CFA 52: Fixed-Income Markets: Issuance, Trading, and Funding

Question 1

London interbank offered rate (Libor)

Overview of Global Fixed-Income Markets

Answer 1

The reference rate for a lot of floating-rate loans, in particular those issued in the Eurobond market. Libor is a collective name for multiple rates. Libor rates reflect the rates at which a select set of banks believe they could borrow unsecured funds from other banks in the London interbank money market for different currencies and different borrowing periods ranging from overnight to one year.

Question 2

interbank money market (or interbank market)

Overview of Global Fixed-Income Markets

Answer 2

The market of loans and deposits between banks for maturities up to one year.

Question 3

municipal bonds (munis)
Overview of Global Fixed-Income Markets

Answer 3

Issued by local US governments and are tax exempt. Some non-profit organizations can issue them too, but they are not tax-exempt.

Question 4

open market operations

Overview of Global Fixed-Income Markets

Answer 4

The purchase or sale of bonds, usually sovereign bonds issued by the national government. By purchasing (selling) domestic bonds, central banks increase (decrease) the monetary base in the economy. Central banks may also purchase and sell bonds denominated in foreign currencies as part of their efforts to manage the relative value of the domestic currency and their country’s foreign reserves.

Question 5

primary bond markets

Primary and Secondary Bond Markets

Answer 5

Markets in which issuers first sell bonds to investors to raise capital.

Question 6

secondary bond markets

Primary and Secondary Bond Markets

Answer 6

Markets in which existing bonds are subsequently traded among investors.

Question 7

public offering

Primary and Secondary Bond Markets

Answer 7

Any member of the public may buy the bonds.

Question 8

private placement

Primary and Secondary Bond Markets

Answer 8

Only a selected group of investors may buy the bonds.

Question 9

underwritten (firm commitment) offering

Primary and Secondary Bond Markets

Answer 9

The investment bank guarantees the sale of the bond issue at an offering price that is negotiated with the issuer. Thus, the investment bank, called the underwriter, takes the risk associated with selling the bonds. The underwriter of a bond issue takes the risk of buying the newly issued bonds from the issuer, and resells them to investors or to dealers who then sell them to investors. The difference between the purchase price of the new bond issue, and the reselling price to investors is the underwriter’s revenue. Underwritten offerings are typical bond issuing mechanisms for corporate bonds, some local government bonds, and some securitized instruments such as MBSs.

Question 10

underwriter

Primary and Secondary Bond Markets

Answer 10

The investment bank that takes the risk associated with selling the bonds.

Question 11

best effort offering

Primary and Secondary Bond Markets

Answer 11

The investment bank serves only as a broker. It only tries to sell the bond issue at the negotiated offering price if it is able to for a commission. Thus, the investment bank has less risk and correspondingly sless incentive to sell the bonds in a best effort offering than in an underwritten offering.

Question 12

auction

Primary and Secondary Bond Markets

Answer 12

A bond issuing mechanism that involves bidding.

Question 13

syndicated offering

Primary and Secondary Bond Markets

Answer 13

For larger bond issues, it is common for the offering to be issued by a group of investment banks. There is a lead underwriter that invites other investment banks to join the syndicate and that coordinates the effort. The syndicate is collectively responsible for determining the pricing of the bond issue and for placing (selling) the bonds with investors.

Question 14

grey market

Primary and Secondary Bond Markets

Answer 14

A forward market for bonds about to be issued. Trading in the grey market helps determine what the final offering price should be.

Question 15

shelf registration

Primary and Secondary Bond Markets

Answer 15

Allows certain authorized issuers to offer additional bonds to the general public without having to prepare a new and separate offering circular for each bond issue. Rather, the issuer prepares a single, all-encompassing offering circular that describes a range of future bond issuances, all under the same document.

Question 16

primary dealers

Primary and Secondary Bond Markets

Answer 16

Financial institutions that are authorized to deal in new issues of US Treasury securities. They have established business relationships with the Federal Reserve Bank of New York. which implements US monetary policy. Primary dealers serve primarily as trading counterparties of the NY Fed and are required to participate meaningfully in open market operations and in all auctions of US Treasury securities. Most US Treasury securities are bought at auction by primary dealers.

Question 17

syndicated loans

Primary and Secondary Bond Markets

Answer 17

Loans from a group of lenders to a single borrower.

Question 18

organized exchange

Primary and Secondary Bond Markets

Answer 18

One of two main ways for secondary markets to be structured. An organized exchange provides a place where buyers and sellers can meet to arrange their trades. Although buy or sell orders may come from anywhere, the transaction must take place at the exchange according to the rules imposed by the exchange.

Question 19

over-the-counter (OTC) markets

Primary and Secondary Bond Markets

Answer 19

Buy and sell orders are initiated from various locations and are matched through a communications network. Thus, OTC markets need electronic trading platforms over which users submit buy and sell orders. Although some very active corporate and government bonds trade on many stock exchanges around the world, the vast majority of bonds are traded in OTC markets.

Question 20

bid-offer (bid-ask) spread

Primary and Secondary Bond Markets

Answer 20

Reflects the prices at which dealers will buy from a customer (bid) and sell to a customer (offer or ask). It is very often used as an indicator of liquidity.

Question 21

settlement

Primary and Secondary Bond Markets

Answer 21

The process that occurs after the trade is made. The bonds are passed to the buyer and payment is received by the seller. Secondary market settlement for a government and quasi-government bonds typicall takes palce on a T+1 basis-that is, the day after the transaction date-whereas corporate bonds usually settle on T+3 basis. Cash settlement, in which trading and setttlement occur the same day, is standard for some governement and quasi-governement bonds and for many money markets. Trades clear within either or both of the two main clearing systems, Euroclear and Clearstream. Settlement occurs by means of a simultaneous exchange of bonds for cash on teh books of the clearing system. An electronic bridge connecting Euroclear and Clearstream allows transfer of bonds from one system to another.

Question 22

sovereign bonds

Sovereign Bonds

Answer 22

Bonds issued by national governments. They are comprised of various types and amounts.

Question 23

on-the-run

Sovereign Bonds

Answer 23

The majority of the trading in secondary markets is of sovereign securities that where most recently issued. These securities are called on-the-run.

Question 24

benchmark issue

Sovereign Bonds

Answer 24

The latest sovereign bond issue for a given maturity. It serves as a benchmark against which to compare bonds that have the same features but that are issued by another type of issuer. As a general rule, as sovereign securities age, they trade less frequently.

Question 25

non-sovereign government bonds

Sovereign Bonds

Answer 25

Bonds issued by levels of government below the national level, such as provinces, regions, states, and cities. These bonds are typically issued to finance public projects.

Question 26

quasi-government (agency) bonds

Sovereign Bonds

Answer 26

Bonds issued by organizations established by national governments that perform various functions for them. These organizations often have both public and private sector characteristics, but they arenot actual governmental entities. Examples would be Fannie Mae Hydro or Hydro Quebec in Canada. NOTE: These bonds are paid back with cashflows, not taxpayer money.

Question 27

supranational bonds

Sovereign Bonds

Answer 27

A form of often highly rate bonds issued by supranational agencies such as the World bank, the IMF, the European Investment Bank, the Asian Devlopment Bank, and the African Development Bank.

Question 28

bilateral loan

Corporate Debt

Answer 28

A loan from a single lender to a single borrower. Companies routinely use bilateral loans from their banks, and these bank loans are governed by the bank loan documents.

Question 29

commercial paper

Corporate Debt

Answer 29

A short-term promissory note issued in the public market or via a private placement that represents a debt obligation of the issuer. The maturity of commercal paper can range from overnight to one year, but a typical issue matures in less than three months.

Question 30

bridge financing

Corporate Debt

Answer 30

Interim financing that privdes funds until permanent financing can be arranged.

Question 31

backup lines of credit

Corporate Debt

Answer 31

Ensure that the issuer will have access to sufficient liquidity to repay maturing commerical paper if rolling over the paper is not a viable option.

Question 32

medium-term note (MTN)

Corporate Debt

Answer 32

Have the unique characteristic of being securities that are offered continuously to investors by an agent of the issuer. This feature gives the borrower maximum flexibility for issuing securities on a continuous basis. MTNs can actually have long maturities. Their initial purpose was to fill the funding gap between commercial paper and long-term bonds. They can be broken into three segments: short-term securities that carry floating or fixed rates, medium-to long-term securities that primarily bear a fixed rate of interest, and structured notes. Financial institutions are the primary issuers of MTNs, in particular short-term ones. Life insurance companies pension funds, and banks are among the largest buyers of MTNs because they can customize the bond issue to their needs and stipulate the amount and characteristics of the securities they want to purchase. These investors are often willing to accept less liquidity than they would get with a comparable publicly issued bond because the yield is slightly higher. But the cost savings in registration and underwriting often makes MTNs a lower cost option for the issuer.

Question 33

serial maturity structure

Corporate Debt

Answer 33

Teh maturity dates are spread out during the bond’s life. A stated number of bonds mature and are paid off each year before final maturity.

Question 34

term maturity structure

Corporate Debt

Answer 34

The bond’s notional prinicipal is paid off in a lump sum at maturity. Because there is no regular repayment of the principal outstanding thoughtout the bond’s life, a term maturity structure carries more credit rsk than a serial maturity structure.

Question 35

central bank funds market

Short-Term Funding Alternatives Available to Banks

Answer 35

Allows banks that have a surplus of funds to loan money to banks that need funds for maturities of up to one year. These funds are known as central bank funds and are called “overnight funds” when the maturity is one day, and “term funds” when the maturity ranges from two days to one year. There is an oportunity cost to the banks for holding reserves with the central bank in that these funds cannot be invested with higher interest or loaned out to consumers or commerical enterprises. Some banks have an excess over the minimum required funds to be held in reserve.

Question 36

central bank funds rates

Short-Term Funding Alternatives Available to Banks

Answer 36

The interest rate at which central bank funds are bought and sold (meaning to borrowed and lent) are short-term interst rates determined by the markets bu influenced by the central bank’s open market operations (central bank funds rates).

Question 37

certificate of deposit (CD)

Short-Term Funding Alternatives Available to Banks

Answer 37

An instrument that represents a specified amount of funds on deposit for a specified maturity and interest rate. A CD takes two forms: negotiable and non-negotiable. If the CD is non-negotiable, the deposit plus the interest are paid to the initial depositor at maturity. A withdrawal penalty is imposed if the depositor withdraws funds prio to the maturity date. A negotiable CD allows any depositor tos sell the CD in teh open market prior to the maturity date. There are two types of negotiable CDs: large-denomination CDs and small-denomination CDs. Thresholds vary by country, in US large-denomination CDs are usually inissued in denominations of $1 million or more. Small -denomination CDs are a retail-oriented product, and they are of secondary importance as a funding alternative. Large-denomination CDs in contrast, are an important source of wholesale funds and are typically traded amount institutional investors.

Question 38

repurchase agreement (repo)
Short-Term Funding Alternatives Available to Banks

Answer 38

The sale of a security with a simultaneous agreement by the seller to buy the same security back from the purchaser at an agreed-on price and future date. In practical terms, a repurchase agreement can be viewed as a collateralized loan in which the secuirty sold and subsequently repurchased represents the collateral posted.

Question 39

repurchase price

Short-Term Funding Alternatives Available to Banks

Answer 39

The price at which the dealer repurchases the security.

Question 40

repurchase date

Short-Term Funding Alternatives Available to Banks

Answer 40

When the security is repurchased. When the term of a repurchase agreement is one day, it is called an overnight repo. When it is more than one day, it is a term repo. An agreement lasting until the final maturity date is known as a “repo to maturity”.

Question 41

repo rate

Short-Term Funding Alternatives Available to Banks

Answer 41

The interest rate on a repurchase agreement. Several factors affect the repo rate: The risk associated with the collateral, the term of the repurchase agreement, the delivery requirement, supply and demand conditions of the collateral, and the interest rates of alternative financing.

Question 42

reverse repurchase agreement (reverse repo)

Short-Term Funding Alternatives Available to Banks

Answer 42

When a repurchase agreement is viewed through the lens of the security lending counterparty. Standard practice is to view the tranaction from the dealer’s perpective. If the dealer is borrowing cash from a counterparty and provididing securities as collateral, the transaction is termed a repurchase agreement. If the dealer is borrowing securities and lending cash to the counterparty, the transacts termaed a reverse repurchase agreement.

Question 43

repo margin (haircut)
Short-Term Funding Alternatives Available to Banks

Answer 43

The difference between the market value of the secutity used as collateral and the value of the loan.