6.2 Fixed-Income Markets

Question 1

Common short-loan term financing instruments include

Answer 1

lines of credit

secured loans

factoring.

Question 2

Uncommitted Lines of Credit

Answer 2

With this facility, a company can borrow up to a specified amount for a pre-determined maximum maturity.

There is no cost other than interest charges on borrowed amounts.

However, this is an unreliable source of financing, as it may be recalled by the bank at any time.

For banks, the capital requirements associated with these facilities are minimal until they are drawn upon by borrowers.

Question 3

Committed Lines of Credit

Answer 3

this is a more reliable source of financing than uncommitted lines of credit because of the bank’s formal commitment.

They are also known as regular lines of credit.

They are unsecured and pre-payable without penalty.

The term is usually 364 days, less than a full year.

The borrowing rate can be negotiated. Common negotiated interest rates include the bank’s prime rate or the money market rate plus a spread. The most common money market rate is a benchmark reference rate plus a spread. The spread depends on the borrower’s creditworthiness (the perceived ability of the borrower to service its debt on a timely manner). Banks also charge a commitment fee, which may be 0.5% of the full or unused amount.

Question 4

Revolving Credit Agreements

Answer 4

Also known as revolvers, these are the most reliable source of financing

They involve formal legal agreements.

They are similar to those for committed lines of credit in terms of borrowing rates, fees, and being unsecured.

They often have a multiple-year term (e.g., terms of 3 to 5 years) and involve much larger amounts than regular lines of credit.

Question 5

Secured (Asset-Based) Loans

Answer 5

These are loans in which the company is required by the lender to provide collateral in the form of an asset (e.g., fixed asset, receivables, inventory).

Assets are pledged against the loan. A lien is filed against them by the lender, and the lien subsequently shows up on the borrower’s financial record.

The collateral can help a company reduce the interest rate because it makes the loan safer for the lender.

Companies that do not qualify for unsecured loans due to their credit quality can make arrangements for secured loans to raise short-term funds.

–> For example, accounts receivable can be used to produce cash flows through the assignment of accounts receivable

Question 6

assignment of accounts receivable

Answer 6

using the receivable as collateral for a loan.

When accounts receivable are assigned as collateral for a loan, the company is still responsible for collecting payments from their customers.

Question 7

Factoring

Answer 7

A factoring arrangement allows companies to sell their accounts receivable to a lending and collection specialist, known as a factor

Effectively, a company is outsourcing its credit granting and collection process to the factor.

These sales provide a company with cash immediately but they often occur at a significant discount, which represents the cost of this source of funding.

The extent of the discount is determined by considerations such as the credit quality of the accounts as well as expected collection costs.

Question 8

commercial paper (CP)

Answer 8

the main instrument used to raise short-term funds for Larger, more creditworthy firms

The CP market is dominated by issues of large financial institutions.

Commercial paper is an unsecured obligation that may be issued in the public debt market or through a private placement.

Firms typically issue CP with maturities of less than three months and roll them over as they mature.

This practice gives companies the financial flexibility to fund working capital requirement and meet seasonal demand for cash.

It can also serve as a source of bridge financing to meet longer-term needs until more permanent sources of capital can be secured.

Question 9

rolling over

Answer 9

Maturing obligations are typically repaid with the proceeds generated from issuing more CP

exposes issuers to the risk borrowing costs will have increased in response to market conditions

Question 10

In order to minimize rollover risk

Answer 10

investors typically require issuers to have a committed backup line of credit that will provide sufficient funds to retire maturing obligations if new CP cannot be issued.

Because of these liquidity enhancements and the short duration of CP, defaults are relatively rare.

Question 11

demand deposits

Answer 11

funds that are kept in checking accounts

an unattractive source of funding because the lack of a stated maturity makes makes them a relatively unstable (can be withdrawn at any time)

Additionally, banks are generally required to maintain liquidity reserves to give clients confidence that they will be able to access their funds

Question 12

operational deposits

Answer 12

Banks also generate operational deposits

provide clearing, custody, and cash management services for larger clients.

This is a relatively stable source of funding compared to demand deposits.

Question 13

Savings deposits

Answer 13

an even more stable source of financing because they have a defined maturity

Banks offer certificates of deposit (CDs) that pay a specified interest rate over a period of up to one year

CDs may be negotiable or non-negotiable.

–> A non-negotiable CD cannot be sold by the depositor and a penalty is charged on early withdrawals.

–> By contrast, a negotiable CDs can be sold on the Eurobond market prior to maturity

Question 14

The central bank funds rate

Answer 14

the policy rate that a central bank uses to pursue its macroeconomic objectives and in its open market operations

This also is the rate that a central bank pays to commercial banks on their reserve deposits

Question 15

asset-backed commercial paper (ABCP)

Answer 15

secured form of CP,

used by Banks a lot

a low-cost source of short-term financing.

Question 16

Repurchase agreements, or repos

Answer 16

important sources of secured financing

In a repo agreement, one party “sells” a security for a purchase price and agrees to buy it (or a similar security) back later at a higher amount, known at the repurchase price.

The difference between the purchase and repurchase prices is determined by the repo rate.

it is effectively a collateralized loan.

–> The “seller” remains the legal owner of the security and receives any interest payments that they make during the term of the agreement.

–> From the lender’s perspective, it can be described as reverse repurchase agreement or reverse repo.

Question 17

A standard master repurchase agreement

Answer 17

can be used as a template for negotiations

Question 18

overnight repo

Answer 18

one-day term

Question 19

term repos

Answer 19

repos with longer maturities

Question 20

an initial margin

Answer 20

security price / purchase price

Question 21

overcollateralized loan

Answer 21

If the initial margin is greater than 100%, the amount of the loan (purchase price) is less than the value of the collateral (security price)

This difference can also be expressed as a haircut

Question 22

A variation margin

Answer 22

used to adjust the amount of collateral based on the change in the security price between initiation at time = 0 and time = t

Question 23

For a general collateral repo

Answer 23

a group of securities is identified and any can be used as collateral.

This type of transaction takes place at the general collateral repo rate.

Question 24

a special trade,

Answer 24

A repo transaction that involves the delivery of a particular security

occurs at a special collateral repo rate that deviates from the baseline general repo rate

Question 25

key factors influencing repo rates include:

Answer 25

Money market interest rates

collateral quality

repo term

collateral uniqueness

collateral delivery

Question 26

how do Money market interest rates affect repo rates?

Answer 26

Repo rates are lower if alternative financing rates are low.

For example, repo rates are correlated with target policy rates because central banks participate in repo markets to influence the money supply.

Question 27

how does collateral quality affect repo rates?

Answer 27

Repo rates increase with the collateral’s credit risk.

Question 28

how do repo terms affect repo rates?

Answer 28

Repo rates generally increase with the length of the term because the yield curve is typically upward sloping and a longer term increases exposure to credit risk.

Question 29

how does a collateral uniqueness affect repo rates?

Answer 29

Repo rates are lower when the collateral used is in high demand, such as on-the-run issues of sovereign bonds.

Question 30

how does a collateral delivery affect repo rates?

Answer 30

Repo rates are lower when delivery to the lender is required or if the loan is overcollateralized.

Question 31

Risks Associated with Repurchase Agreements

Repos are a relative low-cost source of capital because the borrower’s obligations are backed by collateral. However, there are still several important risks to consider:

Answer 31

Default risk

collateral risk

margining risk

legal risk

netting and settlement risk

Question 32

Default risk

Answer 32

For parties to a repo, the primary concern is that their counterparty will fail to meet its obligations.

Question 33

collateral risk

Answer 33

Ideal collateral has little to no correlation with the counterparty and can be quickly liquidated in the event of a default.

Question 34

margining risk

Answer 34

Timely variation margin transfers minimize the risk of shortfalls and forced liquidations in the event of a significant change in market value of collateral.

Question 35

legal risk

Answer 35

Counterparties should have access to courts in order the event that they need to enforce their contractual rights under the repo agreement.

Question 36

netting and settlement risk

Answer 36

Payments and collateral transfers should be timely and leave all parties with the amounts that they are owed under the terms of the contract.

Question 37

bilateral repo transaction

Answer 37

Party A (Security Lender / Cash Borrower)

——- Short Term Repo Rate —–>

Party B (Security Borrower / Cash Lender)

——- Long Term Yield ——–>

Party A (Security Lender / Cash Borrower)

Question 38

triparty repo transaction

Answer 38

Part 1:

Party A (Security Lender / Cash Borrower)

——- Short Term Repo Rate —–>

Triparty Collateral Agent Holds Cash and Securities as Custodian

——- Long Term Yield ——–>

Party A (Security Lender / Cash Borrower)

Part 2:

Party B (Security Borrower / Cash Lender)

——- Long Term Yield ——–>

Triparty Collateral Agent Holds Cash and Securities as Custodian

——– Short Term Repo Rate —–>

Party B (Security Borrower / Cash Lender)

Part 3:

Party A (Security Lender / Cash Borrower)

<———— Trade details ———–>

Party B (Security Borrower / Cash Lender)

Question 39

Investment grade issuers

Answer 39

generate sufficient operating cash flows to service their debt obligations, which makes defaults unlikely.

Analysis of investment grade bonds focuses on financial ratios and credit ratings.

Question 40

Fallen angels

Answer 40

represent a unique segment of the high-yield debt market.

These are firms that enjoyed investment grade credit ratings at the time of issue but have subsequently been downgraded to high-yield status.

A fallen angel’s has the credit risk of a high-yield issue, but the features (e.g., lack of restrictive covenants) of an investment grade issue

Question 41

Government Debt Management Policies

Answer 41

Governments rely on debt management policies to determine how the maturities of their obligations should be structured to minimize borrowing costs

Question 42

the Ricardian equivalence theorem

Answer 42

government debt management policies are irrelevant if the following conditions hold:

–> Taxpayers save expected future taxes in order to smooth their consumption

–> taxpayers believe any current tax cuts will lead to future tax increases

–> Taxpayers can borrow freely in perfectly efficient capital markets with no transaction costs

–> Taxpayers will pass along any accumulated tax savings to their heirs

Question 43

There are several economic benefits that are accrued when governments issue debts across the maturity spectrum, including:

Answer 43

The creation of a benchmark yield curve with risk-free rates for key maturities improves the efficiency of domestic capital markets

Financial institutions use medium- and long-term government securities to manage their interest rate risk exposure

Using government securities as collateral for repo transactions reduces the cost of this form of borrowing

Trading government bonds is an important monetary policy implementation tool for central banks

Government bonds are an ideal vehicle for foreign currency reserves

Question 44

In a single-price auction

Answer 44

all selected bids (both competitive and non-competitive) pay the same price.

The price or coupon rate generated by a single-price auction is determined by the stop yield, which is the yield on the lowest price competitive bid that is accepted

incentivize a wider distribution of bids and tends to result in lower borrowing costs

more successful in allocating entire issues

Question 45

multiple-price auction

Answer 45

each competitive bidder that is accepted pays the price that they have bid.

produces larger bid sizes with a narrower range of prices

Question 46

primary dealers

Answer 46

large financial intermediaries that are required to participate in all competitive auctions and may serve as counterparties for the central bank’s open market operations

Question 47

on-the-run securities

Answer 47

Bonds that have been part of the most recent issue of their maturity

the most frequently traded and their yields are used in the benchmark curve

Question 48

Off-the-run securities

Answer 48

from previous issues

comparatively illiquid

Question 49

General obligation bonds

Answer 49

issued by non-sovereign governments are unsecured debts that are backed by local tax revenues.

Question 50

revenue bonds

Answer 50

issued by local and regional government to fund a specific project, such as a road or a stadium, and backed by the revenues that it generates.

Revenue bonds tend to have longer maturities, reflecting the long-lived nature of their associated projects.

Question 51

Which of the following modifications could Digistrype incorporate to best mitigate the investors’ credit concerns?

a) Digistrype could consider deferred debt coupons and/or principal payments.

b) Digistrype could consider adding a call provision to its new debt.

c) Digistrype could consider accelerating principal repayment or linking debt coupon changes to financial covenants.

Answer 51

c) Digistrype could consider accelerating principal repayment or linking debt coupon changes to financial covenants.

Principal repayment acceleration, such as full amortization, partial principal amortization, or a sinking fund arrangement, is a way to reduce credit risk.

Alternatively, Digistrype could incorporate debt coupon changes linked to financial covenants and/or credit ratings in order to address investor concerns.

Question 52

Which of the following is the best contingency feature Digistrype could add to mitigate its own concerns regarding lower interest rates?

a) Add a call provision to the proposed new debt.

b) Add a put provision to the proposed new debt.

c) Add a step-up coupon to the proposed new debt.

Answer 52

a) Add a call provision to the proposed new debt.

A call provision gives Digistrype the right to redeem all or part of the bond prior to maturity if interest rates decline, so new debt could be issued at a lower cost.