Fixed Income Flashcards
Payment-in-kind toggle note
allows the issuer to pay interest each period in either cash, in-kind, or a combination of the two
A split coupon bond
no coupon payments initially, and then pays a high coupon rate in cash until maturity, this is also known as a deferred coupon bond.
put and convertible bonds benefit the bond holder
allowing them to redeem the bond if the price falls
and
convert to equity shares if they are worth more than the maturity value
When the bank’s core Tier 1 capital ratios fall below a minimum level
bond will automatically convert into a share, boosting the bank’s equity capital
Callable bonds offer less capital appreciation potential because they’re more likely to be called when rates fall. Moreover they should offer higher income in the first place to compensate for the option
pays more tax on capital gains
Callable bonds can be called
in part or in whole (entire issue)
The source of capital to repay supranational bondholders
the repayment of previous loans made by the entity or from paid in capital from its members
An asset-backed security generally requires:
A special purpose vehicle to hold the collateral remotely from the issuer
> get a higher credit rating by ring-fencing the collateral from other obligations an issuer may have
assets are usually receivables: credit cards, student loans or mortgages
Credit cards and student loans are unsecured loans that rely on the borrower’s future income for repayment
monoline insurers
Insurance companies that specialize in providing financial guarantees
e.g. surety bonds
bond issuance process
The legal issuer may be different
By setting up a separate legal entity with its own balance sheet (SPV) an issuer can receive a higher credit rating which would typically reduce (not increase) the required yield.
Assuming the bond has an original issue tax provision, what Is the tax liability for the investor
A prorated portion of the original issue discount is included in taxable income every year until maturity
Primary market activities include
underwritten offering, private placements and best-effort public offerings
A step-up note
is a structured note with a coupon rate that rises over time
An inverse floater
is a structured note with a coupon rate that is inversely related to a reference rate
commercial paper
is typically a short-term unsecured debt instrument issued by corporate issuers
sovereign bonds
are usually unsecured,
the issuer does have the ability to use excess tax revenue (budget surplus) to fund interest payments.
Treasury bills (T-bills) are typically
> pure discount debt instruments with a maturity of 12 months at issue.
do not make explicit interest payments (zero-coupon bonds).
usually bought at a discount to par value and the investor receives the par (face) value at maturity.
Fannie Mae and Freddie Mac are best described as
Government Sponsored Enterprise (GSE) issuers
Ginnie Mae is a
federally related institution
non-sovereign bond can
> bond issuer can use the cash flows of a project (e.g. bridges and airports) that the bond was used to finance.
non-sovereign bond issuer can introduce special taxes on residents to fund bond payments.
A non-sovereign bond or non-sovereign government bond is a bond
issued by levels of government below the national level such as provinces, regions, states and cities.
Examples include municipal bonds issued in the US.
An agency bond or quasi-government bond are organizations
established by national governments to perform various functions for them.
Examples include Fannie Mae, Freddie Mac and Sallie Mae
The z-spread is used to compare
> represents compensation for credit risk, liquidity risk and option risk
measures the equal amount that must be added to each of the spot rates in a given benchmark term structure
Key rate duration helps us understand how a bond’s price will change given a
non-parallel shift in the yield curve
The probability of default is typically measured over
a 12-month horizon
not regarded as being a full securitization
> Covered bonds
no requirement for a special purpose entity since the bank makes payments directly to investors
covered bonds
> Unlike asset-backed securities that can have prepayment risk, cover pool sponsors must replace any prepaid or non-performing assets to ensure sufficient cash flows until maturity
The unique features of covered bonds, including redemption regimens, mean that they usually carry lower credit risk and offer lower yields than otherwise similar asset-backed securities
the underlying assets are kept on the financial institution’s balance sheet and are not transferred to a bankruptcy remote SPE as happens with an ABS. This means that they offer bondholder dual recourse to the issuing financial institution and the underlying asset pool
Soft-bullet covered bond
delay the default and accelerated payments until a new final maturity date, which is usually up to a year after the original maturity date
solar Asset Backed Security can be backed by
> collateralized by solar loans and leases
solar ABS can be further collateralized by a lien placed on the installed system, on the property itself, or both
A CDO is an
asset backed security whose underlying assets are a diversified pool of debt instruments such as non-investment grade corporate bonds, emerging market bonds or bank loans
Time tranching allows
for the redistribution of prepayment risk among the bond classes, with the bond classes having different expected maturities
recourse loan
The lender has a claim against the borrower for the shortfall from the loan amount and proceeds from the property sale
amortizing mortgage loan
periodic mortgage payments consist of interest and scheduled principal repayment and can be partially or fully amortizing over the life of the mortgage
loan-to-value ratio
The higher the ratio the lower the borrower’s equity and less protection the lender has for recovering the amount loaned if default occurs
prepayment in the context of mortgage loans
Any payment towards repaying principal on the loan in excess of the scheduled principal repayment
> unscheduled principal repayment.
residential mortgage loan
An amortizing loan that is secured by collateral of real estate property obliging the borrower to make a series of payments to the lender
Non-agency RMBS have no guarantee from
either the U.S. Government or by a GSE
rates paid on mortgage-backed securities
> In Europe, commercial mortgage-backed securities tend to pay a floating rate
In US, commercial mortgage-backed securities tend to pay a fixed rate
Residential mortgage-backed securities can pay either fixed or floating rates
Top-down approaches
which start by considering the overall economy can be
used by analysts to forecast income and expenses.
Bottom-up approaches
which start with the company or a unit in the company
can also be used. Time series methods are generally considered bottom-up.
Hybrid approach (most common)
combines elements of top-down and bottom-up approaches.
Financial statement modelling most often starts by considering the income
statement:
- This is because companies usually derive the majority of their income from future income generation. (P/E)
- Banks and building societies are an exception. Existing assets and liabilities held are
likely to be more relevant.
Basic features of a bond
* Issuer
- Supranational organisations, e.g. World Bank
- Sovereign national governments, e.g. U.S. Treasury bonds
- Non-sovereign (local) governments, e.g. state of California in the U.S.
- Quasi-governmental entities – agencies owned or sponsored by the government,
e.g. Federal National Mortgage Association (Fannie Mae) - Corporate issuers – sub-divided into financial and non-financial issuers
- Special legal/purpose entities – issuers of asset-backed securities
Money market securities
– bonds issued with a maturity of one year or less
Capital market securities
– bonds issued with a maturity more than a year
Perpetual bond
– bonds with no stated maturity date
- Seniority
- Seniority or priority of repayment is an important determinant of risk
- Senior debt has priority over other debt claims in the event of bankruptcy or liquidation
- Junior or subordinate debt have a lower priority than senior debt and are paid only once senior claims are settled
- Current/Running yield
- Is similar to the dividend yield on a share and is often described as an incomplete
measure of return - It is calculated as:
Annual coupon / Market price
- Yield to redemption/maturity
- Is the bond’s internal rate of return
- That is, it is the rate that equates the discounted future cash flows to the bond’s price
- Yield to maturity assumptions
- Bond is held until maturity
- All expected cash flows are received as and when promised
- Coupons are reinvested at the YTM from receipt until maturity
- Yield Curves
- yields of the bonds with different maturities and create a yield curve for a given issuer
- longer-dated bonds would have higher yields to compensate for the extra risk that longer-dated bonds have
- We can compare the yield on a corporate bond with the yield on a government bond of the same maturity to establish the credit risk of the corporate bond (diff in yield is the credit spread)
- Contingency provisions
- The most common contingency provisions for bonds involve embedded options (call and
put) and conversion to equity options - They resemble option contracts but cannot be traded separately from the bond itself (warrants can)
Bond indenture
- Legal contract that describes the form of the bond, the obligations of the issuer and the rights of the bond holders
- Source of repayment proceeds
- indenture will describe how the issuer intends to service the debt and repay principal
- Sovereign bonds – backed by the “full faith and credit” of the national government
- Governments have the right to tax economic activity
- In developed countries considered to be risk-free
- Non-sovereign debt
- Generally use the taxing authority of the issuer or cash flows from the project the bond may be financing, e.g. toll road
- Corporate bonds
- Issuers of higher credit quality usually issue unsecured bonds
- Issuers of lower credit quality often issue secured bonds – they offer investors a lien or pledge on specific assets
- Securitized bonds – repaid from cash flows of the financial assets owned by the special purpose vehicle
- Such bonds might be issued in tranches
Bond Covenants
- Bondholders cannot vote and, therefore, have limited influence over an issuer
- The exception to this are the bond covenants agreed upon when the bond is issued
- Affirmative covenants are typically administrative in nature
- Common affirmative covenants include
- How proceeds raised can be used
- Provision of timely financial reports
- Permitting bondholders to redeem their bonds above par if the issuer is acquired
- Other affirmative covenants include
- A pari passu clause – ensuring that a bond is treated in the same way as others with similar seniority
- A cross-default clause – the bond issuer is considered to be in default if they default on another debt obligation
- Negative covenants seek to ensure that an issuer maintains the ability to make interest and principal payments
- Common negative covenants include
- Limitations on investments or disposal of assets
- The new issue must not be senior to existing debt (negative pledge clause)
- Linking to financial ratios – e.g. Interest cover must be greater than 2.5x for each reporting
period - Covenant breaches might lead to a change in financial terms (e.g. an increase in the coupon rate),
accelerated payment or termination of the debt agreement
- Sinking fund arrangements (provisions)
- issuers set aside funds over time to retire the bond
- Could be set aside in a segregated cash reserve or a specific provision to retire a specific portion (e.g. 4%) of principal ever year
- Usually at random by drawing serial numbers
- Price at which they retired could be different from par
- Lowers credit risk of the issue (good for bond holders) but means possible reinvestment risk
- Bullet repayment
- entire repayment of capital occurs on maturity
- Amortizing bond
- scheduled payment of interest and principal over the life of the bond:
- Fully amortized bond – entire principal is paid over the life of the bond such that zero outstands on maturity
- Partially amortized bond – pays interest and principal over the life of the bond but principal is still outstanding on maturity
- A balloon repayment is required at maturity to retire the outstanding principal
- Floating rate notes (FRNs)
- Coupon is linked to an external reference rate such as LIBOR
- Coupon rate = Reference rate + Spread, e.g. LIBOR + 20 basis points
- 1 basis point = 0.01%
- Most floaters pay coupons quarterly in reference to a 3-month reference rate
- A variable-rate note is a FRN where the margin above the reference rate is not fixed
- Additional features that may be observed in FRNs:
- Floor – prevents the coupon from going below a specified value
- Cap – prevents the coupon rising above a specified value
- Collared FRN – combination of a cap and a floor
- Inverse floater – bond whose coupon has an inverse relationship to the reference rate
- Step-up coupon bonds
- Coupon increase by specified margins at specified dates
- Offer bond holders protection against rising rates
- Typically have a call feature where the issuer can redeem the bond at a set price on the
step-up date
- Credit-linked coupon bonds
- Coupon that changes when the bond’s credit rating changes
- Attractive to investors concerned about the future credit-worthiness of the bond issuer
- Also wider protection to poor economy given ratings tend to deteriorate in economic downturns
- However, the increasing coupon payment resulting from the downgrade creates an extra burden on issuer or even default
- Payment-In-Kind (PIK) bonds
- Allows the issuer to pay interest in the form of additional amounts of the bond issue rather than a cash payment
- Favored by issuers concerned about cash flows in the future being able to service the debt
- Used to finance companies with high debt levels
- Because of the assumed credit risk investors require a higher yield
- Deferred coupon (split coupon) bond
- Regular coupon payments occur after a set time after issue
- Issued by firms that foresee higher cash flows in the future to be able to service the debt
- Typically priced at a discount to par
- In certain jurisdictions investors may find the deferred coupon useful in managing taxes
- Index-linked bonds
- Coupon payments and/or principal linked to a specified index such as a commodity index, equity index or other index
- Inflation-linked bonds offer protection against inflation
- Coupon and/or principal is linked to an inflation index (RPI in the UK, CPI in the U.S.)
- Several methods of linking the coupon to the index have been identified, e.g. for inflation
as an example: - Zero-coupon indexed bond pays no coupon so the inflation adjustment is made via the principal repayment only.
- Interest-indexed bonds pay a fixed nominal principal at maturity but the coupon are index-linked over the bond’s life.
- Capital-indexed bonds pay a fixed coupon rate on an inflation adjusted principal, both principal and
coupon are adjusted. - Indexed-annuity bonds are fully amortized bonds in contrast to the above that are not. The interest
and principal paid in a coupon rises in line with inflation over the bond’s life.
- Callable bonds
- Issuer has the right to buy back the bond before the specified maturity date
- Beneficial to the issuer to protect against a fall in interest rates or a increase in the issuers credit quality, enabling the company to re-finance at a lower level of borrowing
- Investors that hold callable bonds have higher levels of reinvestment risk than noncallable bonds
- Details of the call provision will be found in the indenture:
- Call price
- Call schedule including any call protection (period of time the bond cannot be called)
- Make-whole provision – issuer required to make a lump sum payment equal to the present value of the remaining cash flows
- Exercise styles of callable bonds include:
- American call – bonds called any time after the call date
- European call – bonds only called on the call date
- Bermudan-style – called on specified dates after the call date
- Putable bonds
- Bond holder has the right to sell back the bond at a pre-determined price to the issuer on specified dates
- Beneficial for the bond holder who can sell the bond back when rates rise, enabling the investor to realize cash to then buy bonds with a higher yield
- Price of a putable bond will be higher (therefore yield lower) than an equivalent option-free bond
- Selling price is usually the par value of the bond
- Exercise styles are similar to those of callable bonds
- Convertible bonds
- Bond holder has the right to exchange the bond for specified number of common shares of the issuing company
- Beneficial to the bond holder
- Straight bond + Embedded equity call option
- Hybrid instrument; debt and equity features
- Able to participate in the appreciation of share price
- Downside protection (but lower yield) by receiving the regular coupon and principal of the bond (floor value)
- Key terms regarding the conversion provision:
- Conversion price = Price per share at which the convertible bond can be converted
- Conversion ratio = Number of shares the convertible bond can convert into
- Conversion value (parity value) = Current share price x Conversion ratio
- Conversion premium = Convertible bond price - Conversion value
- Warrants
- Entitles the warrant holder to buy the underlying stock (new shares) at a fixed price until the expiration date.
- An ‘attached’ option rather than an embedded option.
- Considered yield enhancements (‘sweetners’) when attached to a bond issue.
- Contingent convertible bonds ‘CoCos’
- Bonds that convert to common equity upon the downward movement of equity share price.
- Issued by several European banks; if bank’s equity falls below a specified level set by regulators. Banks have to issue more equity. CoCos will be triggered upon breach of
regulation and will automatically trigger a conversion of bonds to equity. Decreasing liabilities and increasing equity re-establishes the regulatory capital ratio.
Legal and regulatory considerations
- Bonds are subject to different legal and regulatory requirements depending on where they are issued and traded
- Domestic bond – bonds issued by entities incorporated in that country, denominated in that country’s currency
- E.g. U.S. company issuing a bond in the U.S. market in U.S.$
- Foreign bond – bonds issued by entities that are incorporated in another country in the national bond market of another country in that country’s currency
- E.g. UK company issuing bonds in the U.S. market in U.S.$, called a ‘yankee bond’
- Eurobond – Issued outside the jurisdiction of any one country and trade in a currency different from the countries in which they trade
- E.g. Japanese company issuing a yen denominated bond that trades in the U.S. (Euroyen bond)
- Typically less regulated
- Historically, Eurobonds were bearer but these days typically they (along with domestic and foreign bonds) are registered with ownership being recorded by name or serial number
- Global bond – a bond issued simultaneously in the Eurobond market and at least one domestic market
Tax considerations
- Income portion is generally taxed at investors ordinary tax rate.
- Capital gain usually treated different from taxable income. Often a more favorable rate. Also, the capital gains tax rate often gets lower the longer the bond is held for before the disposal.
- Original issue discount bond may have a portion of the discount subject to income tax.
- Some jurisdictions have a tax provision for bonds bought at a premium where the premium can be used to offset taxable income.
issuers typically issue more debt instruments than equity
instruments
- Issuers might have short-term loans or bonds to fund working capital needs or longer term debt to fund capital investment
- Essentially the universe of fixed-income products is greater than the universe of equities
< 1 year
Short-term
Default risk-free :
Treasury bills
Investment grade :
Repo
Commercial paper
Asset-Backed CP
High yield :
-
1 year – 10 year
Intermediate-term
Default risk-free :
Treasury notes
Investment grade :
Unsecured corporate bonds
ABS
High yield :
Secured corporate bonds
Leveraged loans
> 10 year
Long-term
Default risk-free :
Treasury bonds
Investment grade :
Unsecured corporate bonds
MBS
High yield :
-
< 1 year
Short-term
Default risk-free :
Financial intermediaries
Central banks
Money market funds
Investment grade :
Corporate issuers
1 year – 10 year
Intermediate-term
Default risk-free :
Financial intermediaries
Central banks
Investment grade :
Bond funds and ETFs
High yield :
Asset managers
Hedge funds
Distressed debt funds
Default risk-free :
Financial intermediaries
Central banks
Pension funds
Insurance companies
Investment grade :
Pension funds
Insurance companies
High yield :
-
fallen angels are
issuers who were formerly investment-grade but have
been down-graded to high yield
issuers who were formerly investment-grade but have
been down-graded to high yield
- Although fixed income indexes perform a similar role to equity indexes there are three important differences
- Issuers often have many bonds in issue but only a small number of equities
- Fixed income indexes, therefore, often have many more constituents
- Bonds tend to mature and, as such, there is more turnover in fixed-income indexes
- Bond indexes are usually rebalanced every month to add new issues and remove those that don’t
have long enough maturities
- Bond indexes are usually rebalanced every month to add new issues and remove those that don’t
- Bond indexes are, like equity indexes, usually weighted but by market value of debt outstanding
- Since bond indexes contain bonds issued by a wide variety of issuers, they will reflect changes to bond market composition over time
- If a bond fund wants to track a specific index it will hold a representative sample of constituent bonds because it not practical to hold all the bonds in the index
- Fixed income indexes are classified as broader aggregate indexes with many constituents, or narrower indexes, based on criteria such as sector, credit quality, time to maturity, geography or ESG characteristics
Primary fixed-income markets
- Markets in which an issuer sells a new bond to investors to raise capital
- In contrast secondary bond markets are such that investors trade bonds with each other
- A debut issuer is an issuer approaching debt markets for the first time
- The debut issuer is often replacing bank loans as a source of funding with publicly issued bonds
- The issue could be brought to market via a public offering or a private placement
- Underwriters usually conduct ‘roadshows’ to familiarize the market with the new issuer and its use of and sources of repayment for the new bond
- For repeat issuers of fixed-income securities the process is much quicker
- Issuance of unsecured investment-grade bonds usually takes place within a several-hour period
- Unlike equity issuers that issue more of the same, bond issuers often issue a new security at or close to par
- Less commonly, repeat issuers might issue the same bond at a price significantly away from par (referred to as a reopening of an existing bond)
- With an underwritten bond offering, a number of financial intermediaries (underwriters) guarantee the sale of the bond at a price agreed with the issuer
- Investors in such bonds are usually familiar with the indenture and financial statements of frequent issuers
- Issuers usually often choose issuance timing on an opportunistic basis when conditions are favourable
- Such issuers often make use of a shelf registration that is updated regularly and is used for multiple future issues
- Secured bond issuance is often a more convoluted process
- Investors must familiarise themselves with unique and more complex covenants as well
as the use of operating cash flows and collateral as sources of repayment - For lower credit quality bonds, the financial intermediary is more likely to act as a broker
on a best-efforts basis - If the bond issue is small, the issuer is less well-known or the terms are more customised the bond might be issued via private placement
- Primary market issuance of sovereign debt usually takes the form of a public
auction led by a national treasury or finance ministry
Secondary fixed-income markets
- We have seen some recent moves to electronic trading but fixed-income secondary markets are still largely quote-driven or OTC markets
- Secondary market liquidity can vary dramatically and the bid-offer spread is a key measure of liquidity
- The most recently issued, or on-the-run, developed market sovereign bonds are typically the most liquid
- Amongst corporate issuers, recently issued corporate bonds from frequent issuers of higher credit quality tend to be more liquid
- Bonds of less frequent issuers or seasoned bonds of more frequent issuers tend to be less liquid
- Seasoned bonds don’t tend to be heavily traded
- An exception that can increase trading activity in a seasoned bond is a significant deterioration in the bond’s credit quality
- Bonds of issuers close to bankruptcy (distressed debt) typically trades well below par
- Funds with strict credit quality criteria might be forced to sell and this represents an opportunity for hedge funds to potentially benefit
- Distressed debt is traded until the issuer has liquidated its assets or its outstanding bonds have been restructured
- By the time that an issuer’s debt has become distressed, its shares are likely to have been delisted
External Loan Financing for Non-Financial Corporations
- Non-financial corporations rely on financial intermediaries which includes bank and non-bank lenders
- Uncommitted lines of credit (more frequently used in the US)
- Least reliable form of bank borrowing
- A bank can offer an uncommitted line of credit for an extended period but reserve the right to refuse to honor any request to use the facility
- Their main attraction is that the only cost is interest payable
- Committed (regular) lines of credit (more frequently used outside the US)
- More reliable than uncommitted lines because banks formally commit to providing the funds as needed
- Lines are in place for 364 days
- Usually classified as “notes payable” on the financial statements
- The borrowing rate is often the bank’s prime rate or at a money market rate plus a spread
- As well as paying interest the lender will also require the borrower to pay a commitment fee
External Loan Financing for Non-Financial Corporations
- Revolving credit agreements or revolvers (more frequently used in the US)
- The most reliable form of short-term bank borrowing
- Similar to committed lines of credit but can be in place for 3–5 years (i.e. multi-year) and often used for larger amounts
- Borrowers draw down and pay back periodically
- Secured (asset-based) loans
- Assets such as fixed assets, high-quality receivables, or inventory are used as collateral for the loan
- The lender files a lien against the assets and the lien becomes part of the borrower’s financial record
- Used by companies that lack sufficient credit quality to qualify for unsecured loans
- Factoring
- The company sells its accounts receivable to a lender (the factor) at a discount
- The factor then is responsible for collecting the cash from the company’s customers
External, Securities-Based Financing for Non-Financial Corporations
- Commercial Paper
- Short-term unsecured promissory note issued in a public offer or private placement
- Funds working capital requirements, as well as interim (bridge) finance until permanent funding can be arranged
- Issued by large, highly rated companies and financial institutions, governments and supranational agencies
- Maturity ranges from overnight to one year, but is typically less than three months
- Usually, the proceeds of new commercial paper is used to pay the holders of maturing commercial paper (‘rolling over the paper’)
- Creates rollover risk (issuer fails to issue new paper)
- To protect against this risk, investors require the issuer to obtain backup lines of credit from their banks (‘liquidity enhancement’)
- Defaults are relatively rare
- U.S. Commercial paper vs. Eurocommercial paper
- U.S. Commercial paper (USCP) market is the largest and most liquid globally
- Eurocommercial paper (ECP) represents the international commercial paper market
Short-Term Funding Alternatives for Financial Institutions
- Financial institutions (banks) have greater funding needs than non-financial institutions.
- Depositary institutions have access to deposit accounts, and generally originate a greater amount of loans. The wholesale market provides various sources of capital, e.g. central bank, interbank, and CDs.
- Retail deposits
- Primary source of funding, includes both individual and commercial deposits.
- Demand deposits (checking accounts) provide highest level of liquidity (immediate access on
demand), typically zero interest. - Savings accounts, pay interest, but less liquid than demand deposits.
- Certificate of deposit
- A specified amount on deposit for a fixed term and fixed rate payable on maturity
- Maturities typically less than one year with interest paid at maturity
- They may represent a deposit that can be traded (negotiable) or not traded (non-negotiable, with
early withdrawal penalties) - Only large denomination CDs are relevant as a wholesale funding source (institutional investors)
- Negotiable CDs oriented towards the retail market are called small-denomination CDs
- CD are traded in the Eurobond market
Short-Term Funding Alternatives for Financial Institutions
- Short-term wholesale funds
- Interbank funds
- Unsecured loan and deposit market between banks, with terms ranging from overnight to one year
- The rate on funds is closely tied to a reference rate, with interest payable on maturity
- In most countries financial institutions are required to maintain reserves at the central bank
- Some banks might have excess reserves and some might have a shortage of reserves
- The imbalance is solved through the central bank funds markets where banks borrow and lend with each other at the central bank funds rate
- A bank that is unable to borrow in the interbank market may do so directly from the central bank as a last resort (discount window lending)
- If this facility is used then it might lead to more oversight from the central bank and a restriction on the bank’s activities
Short-Term Funding Alternatives for Financial Institutions
- Commercial paper
- Commercial paper issuance is dominated by banks and financial institutions
- Like corporations, banks also face rollover risk to the extent that their funding needs exceed the maturity of commercial paper outstanding
- Banks often issue a secured form of commercial paper known as asset-backed commercial paper (ABCP)
- First, a bank agrees to transfer short-term loans to an SPE in exchange for cash
- Second, the SPE issues ABCP to investors with a backup credit liquidity line provided by the bank
- This financing is not recorded on the balance sheet of the issuer
- This off-balance sheet financing benefits the bank and investors
- The bank receives cash when the CP is issued
- Investors purchase a liquid, short-term note with interest and principal payments from a loan portfolio that they would not otherwise have access to
Repurchase agreements structure
- Repurchase agreements (repo) structure
- Sale of a security with a simultaneous agreement to buy back the same security from the original buyer at a set price (repurchase price) on an agreed date (repurchase
date) - The difference between the prices represents the interest (repo rate) on a collateralized loan (the security represents the collateral)
- Terms can be one day (overnight repo), or more than one day (term repo)
- Any coupon paid during the term belongs to the security seller (cash borrower)
- reverse repoer security buyer (cash ledner)
Repurchase agreements structure
- Instead of involving a single bond, a repo might involve a specific group of securities in what is known as a general collateral repo conducted at the general collateral repo
rate - Repos might be subject to a haircut, i.e. the need to provide collateral greater than the value of the funds being lent
- This is known as initial margin and is calculated as:
Initial margin = Security Price0/ Purchase Price0 - A 100% initial margin indicates a fully collateralized loan whilst a higher margin provides for even greater initial protection
- We can also consider the reduction or haircut of the loan relative to the initial collateral value
- This is calculated as:
Haircut = (Security Price0 − Purchase Price0)/ Security Price0 - Variation margin – as the price of the underlying bond (the 5-year US Treasurynote) changes the loan can become overcollateralized or undercollateralized
- If this happens then either party can request that variation margin be paid
- The variation margin = (Initial margin x Purchase price at time t) – Security price at time t
- Repurchase agreements applications and benefits
- Repos are used for three specific reasons
- Finance the ownership of a security (REPO)
- Earn short-term interest by lending funds securely (Reverse REPO)
- Borrow a security in order to sell its short (Reverse REPO)
- Factors that affect the repo rate
- Collateral credit risk (higher risk leads to higher rates).
- Maturity term (higher term leads to higher rates).
- Collateral delivery requirements (if delivery is not to the lender, then rates are higher).
- If demand for the collateral is higher, the lower the repo rate. On-the-run issues usually have lower rates.
- Interest rates on alternative financing in money markets (higher rates elsewhere will lead to higher repo rates)
Risks associated with Repos
* Risks associated with repurchase agreements
- Default risk – the collateral could default
- Collateral risk – the collateral should have little or no correlation with the credit risk of the repo counterparty
- Margining risk – adverse market conditions might lead to large changes in collateral value which would lead to more margin calls and increasing liquidations
- Legal risk – the ability to enforce legal rights under a repo
- Netting and settlement risk – is it possible to offset obligations and can we actually settle the transaction
Tripartite Repos
* Tripartite repos
- Tripartite repos offer a means to manage many of these risks
- Unlike with a bipartite repo, both parties agree to use a
third-party agent in the transaction
- Unlike with a bipartite repo, both parties agree to use a
- Tripartite repos don’t take away credit risk but do create cost efficiencies by providing access to a larger collateral pool as well as specializing in asset valuation and
safekeeping- The agent administers the transaction and is responsible
for cash, securities, collateral valuation and management
as well as collateral custody
- The agent administers the transaction and is responsible
Similarities between Long-Term Investment Grade and High-Yield Issuance
- Issuers and investors consider the relative risk associated with longer-dated bonds
- Normally longer-dated bonds have higher yields than government bonds and higher credit spreads
- Investors with a 5-year investment horizon might be tempted to buy a 7-year bond to get more return but are then exposed to the price achieved when they sell it two years early
- Issuers investing in a 5-year project might be tempted to issue a 3-year bond but are then exposed to rollover risk for the final 2 years
- These trade-offs exist for both investment-grade and high-yield bonds
- Higher spreads associated with high-yield debt increase the risk-versus-return trade-off for issuers of lower credit quality
AAA
BBB
AA
A
Lower YTM proportion
due to credit spread
Fewer issuer restrictions
Unlikely to default
Bond-like cash flows
> Use financial ratios and credit ratings to determine if/when
IG issuer’s likelihood of default likely to change
BB
B
CCC
CC, C, D
Equity-like cash flows
Higher YTM proportion
due to credit spread
Issuer restrictions and/or
secured by assets
More likely to default
> Consider likelihood of default and potential loss given default given covenants, restrictions and/or security
Differences between Long-Term Investment Grade and High-Yield Issuance
- Investment-grade bonds are relatively standardized debt instruments
- Issuers often have many general obligation bonds in issue at the same time
- These might have different maturities but generally have similar terms
- The most frequent investment-grade issuers often minimize refinancing risk by staggering debt maturities over time
- This reduces rollover risk and allows for opportunistic debt issuance if, and when, conditions become more favourable
- High-yield bonds are often characterized by the existence of covenants
- The debt covenants in a bond’s indenture establish the ability to monitor issuer financial performance based on predetermined criteria
- This allows lenders to take or require action to be taken
- Investor restrictions and constraints result in far less high-yield issuer flexibility and market availability than for investment-grade issuers
- Typically, such bonds are issued for 10 years or less and have less market availability over the economic cycle
- Issuers in the high-yield market often seek to retain financial flexibility by borrowing under leveraged loans with prepayment features or issuing bonds with contingency
features - Issuers of callable bonds have the right to redeem all or part of a bond prior to maturity
- Such bonds are often issued by borrowers who believe that their creditworthiness will improve
- If this happens, they can call in the callable bond and raise cash by issuing a new bond on a
lower yield
Differences between Long-Term Investment Grade and High-Yield Issuance
- Some high-yield might be described as ‘fallen angels’
- These bonds were formerly investment-grade bonds
- The borrowers’ likelihood of financial distress is similar to that of other high-yield issuers but the bonds have investment-grade features
- They are typically non-callable with few restrictions/covenants and longer maturities
- This is because they were issued when the issuer was highly rated
- The deterioration in issuer credit quality results in a fall in price which leads to the original investors suffering losses
- The investors might also be forced to divest these bonds if they no longer meet minimum rating requirements of their portfolios
Sovereign Debt
Characteristics
- National or sovereign government issuers are distinguished by
- Their legal authority to establish and maintain a country’s public goods and services
- Their ability to tax economic activity in their jurisdiction
- Additional sources of repayment of their debt obligations include tariffs, usage fees, and cash flows from government-owned enterprises
- Public sector financial accounting standards are generally prepared on a cash basis
- For example, depreciation is usually excluded
- Developed markets (DMs) are generally characterized by strong, stable, welldiversified domestic economies
- Consistent inflows and outflows of cash generally lead to stable and transparent fiscal policy which allows sovereign issuers to issue ‘default-free debt
- Emerging markets (EMs) are usually characterized by higher growth but less stable and less well-diversified economies that fluctuate more across economic cycles
- EMs often depend on a dominant industry, such as a commodity, and may involve more state-owned or state-controlled enterprises
- Government budgets may involve investments to expand economic and social infrastructure that exceed tax revenues which leads to the need for external or supranational funding
- Currency restrictions may limit foreign investment and constrain access to longer-term maturities in domestic currency
- Sovereign debt issued in the domestic currency is usually held by domestic financial institutions and domestic investors
- External debt comprise debt from foreign supranational financial organizations and debt issuance denominated in a foreign currency held by foreign private investors
