Chapter 12 Flashcards
Fixed income
Where have retail and wholesale banks traditionally balanced customer deposits and loan demand
- interbank market
- minimum deposit of £500,000 and is unsecured
Until the financial Crisis in 2008 what was the most important rates quoted by the bank
- London inter-bank offered rates (LIBOR) - the rate at which banks lend to one another for the short term.
- London inter-bank bid (LIBID) - the rate at which banks are prepared to accept short term deposits
Main characteristics and risks and money market instruments of certificates of deposits (CDs)
- tradable time deposits issued by a depositing institution such as a commercial bank
- need a UK banking license
- issued with denominations of £10,000 with minimum value of £100,000
- are negotiable
- price is lower than an equivalent fixed-term deposit
- based on a future value of the deposit paid to the investor when the deposits matures
- risk free up to US$250,000 - no protection in the UK
Main characteristics and risks associated with cash deposits and money market instruments in commercial paper (CP)
- short-term promissory not that can be issued by both financial firms and creditworthy corporations.
- issued at a discount
- time to maturity usually 7 days to a year
- CP is an unsecured promissory note, so, the credit rating of the issuing firm is crucial in assessing the risk.
Explain the main characteristics and risks associated with cash deposits and money market instruments for floating rate notes (FRNs)
- issued at par but have a coupon that is linked to a pre-specified market rat.
recalculated every three to six months
what is the gilt-edged securities market
- the largest fixed-income market in the UK
- issued by His Majesty’s
- Gilt - refers to two different types of security
1. conventional gilts
2. index-linked gilts - Issued through auction
- Market makers typically sell the gilts on to clients, typically big pension or insurance funds, or hold them
What are conventional gilts
- liability of the UK government - guarantees to pay the holder of the gilt a fixed cash payment (coupon) every 6 months until maturity at which the holder receives the final coupon payment and the return of the principal.
What is an index-linked gilt
- form the largest part of the gilt market after conventional gilts
- index-linked coupon reflects the real borrowing rate for the government rather than the nominal borrowing rate - much smaller variation in real yields over time
- information can be found in the FT and DMO
- categories according to remaining respective maturity
‘long’ - more than 15 years
‘medium’ - 7 to 15 years
‘short’ - less than 7 years
‘ultra-short’ - under three years maturity - Index-linked gilts have both their principles and coupons linked to inflation - measure of inflation used is RPI
what are gilt strips
- acronym for Separate Trading of Registered Interest and Principal Securities.
- stripping a guilt refers to breaking it down into its individual cash flows, can be traded separately as zero-coupon gilts
- a newly issued gilt on the relevant coupon series is not declared strippable until a sufficient amount of the gilt has been issued to maintain liquidity in both stripped and unstripped format - minimum of £5 billion
- only Gilt-edged Market Makers (GEMMs), HM Treasury and the BoE can strip and reconstitute gilts
What is Gilt Repos
- allows the sale and repurchase of a security (gilt)
- a contract to sell securities for cash and then buy them back at an agreed future price and date
- interest rates lower compared to other sources of borrowing
- bond dealers and institutions can borrow bonds through repo agreements to cover short positions
what is clean and dirty gilt pricing
Clean
- excluding accrued interest
reported price changes reflect changes in market conditions and not changes in accrued interest
Dirty
- purchased, the actual price paid
- clean price plus any accrued interest
- due to seller of the bond having learnt some fraction of the coupon
roles into the actual price paid for the bond
what is an index-linked bond
- a bond for which payment of interest income (coupon) and the principal is related to a specific price index, e.g. the retail prices index (RPI) UK
- thus, protection is provided to investors from changes in the underlying price index.
- cash flow for bonds is adjusted to ensure that the holder of the bond receives a known real rate of return
- known as treasury inflation-protected securities (TIPS) in the USA
- known as linker or ILG in the UK
aspects of ILGs (index-linked bonds in the UK)
- bonds paying fixed nominal coupons will see their real value diminish with time
- governments issue to offer investors bonds that make inflation-protected payments
- ILGs have both their coupon and redemption values linked to the RPI
Characteristics of Corporate Bonds - The bond indenture
Corporate bonds are issued by companies to raise long-term capital.
- not standardised investment vehicles
- each issue had an accompanying legal document known as the bond indenture
Characteristics of Corporate Bonds - Sinking funds
Provision requires that the firm ‘retires’ (buys back) a certain proportion of the bond issue throughout the life of the bond each year.
- reduces the credit risk for the remaining bondholders since it reduces the final amount that the firm has to pay when the issue finally matures
Characteristics of Corporate Bonds - Protective Covenants
Limitations on the future actions of the issuing firm.
- designed to ensure that the stream of income required to meet coupon and principal payments from the bond is not exposed to undue risk
e.g.
- proportion of earnings to be paid to shareholders
- amount of additional debt that can be raised by the company
- ranking of any future debt
- amount that company executives can pay themselves
Characteristics of Corporate Bonds - Call/put provisions
allows firms to redeem the issue at its discretion on pre-specified dates at pre-determined prices.
- Call provisions are only beneficial for the firm, which will call the bond if rates fall substantially below the coupon rate of the bond, giving the firm the opportunity to issue new debt at a lower interest cost.
- greater reinvestment risk than with straight (non callable) bonds
Put provision
- allows the investor to sell the bonds back to the issuer at a pre-specified price
- advantage of investor - if interest rates are high by selling the bonds back to the issuer and purchasing new higher yielding fixed-income securities
- effectively buying a straight bond and buying put options at the same time (the right to sell the bond back to the company should rates rise high enough)
Types of Corporate Bonds - Mortgage bonds, debentures and unsecured loan stock
Mortgage bonds
- type of secured bond backed by real estate holdings or real property
Debentures
- usually secured by a floating charge on the assets of the company as opposed to a fixed charge
- type of debt instrument that is not secured by physical assets or collateral; instead backed by the general creditworthiness and reputation of the issuer
Unsecured loan stock
- form of bond that is not backed by collateral - only by the creditworthiness of the issuing firm
- firm failure - holders of unsecured loan stock are ranked with other unsecured creditors, such as firm’s suppliers
Types of Corporate Bonds - Eurobonds
A bond that is denominated in a currency other than the home currency or market in which it is issued
- variety of institutions raise money through issue of Eurobonds
- can be issued in a number of currencies, with either floating or fixed coupon payments, or as a convertibles.
Aspect of contingent convertible bonds (CoCos) - Trigger mechanisms
Major innovation issued mainly by banks is the contingent convertible bond (CoCos). It is debt that is converted into equity if a pre-specified trigger event occurs - such as the capitalisation facing below a certain level
- toolkit for crisi management
- absorb losses before the point of insolvency
- be robust to price manipulation
2 key fining characteristics
1. mechanism by which losses are absorbed
2. trigger that activates that mechanism
Trigger Mechanism - book market triggers
- point at which the loss-absorption mechanism is activated - book market trigger - may be open to stock price manipulation, including giving holders the incentive to short sell the stock
Trigger Mechanism - discretionary triggers
- based on bank supervisors judgement on the issuing banks solvency
- offset the unreliability of book value triggers
- conditions under which the loss-absorption mechanism can be activated must be set out in advance to avoid uncertainty
Aspect of contingent convertible bonds (CoCos) - Loss-absorption mechanism
- a conversion-to-equity CoCo can have a conversion rate based on the market price of the stock at the time of trigger breach, or a pre-specified price
- in contrast, if the conversion rate is based on a pre-set price, then dilution of existing shareholders would be limited, with a reduced incentive for them to avoid the trigger’s activation
- alternative approach involving principal write-down can feature full or partial write-downs though the others are more popular
Aspect of contingent convertible bonds (CoCos) - Issuance, supply and investor demand
the press from regulators on banks to raise capital has been the main driver of CoCo supply.
- CoCos with low triggers have lower loss-absorbing capacity, hence may no qualify for certain definitions of capital, but will consequently be cheaper to issue
Regular requirements can be met with either conversion-to-equity or principal write-down CoCos
- Tax considerations in different jurisdictions affect the issuance of CoCos
Main investor groups purchasing CoCos
- Private banks - attracted by relatively high nominal yields
- US institutional investors and European non-bank financial institutions - seen as an alternative asset class
- certain high-trigger CoCos possesses the ability to invert the usual hierarchy of investors, leading to obvious difficulties in ranking credit risk
Aspect of contingent bonds (CoCos) - Pricing of contingent convertibles
Key determinants in pricing CoCos are their position in the bank’s capital structure, the loss-absorbing mechanism and the trigger itself.
- subordinate to other debt instruments as they incur losses first
- relatively low trigger levels - often more favourable terms to holders than to equity owners, since the trigger is less likely to be breached and the holder less likely to suffer
- issuing banks prefer PONV triggers
CoCo owners prefer not to have PONV triggers
- Equity and CoCo holders have differing interests when ti comes to loss-absorption mechanisms
- Holders of CoCos prefer the conversion-to-equity class over the principal write-down clause
- In the secondary market, CoCo bond yields are most highly correlated with subordinated debt yield, albeit with substantial variation between high- and low-trigger CoCos
Define the yield curve
The relationship between maturity and yield (or as the term structure of interest rates)
Explain the pure expectation theory contributing to explain the shape of the yield curve
Is the term structure of interest rates states that, in equilibrium, the long term rate is a geometric average of todays short term rate and expected short term rates in future. Requires that there is an implicit relationship between current fixed income yields and forward rates.
Liquidity preference theory explaining the shape of the yield curve
Asserts that in a world of uncertainty, investors and lenders want to hold assets that can be converted to cash quickly. Demands a liquidity premium for holding long term debt. In reality we need to consider the combined effect of expectations together with liquidity preference. A downward sloping yield curve will occur when expectations of an interest rate fall are sufficient to offset the liquidity premium.
Explain market segmentation to explain the shape of the yield curve
Suggests that the bond market is actually made up of a number of separate markets distinguished by time to maturity, each with their own supply and demand conditions. Different classes of investors and issuers will have a strong preference for certain segments of the yield curve, and therefore parts of the curve will move up or down as investors preferring these segments change their behaviour.
Relationship between forward rates, spot rates and the GRY
Forwards - are the implied, future short term rates
Spots - are single rates from now up to a specified future point in time. They are a geometric average of the current short term rate together with all other rates up to that point in time.
Yield - of a bond is a complex weighted average of the spot rate. The waiting are roughly the cash flows paid out by that bond. A zero coupon bond will have all of its cash flow returns at the maturity date. So the yield will equal the spot rate for that particular time horizon.
For an upward sloping yield curve where the bonds are not zero coupons the following relationship hold: forward > spot rates > yield. The reverse is true for a downward sloping yield curve.
