standard & Poor’s provides measures of an issuer’s credit risk. In recent years managed funds have been the major buyers of bonds.

  26. A corporate bond is a bond issued by a company and can be categorised as a debenture or unsecured note. A debenture is secured by a fixed and/or floating charge over the issuing company's unpledged assets. These are assets over which there is no charge or interest conveyed to another party. An unsecured note has no underlying security attached.

  27. An issue of debentures is formalised through a debenture • trust deed. The deed will specify and protect the • underlying security attached to the debenture bond issue. • The three principal issue methods are: • public issues to the public at large • 2. holders of the company's securities, including • shareholders, bondholders and holders of convertible • notes • 3. private placements to institutions that regularly deal • in securities or other institutional investors such as fund • managers and insurance offices.

  28. For most corporate bond issues, the price paid on subscription is the same as the face value of the security. In most countries corporations law will require any invitation to the public to deposit money with or lend to a corporation to be accompanied by a prospectus that has first been registered with the corporate regulator. A prospectus will provide detailed information on the issuer corporation, the purpose of the finding, company financial statements and projections, management profiles, expert reports and other material information. However, a prospectus is costly and time consuming to prepare so companies often prefer to use placements where they are only required to provide an information memorandum.

  29. A bond’s price is the present value of its cash flows, • the periodic coupon payments and the repayment of • principal at the maturity date. • The coupon’s present value will be: • PVcoupons= C × [(1-(1+i)-n)/i] • The present value of the face value will be: • PVface value = FV × (1+i)-n • where • i = current yield for the period • n = number of future coupon periods • C = periodic fixed coupon payment • FV = principal or face value of the bond

  30. If the bond is not purchased on a date a coupon is paid • the following adjustment will need to occur: • (PVcoupons + PVface value) x (1+i)k • wherek = number of days elapsed since the last coupon • payment divided by days in the coupon period. • When the bond’s market yield is less than the coupon • rate the price of the bond will be greater than its face • value. This is called a premium bond. • When the bond’s market yield is greater than the coupon • rate the price of the bond will be less than its face value. • This is called a discount bond.

  31. Coupon Bond Example • Calculate the price of a corporate bond on 20 May 2011 • with a face value of $100,000, paying 10%pa half yearly • coupons, maturing 31 December 2016 and trading at a • yield of 8%pa: • C = $100,000 × 0.10/2 = $5,000; • I = 0.08/2 = 0.05; • n = 12 coupons will be paid between 20th May 2011 and • 31st December 2016 • k=140/181 as 140 days have elapsed since the last • coupon date and the coupon period is 181 days

  32. PVcoupons = $5,000×[(1-(1+0.04)-12)/0.04] = $46,925.37 PVface value = $100,000×(1+0.04)-12 = $62,459.70 So the bonds price discounted to the last coupon will be: $46,925.37 + $62,459.70 = $109,385.07 So the bonds price now will be ($109,385.07) x (1+0.04)140/181 = $112,754.27

  33. Zero Coupon Bond Valuation A zero coupon bond is one which pays no Coupons, only the Face Value at maturity Price = Face Value x (1 + i)-n = Face Value/(1 + i)n E.g.. A 5 year $100 Zero Coupon Bond is yielding 12% pa. P = 100/1.125 = $56.74

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