2.2 Debt types and features Flashcards
What options do companies vs governments have for raising capital?
Companies: debt and equity
Governments: Debt only
Can governments use bank loans to raise capital?
No - only companies have this option
What are the two types of debt securities and their respective maturities?
Bills: <1 year
Bonds: >1 year
What is the difference between capital markets and money markets?
Capital markets: Long-term issuance, generally >1year; (bonds)
Money markets: Short-term issuance, generally <1year; (bills)
What are the 4 main features of a bond?
- Coupon - represents interest (expressed as annual percentage per £100 of nominal value)
- Nominal value - capital payment holder receives at redemption (not the price of the bond!)
- Name - name given at issue (common for governments to refer to their bonds as treasury stock/bonds)
- Redemption - the year and date when the gilt is repaid (maturity date)
How often can coupons be paid?
On an annual or semi-annual basis
- UK Government pays coupon on semi-annual basis
What are other names for the nominal value of a bond?
Par/redemption/capital
value
Why is the coupon of a bond often called the gross coupn?
Coupons are taxable (subject to income tax for individuals); but tax
is not normally deducted from the coupon payment -0 therefore it is referred to as being a gross coupon.
Who is responsible for debt and cash management for the UK government?
The Debt Management Office (DMO)
- they repay capital to investor at redemption of a bond
What is the yield on UK Gilts considered?
UK Gilts are effectively credit risk free and are therefore used for benchmarking - their yield is considered the risk-free rate for sterling denominated bonds
What are the two main types of UK government bond?
- Conventional
- Index linked
What are the features of a conventional government bond?
- fixed coupons
- fixed maturity
What is a disadvantage of conventional gov. bonds?
If invested for a long period of time cashflows (coupon and nominal value) can be very easily eroded by inflation
What are the features of an index-linked government bond?
- coupon and nominal value linked to inflation index
- therefore inflation protected
- NOTE: no deflation protection
- stated cashflows (coupon and nominal value) will be returned in the case of zero-inflation since investing in the bond
Do index-linked bonds have higher or lower yield than conventional?
- Lower yields as they provide additional safety so are lower risk (and therefore lower potential return)
What is the RPI?
Retail Prices Index - An average change in the prices of household
goods and services
What is the CPI?
Consumer Prices Index: Based on an EU-wide formula to allow
international comparison. Used by the MPC (monetary policy committee)
What is the PPI?
Producer Prices Index: Looks at goods and services further up the
production chain, at the wholesale level
What does STRIPS stand for?
Separate Trading of Registered Interest and Principal of Securities
What is a zero-coupon bond?
A bond issued at a discount to the nominal value - later redeemed at nominal value (pays no coupon)
What is a key benefit of zero coupon bonds?
It removes reinvestment risk as investors can precisely match their liabilities
Which firms dominate the zero-coupon market?
Large institution investors, insurance companies, pension funds - who have liabilities to meet
aka. Liability driven investors
Do UK and US governments issue zero-coupon bonds?
UK and US governments have historically never issued zero-coupon bonds in the capital market
How do the UK and US provide investors with zero-coupon bonds in another way?
Through the STRIPS market developed in US and UK treasury market
Designate certain UK Gilts to be strippable by the DMO - take all the cash flows of a gilt and turn it into a mini-zero coupon bond (STRIPS)
Which 3 parties in the UK are permitted to strip Gilts and create the zero-coupons?
GEMMs - Gilt-Edged Market Makers
HMT
BoE
How many STRIPS can a 5 year strippable Gilt be stripped into?
11 - it is the number of years x2 (to get the coupon cash flows) + 1 (to get the capital payment cash flow)
What is reinvestment risk and how can it be avoided?
- Where the investor may not receive a required rate
of return when reinvesting coupon payments - Often avoided through
cash-flow matching, or dedication
What is dedication?
Where the investor matches the maturity of cash-flows to the
liabilities
- Simplest way to do this is use a zero-coupon bond
What are the features of French government bonds?
Legal form - bearer
Life when issued -
OATs: 2-50 years
Coupons - annual
Settlement time - T+2
What are the features of German government bonds?
Legal form - bearer
Life when issued -
Schatz: Up to 2 years
Bobl: 5 years
Bund: >10 years
Coupons - annual
Settlement time - T+2
What are the features of UK government bonds?
Legal form - registered
Life when issued -
Short: < 7 years
Medium: 7-15 years
Long: >15 years
Coupons - semi-annual
Settlement time - T+1
What are the features of US government bonds?
Legal form - registered
Life when issued -
T-notes: 2-10 years
T-bonds: >10 years
Coupons - semi-annual
Settlement time - T+1