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Fixed Income Instruments 3

Explore the world of fixed income instruments, including government-sponsored enterprises, corporate bonds, bond indentures, provisions, ratings, high-yield bonds, structured notes, commercial papers, bankruptcy, credit rights, and municipal securities.

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Fixed Income Instruments 3

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  1. Fixed Income Instruments 3 Zvi Wiener 02-588-3049 mswiener@mscc.huji.ac.il http://pluto.mscc.huji.ac.il/~mswiener/zvi.html

  2. Government-Sponsored Enterprises Fannie Mae “benchmark” and Freddie Mac “reference” notes and bond. Can be electronically transferred through clearing houses as Euroclear and Cedel and NBES. Outstanding amount $150B with 2-30 years to maturity. FIFIBI - 3

  3. Government-Sponsored Enterprises GNMA - Government National Mortgage Association FHLBS - Federal Home Loan Bank System Sallie Mar - Student Loan Marketing Association FIFIBI - 3

  4. Corporate Debt Instruments • corporate bonds • medium-term notes • CP = commercial papers • ABS = asset backed securities They have priority over common stocks in the case of bankruptcy. FIFIBI - 3

  5. Corporate Bonds Main types of issuers • utilities • transportation • industrial • banks and financial companies FIFIBI - 3

  6. Bond Indentures • trustee • term bonds, serial bonds • collateral • debenture bond - not secured • guaranteed bonds FIFIBI - 3

  7. Bond Provisions • Call and refund provisions - the issuer has the right to redeem the entire amount before maturity. Sometimes there is a premium to be paid in such a case (redemption schedule). • Special redemption prices for debt redeemed through the sinking fund • Refunding means replacing by another debt. FIFIBI - 3

  8. Bond Provisions • Sinking fund provision sometimes the issuer is required to retire a portion of an issue each year. • either by cash payment to bondholders (lottery) • or by buyback bonds FIFIBI - 3

  9. Bond Rating • Duff and Phelps Credit Rating Co. • Fitch Investors Service • Moody’s Investors Service • Standard & Poor’s Corporation FIFIBI - 3

  10. Rating Moody’s S&P Fitch D&P Aaa AAA AAA AAA Aa1 AA+ AA+ AA+ Aa2 AA AA AA Aa3 AA- AA- AA- A1 A+ A+ A+ A2 A A A A3 A- A- A- FIFIBI - 3

  11. Rating • BBB- or better = investment grade • BB+ and below - speculative grade • D to DDD default • transition matrix FIFIBI - 3

  12. One year transition matrix Aaa Aa A Baa Ba B C&D Aaa 91.9 7.38 0.72 0 0 0 0 Aa 1.1 91.3 7.1 0.3 0.2 0 0 A 0.1 2.6 91.2 5.3 0.6 0.2 0 Baa 0 0.2 5.4 87.9 5.5 0.8 0.2 FIFIBI - 3

  13. High Yield Bonds • LBO, downgrading, refinancing • fallen angels • deferred interest bonds • Step-up bonds pay initially low interest which increases with time FIFIBI - 3

  14. SEC rule 144A Allows to trade private placements among qualified institutions. FIFIBI - 3

  15. Medium Term Notes (MTN) Notes are registered with the SEC under Rule 415 (the shelf registration) and are offered continuously to investors by an agent of the issuer. Maturities vary from 9 months to 30 years. Can be either fixed or floating. Very flexible way to raise debt! FIFIBI - 3

  16. Primary Market (MTN) Issuer posts spreads over Treasuries for a variety of maturities. Then an agent tries to find an investor. Minimal size is between $1M and $25M. The schedule can be changed at any time! Often structured MTNs are used (caps, floors, etc.) = structured notes. FIFIBI - 3

  17. Structured Notes Many institutional investors can use swaps and structured notes to participate in markets that were prohibited. Another use of structured notes is in risk management. Financial Engineering is used to create securities satisfying the needs of investors. FIFIBI - 3

  18. Commercial Papers • Short term unsecured promissory note • An alternative to short term bank borrowing • A typical round-lot transaction is $100,000 • In the USA maturity is up to 270 days • Requires less paperwork • Those with maturity up to 90 days can be used as collateral for FED discount window. FIFIBI - 3

  19. Commercial Papers • Typically rolled over • Rollover risk is backed by an unused bank credit line • In order to issue CP one need either a high rating or good collateral • Sometimes credit enhancement is used (LOC) • CP issued in the USA by foreigners are called Yankee CP FIFIBI - 3

  20. Commercial Papers • Between 71 an 89 there was one default on CP. • 3 defaults occurred in 89 and 4 in 90 • Direct paper is sold without an agent • Secondary market is thin • There is a special rating for CP, P-1,3, A-1,3 • discount instruments, used by money market FIFIBI - 3

  21. Bankruptcy and Credit Rights • liquidation - all assets will be distributed • reorganization - a new corporate entity will result • a company that files for protection becomes a debtor in possession and continues to operate under the supervision of the court FIFIBI - 3

  22. Bankruptcy and Credit Rights Absolute priority rule - senior creditors are paid in full before junior creditors are paid anything. Works in liquidation but often does not work in reorganization. FIFIBI - 3

  23. Municipal Securities Exemption of interest income from federal taxation. Issued by states, counties, special districts, cities, towns, school districts. FIFIBI - 3

  24. Municipal Securities Exemption of interest income from federal taxation. General obligation bonds - backed by tax power Limited tax general obligation bonds Revenue bonds - based on specific projects FIFIBI - 3

  25. Municipal Securities Airport Revenue Bonds College and University Revenue Bonds Hospital Revenue Bonds Industrial Revenue Bonds Single-Family Revenue Bonds (mortgages) Multifamily Revenue Bonds (housing projects) Water Revenue Bonds FIFIBI - 3

  26. Hybrid and Special Bond Securities • Insured bonds - typically by an insurance firm • Bank-backed municipal bonds (letter of credit) • Refunded Bonds - a portfolio of safe securities is placed in trust and they will cover the payments. • Troubled city bailout bonds FIFIBI - 3

  27. Municipal Money Market Products • TAN = tax anticipation notes • RAN = revenue anticipation notes • GAN = grant anticipation notes • BAN = bond anticipation notes • Tax exempt commercial paper FIFIBI - 3

  28. Municipal Derivatives • floaters = floating rate + spread • inverse floaters = interest - floating rate • strips • partial strip = are zeros till a call date and then become coupon type FIFIBI - 3

  29. Yield on Municipal Bonds tax-exempt yield equivalent taxable yield = 1-marginal tax rate for example bond offers 6.5% and marginal tax rate 40%: 0.065 = 0.1083 1-0.40 FIFIBI - 3

  30. Non-US Bonds • national bond markets • domestic market • Foreign market • Yankee USA • Samurai Japan • bulldog UK • Rembrandt Holland • matador Spain FIFIBI - 3

  31. International bond market • Eurobond and Euroyen markets • Global bond - simultaneous offering • Typically registered in Luxembourg, London or Zurich, but traded OTC. • Supranationals - IBRD, World Bank, etc. FIFIBI - 3

  32. Eurobond market • Dual currency bonds (coupon in one currency, principal in another). • Option currency bond one side can choose the currency. • Convertible bonds with warrants - can be converted into another asset. Equity, debt, gold or currency warrant. FIFIBI - 3

  33. Eurobond market • Floating Rate Notes = FRN based on LIBOR or LIBID • many are collared • some are perpetual FIFIBI - 3

  34. Comparing Yields bond equivalent yield of Eurodollar bond = 2[(1+yield to maturity)0.5-1] for example: A Eurodollar bond with 10% yield has the bond equivalent yield of 2[1.100.5-1] = 9.762% FIFIBI - 3

  35. Japanese Government Bonds JGB • short term Treasury bills • medium term bonds • long term bonds • super long term bonds (20 years) FIFIBI - 3

  36. German Government Bonds • U-Schatze discount paper up to 2 years • Kassens = federal government notes (2-6 y.) • OBLEs = 5 year federal government notes • Bunds = federal government bonds (6-30 y.) all coupon payments are annual FIFIBI - 3

  37. UK Government Bonds Gilts • straights = bullet bonds (some callable) • convertibles (option to holder to convert to longer gilts) • index linked low coupon 2-2.5% • irredeemable (perpetual) FIFIBI - 3

  38. Brady Bonds Argentina, Brazil, Costa Rica, Dominican Republic, Ecuador, Mexico, Uruguay, Venezuela, Bulgaria, Jordan, Nigeria, Philippines, Poland. Partially collateralized by US government securities FIFIBI - 3

  39. Internet sites • www.federalreserve.gov/releases • www.tradeweb.com • www.bondclick.com • www.fxall.com • www.atriax.com • www.convertbond.com • www.bondsonline.com • www.bba.org.uk • www.streetsoftware.com/data/mpage.htm • www.bondmarkets.com FIFIBI - 3

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  43. Hedging Linear Risk Following Jorion 2001, Chapter 14 Financial Risk Manager Handbook http://pluto.mscc.huji.ac.il/~mswiener/zvi.html

  44. Hedging Taking positions that lower the risk profile of the portfolio. • Static hedging • Dynamic hedging FIFIBI - 3

  45. Unit Hedging with Currencies A US exporter will receive Y125M in 7 months. The perfect hedge is to enter a 7-months forward contract. Such a contract is OTC and illiquid. Instead one can use traded futures. CME lists yen contract with face value Y12.5M and 9 months to maturity. Sell 10 contracts and revert in 7 months. FIFIBI - 3

  46. Market data 0 7m P&L time to maturity 9 2 US interest rate 6% 6% Yen interest rate 5% 2% Spot Y/$ 125.00 150.00 Futures Y/$ 124.07 149.00 FIFIBI - 3

  47. Stacked hedge - to use a longer horizon and to revert the position at maturity. Strip hedge - rolling over short hedge. FIFIBI - 3

  48. Basis Risk Basis risk arises when the characteristics of the futures contract differ from those of the underlying. For example quality of agricultural product, types of oil, Cheapest to Deliver bond, etc. Basis = Spot - Future FIFIBI - 3

  49. Cross hedging Hedging with a correlated (but different) asset. In order to hedge an exposure to Norwegian Krone one can use Euro futures. Hedging a portfolio of stocks with index future. FIFIBI - 3

  50. FRM-00, Question 78 What feature of cash and futures prices tend to make hedging possible? A. They always move together in the same direction and by the same amount. B. They move in opposite direction by the same amount. C. They tend to move together generally in the same direction and by the same amount. D. They move in the same direction by different amount. FIFIBI - 3

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