Fixed Income: Features, Issuance & Trading Flashcards
Loans
Private (nontradable) agreements between a borrower and lender.
Bonds (Fixed-Income Securities)
Standardized, tradable securities representing a debt investment.
Investors in bonds are lending capital (referred to as principal, par, or face value) to the issuer of the bond. The issuer of the bond promises to repay this principal amount plus interest, typically in the form of a regular periodic coupon that is stated as a percentage of par. The capital raised is usually used to finance the long- term investments of the bond issuer.
Issuers of a Bond
Sovereign national governments, corporations, local governments, supernational entities, quasi government entities, special purpose entities
Maturity, Tenor, money market & capital market securities, perpetual bonds
-The maturity date of a bond is the date on which the final cash low is to be paid.
-Once a bond has been issued, the time remaining until maturity is referred to as the tenor of a bond.
-Bonds with original maturities of one year or less are referred to as money market securities.
-Bonds with original maturities of more than one year are referred to as capital market securities.
-Bonds that have no stated maturity date are called perpetual bonds.
Principal or Par Value or Face Value
The par value of a bond is the principal amount that will be repaid. Repayment of principal typically occurs at maturity, but debt instruments may specify that principal is paid back gradually over the life of the instrument, such as with a mortgage loan.
Coupon Rate & Frequency
-The coupon rate on a bond is the annual percentage of its par value that will be paid to bondholders, default frequency is semi-annual, although may vary.
-Coupon rates can based on variable market rate called Floating Rate Notes (based on MRR)
-Zero Coupon Bonds or Pure Discount Bonds refer to bonds that are sold at a discount to their par value, and the interest is all paid at maturity when bondholders receive the par value.
Seniority
In the event of bankruptcy or liquidation of an issuer, debt investors’ claims on the issuer’s assets rank above those of equity investors, making debt senior to equity in the capital structure of the issuer. However, not all debt claims rank equally. Senior debt ranks higher than junior debt (also called subordinated debt), making senior debt a less risky investment from a credit risk perspective.
Contingency Provision
A bond may have an embedded option, such as a call option, put option, or the right to convert the debt into equity.
Yield
Given a bond’s price and its expected cash lows, we can calculate the expected return from investing in the bond, referred to as the bond’s yield. For a fixed-coupon bond, when prices fall, the bond offers a higher yield, and when prices rise, the bond offers a lower yield. As such, prices and yields are inversely related.
Yield Curve
Graphical Plot of yield versus maturity
Upward Sloping: High Yield for High Maturity (Normal Yield Curve)
Downward Sloping: Low Yield for High Maturity - lnverted Yield Curve - less common
Bond Indenture
The legal contract between the bond issuer (borrower) and bondholders (lenders).
The indenture de fines obligations of, and restrictions on, the borrower, including the sources of repayment, and it forms the basis for all future interactions between the bondholder and the issuer.
Sources of Repayment
-Sovereign Bonds: Repaid from taxes collected on economic activity
-Local Gov Bonds: Local Taxes/Revenue
-Secured Corporate Bond: Operating Cash Flow + Investment Cash Flows + Added security of legal claim (lein/pledge) on specific assets (collateral) in the event of issuer default.
- Unsecured Corporate Bond: repaid only from the operating and investment cash f low of the issuing company.
- ABSs: Cash flows from underlying asset
Bond Covenants
- Affirmative Covenants: requirements issuer must fulfill.
Cross-default: default on any other debt –> default on the bond
Pari-Passu: Bond ranks equal to other senior debt issues - Negative Covenants: restrictions on the issuer.
Negative Pledge Clause: Bond issue ranks more senior than existing debt
Incurrence Test: Breach of pre-defined financial ratios
Bullet Structure
Principal (par value) is paid back in a single payment at maturity. Periodic payments across the life of the bond (referred to as the bond’s coupons) are purely interest payments.
Amortizing Loan
A loan structure in which the periodic payments include both interest and some repayment of principal (the amount borrowed) is called an amortizing loan.
A bond can be fully amortizing or partially amortizing (or have a bullet structure).
Fully Amortizing Bond
If a bond (loan) is fully amortizing, this means the principal is fully paid off when the last periodic payment is made.
Partially Amortizing Bond
A bond can also be structured to be partially amortizing so that there is a repayment of some principal at maturity (referred to as a balloon payment). Unlike a bullet structure, the final payment includes just the remaining unamortized principal amount rather than the full principal amount.
Sinking Fund Provisions
Provide for the repayment of principal through a series of payments over the life of a bond issue.
For example, a 20-year issue with a face amount of $300 million may require that the bond trustee redeems $20 million of the principal from investors selected at random every year beginning in the sixth year.
+ve: Less Credit Risk as reduces total amount owed over the years
-ve: Reinvestments risk for the same reason.
Waterfall Structure
Used to establish principal repayments to holders of ABSs and MBSs.
These structured products can be split into tranches of varying seniority. A common waterfall structure is for junior tranches not to receive any principal payment from the collateral pool until all senior tranches have been fully repaid. Interest payments would still be made to all tranches.
FRNs/Floaters
Some bonds pay periodic interest that depends on the prevailing market rate of interest at the time future coupon payments are made. These bonds are called floating-rate notes (FRNs) or lfoaters. The variable market rate of interest is called the market reference rate (MRR), and an FRN promises to pay the MRR plus some f ixed margin (called a credit spread).
Step-Up Coupon Bonds
Structured so that the coupon rate increases over time according to a predetermined schedule, providing protection to investors against interest rates rising over the life of the bond.
Coupon changes could also be linked to future potential events., eg: Debt/EBITDA rising above 3% will call for an extra credit spread of 50 basis points.
Leveraged Loans
Loans to borrowers of lower credit quality or borrowers who already have a high amount of debt
Credit-Linked Notes
The coupon rate increases if the credit rating of the issuer deteriorates (or decreases if the credit rating improves).
Payment in Kind (PIK) Bonds
Allows the issuer to make the coupon payments by increasing the principal amount of the outstanding bonds, essentially paying bond interest with more bonds.
When firms anticipate that firm cash flows may be less than required to service the debt, often because of high levels of debt financing (leverage).
These bonds typically have higher yields because of the lower perceived credit quality implied by expected cash flow shortfalls, or simply because of the high leverage of the issuing firm.
Green Bonds
Whereby the coupon paid increases if certain environmental goals (for example CO2 emissions reduction) are not met by
the issuer over a speci fied time frame.
Index-Linked Bond
Coupon payments or a principal value that is based on a specif ied published index.
Inflation-Linked Bonds (Linkers)
Most common type of index-linked bonds, which increase their cash lows in line with a speci fied inf lation index, such as the Consumer Price Index (CPI) in the United States, to protect the real value of the cash lows promised to investors.
Structure of Inflation-indexed bonds
- Interest-indexed bonds. The coupon rate is adjusted for inf lation, while the principal value remains unchanged. This means the principal value of the debt is not in flation-protected.
- Capital Indexed Bond: The coupon rate remains constant, but the principal value is increased by the rate of in flation, or decreased by def lation.
(*Coupon value increased if inflation increased as principal value increases - only RATE is constant)
In the case of def lation, TIPS investors receive the maximum of inf lation-adjusted principal or the unindexed par amount at maturity.
Zero Coupon Bond
Simplest form of fixed-income instrument, offering only a single payment of par at maturity. These bonds are popular with investors that wish to minimize reinvestment risk. With no periodic coupon, zero-coupon bonds must trade below par to offer investors a positive return.
Contingency Provision
Describes an action that may be taken if an event (the contingency) actually occurs. Contingency provisions in bond indentures are referred to as embedded options.
Bonds that do not have contingency provisions are referred to as straight bonds or option-free bonds.
Deferred Coupon Bond
Regular coupon payments do not begin until a specif ied time after issuance. These bonds may be appropriate financing for issuers with a low credit rating or with a large project that will not be completed and generating revenue for some period after bond issuance. Zero-coupon bonds can be considered the most extreme type of deferred coupon bond—and, like zero-coupon bonds, deferred coupon bonds often trade below par to provide investors with the yields they demand.
Callable Bonds
A callable bond gives the issuer the right, but not the obligation, to redeem (through buying bonds back from investors before maturity) all or part of a bond issue at a predetermined fixed price (known as a call price).
Call Protection
The period until which bond is not callable.
Call Period
Where bonds can be called by the issuer
Call Risk
The issuer holding the call option creates call risk for the bondholder. Call risk relates to the fact that bondholders face an uncertain redemption date. For a bond that is in its call period, the call price will put an upper limit on the value of the bond in the market.
Value of Callable Bond
Due to call risk, bondholders will demand a higher yield and will pay a lower price for a callable bond than they would for an otherwise equivalent straight bond. The difference in price between a callable bond and an otherwise identical noncallable bond is equal to the value of the call option to the issuer.
VCB < VNCB
VCB = VNCB - Co
Putable Bond
Gives the bondholder the right to sell the bond back to the issuing company at a prespeci ied price, typically par. Bondholders are likely to exercise such a put option when the price of the bond is less than the put price because interest rates have risen or the credit quality of the issuer has fallen.
Value of Putable Bond
The embedded option for a putable bond has value to the bondholder because the choice of whether to exercise the option is the bondholder’s. For this reason, a putable bond will sell at a higher price (offer a lower yield) than an otherwise equivalent straight bond. The difference in price between an otherwise identical straight bond and a putable bond is equal to the value of the put option to the bondholder.
VPB > VNPB
VPB = VNPB + Po
(Reinvestment risk for issuer and hence will issue at higher price)
Convertible Bond
Gives bondholders the option to exchange the bond for a speci fic number of shares of the issuing corporation’s common stock. This gives bondholders the opportunity to prof it from increases in the value of the common shares.
VCB > VNCB
Conversion Price
This is the par amount per share at which the bond may be converted to common stock.
Conversion Ratio
This is equal to the par value of the bond divided by the conversion price. If a bond with a $1,000 par value has a conversion price of $40, its conversion ratio is 1,000 / 40 = 25 shares per bond.
Conversion Value
This is the market value of the shares that would be received upon conversion. A bond with a conversion ratio of 25 shares when the current market price of a common share is $50 would have a conversion value of 25 × $50 = $1,250.
Warrants
An alternative way to give bondholders an opportunity for additional returns when the firm’s common shares increase in value is to attach warrants to straight bonds when they are issued. Warrants give their holders the right to buy the f irm’s common shares at a fixed price over a given period.
Warrants can be detached from the bond issue and traded on securities exchanges.
Contingent Convertible Bonds (CoCos)
Bonds that convert from debt to common equity automatically if a speci fic event occurs.
Eg: Banks must maintain speci fic levels of equity financing. CoCos are often structured so that if the bank’s equity capital falls below a given level, they are automatically converted to common stock. This has the effect of decreasing the bank’s debt liabilities and increasing its equity capital at the same time, which helps the bank to meet its minimum equity requirement.
Domestic Bonds
Bonds of issuers domiciled in the same country as the market in which the bonds are issued and traded are referred to as domestic bonds
Foreign Bonds
Bonds of issuers from countries other than the market in which the bond trades are referred to as foreign bonds.
(UK Company raised $$ in US Market)
Eurobonds
Issued outside the jurisdiction of any one country and can be issued in any currency, have less regulations. Ex: Bond issued by a Chinese firm denominated in yen traded outside Japan (Euroyen).
Global Bonds
Eurobonds that trade in at least one domestic bond market and in the Eurobond market are referred to as global bonds.
International Bonds
Foreign bonds, global bonds, and Eurobonds that involve more than one country are often collectively referred to as international bonds to distinguish them from domestic bonds, which involve only a single country.
Sukuk Bonds
Sharia-compliant bonds with speci fic restrictions on the payment of interest and use of the proceeds of the bond issue to comply with Islamic law. The periodic payments on these bonds are considered to be cash flows from rent on underlying assets.
Original Issue Discount (OID) Bonds
Zero-coupon bonds and other bonds sold at signif icant discounts to par when issued are termed original issue discount (OID) bonds.
Because the gains over an OID bond’s tenor as its price moves toward par value are really interest income, these bonds can generate a tax liability even when no cash interest payment has been made.
In many tax jurisdictions, a portion of the discount from par at issuance is treated as taxable interest income each year.
Bond Taxation
- Interest usually taxed as ordinary income (wages, salaries)
- If sold before maturity, may be sold at profit or loss - this will be treated as capital gains income (maybe Long/Short Term)
- Sovereign Bonds - Interest Income maybe tax free
- In many tax jurisdictions, a portion of the discount from par at issuance is treated as taxable interest income each year.
- Some tax jurisdictions provide a symmetric treatment for bonds issued at a premium to par, allowing part of the premium to be used to reduce the taxable portion of coupon interest payments.
Maximum Price for a Currently Callable Bond?
Call Price
Credit Quality
Standard & Poor’s (S&P) and Moody’s are major examples of credit rating agencies that provide credit ratings on bonds. Ratings from AAA down to BBB- (for S&P) and Aaa through Baa3 (Moody’s) are considered investment- grade bonds. Bonds BB+ or lower (Ba1 or lower for Moody’s) are termed high- yield bonds (speculative, or “junk” bonds).
Credit/Maturity Spectrum
Default Risk Free:
<1y = T Bills
1-10y = T Notes
>10y = T Bonds
Investment Grade:
<1y = Repo/Commercial Paper/ABCP
1-10y = Unsecured Corp Bonds/ABSs
>10y = Unsecured Corp Bonds/MBSs
High Yield:
1-10y: Secured Corp Bonds/ Leveraged Loans
Fallen Angels
The high-yield sector also includes the bonds of previously investment-grade issuers that have been downgraded by credit rating agencies due to deteriorating credit quality.
Pension & Insurance Funds Positioning in credit/maturity spectrum
Pension funds and insurance companies invest in long-term, investment-grade securities to match their long-term liabilities (paying pensions and claims on insurance policies). These institutions are often prohibited by regulations from owning high-yield securities.
Corporations Positioning in credit/maturity spectrum
seek to earn returns on excess liquidity by investing in commercial paper, repos, and ABCP.
Central Bank Positioning in credit/maturity spectrum
Central banks use intermediate-term Treasury notes as a monetary policy tool to increase or decrease the monetary reserves of commercial banks.
Bond Funds & ETFs Positioning in credit/maturity spectrum
Bond funds and ETFs will position according to their stated mandate, usually in investment-grade intermediate securities excluding Treasuries.
Hedge Funds Positioning in credit/maturity spectrum
Asset managers seeking higher returns would invest in riskier high-yield intermediate securities, alongside hedge funds and, at the lowest end of the credit spectrum, distressed debt funds.
Banks Positioning in credit/maturity spectrum
Financial intermediaries (banks) use Treasuries across the whole maturity spectrum to manage interest rate and liquidity risks.
Difference between Fixed Income Indexes & Equity Indexes
- Number different bonds outstanding»_space; classes of shares. Thus, FI indexes have many more constituents than equity indexes and often employ sampling techniques rather than purchasing all the constituents to ease complexity.
- Turnover in FI Index is higher (due to high level of new issuances/maturities)
- Large weight to sovereign bonds as largest issuer.
Aggregated Indexes
Bond indexes that contain a broad selection of bonds.
Fixed Income Primary Market
Sales of newly issued bonds are referred to as primary market transactions, whereby the issuer sells new securities to investors and receives new capital in return. Newly issued bonds can be registered with securities regulators for sale to the public (a public offering) or sold only to selected investors (a private placement). Both are usually carried out through financial intermediaries (i.e., investment banks).
Debut issuer
An issuer that is offering its first-ever bond is referred to as a debut issuer and is typically a growing and maturing f irm that is replacing bank loans in its capital structure with the proceeds from the bond issue.
Underwritten Offering
In an underwritten offering, the bond issue price is guaranteed by the financial intermediaries conducting the bond sale to investors.
Best-Efforts Offering
Issues that are not underwritten are said to be conducted on a best-efforts basis. An issue price is not guaranteed by the intermediaries, but they will charge a commission for placing the bonds with investors at the best price possible.
Shelf Registration
A bond issue is registered with securities regulators in its aggregate value with a master prospectus. The bonds can then be issued over time when the issuer needs to raise funds.
FI Secondary Markets
trading of previously issued bonds among investors. While some electronic trading platforms and exchange-based trading exist, the majority of trading in the secondary market remains in the dealer, or over- the-counter (OTC) market.
Bid/Ask
Dealers post quotes comprising bid (purchase) prices and ask or offer (selling) prices for various bond issues. The difference between the bid and ask prices is the dealer’s spread.
One-the-run Bond
Most recent issue of bond for a particular maturity
Distressed Debt
Bonds of issuers that are in, or expected to file for, bankruptcy. A distressed debt investor might buy the debt from other institutions that are prohibited from owning securities with low credit ratings, and aims to prof it from the issuer’s fortunes reversing, higher-than-expected recovery rates in liquidation, or value-enhancing restructuring of the issuer. For an otherwise infrequently traded issue, entering a distressed situation may temporarily increase its trading activity.
External Loan Financing
AKA Bank Lines of Credit
refers to agreements between borrowers and banks to draw down funds as required.
Three Types: Uncommitted, committed, revolving
Uncommitted Line of Credit
- usually at MRR + fixed credit spread
- credit is “uncommitted” - bank may refuse to lend if circumstances change
- Less reliable
- More flexible: no fees (Except interest)
- Usually unsecured, given borrower maintains stable cash flows
Committed (Regular) Line of Credit
- Banks commit to offer credit for a specific time period
- More reliable
- Charge a commitment fee (approx 50 bps over full/unused credit)
- regulators require banks to hold a higher level of reserves to cover potential default
- default risk can be mitigated by short commitment period/acting in syndicate
- may withdraw agreement at maturity should credit conditions worsen leading to renewal risk
Revolving (Operating) Line of Credit
- Most reliable
- Typically longer terms
- Banks place restrictive covenants on borrowers under such agreements.
- Fees and rates are similar to committed
Factoring
- Companies can assign receivables to lenders to act as collateral for loans.
- Factoring refers to the actual transfer of credit granting and collection of receivables to a lender (“factor”) at a discount from their face value.
- The size of the discount, which represents the interest rate on the loan from the factor, depends on the creditworthiness of the f irm’s customers, and on collection costs.
Commercial Paper
Large corporations with high credit ratings can reduce their funding costs by issuing short-term unsecured debt securities, referred to as commercial paper (CP).
For these firms, the interest cost of CP is less than the interest on a bank loan.
With maturity of typically less than three months, CP is issued by f irms to fund working capital and as a temporary source of funds before issuing longer-term debt.
(CP in US - pure discount bonds)
Bridge Financing
Debt that is temporary until permanent inancing can be secured
Rollover Risk
CP is often reissued, or “rolled over,” when it matures. The risk that a company will not be able to sell new CP to replace maturing paper is termed rollover risk.
Backup liquidity lines
AKA Liquidity enhancement lines
To manage rollover risk, borrowers maintain backup lines of credit with banks.
Short Term Funding for Financial Institutions
- Checking accounts (Demand Deposits): provide transactions services and immediate availability of funds but typically pay no interest.
- Operational Deposits: made by larger customers who require cash management, custody, and clearing services.
- Savings deposits: have a stated term and interest rate. These may take the form of an interest-bearing certif icate of deposit (CD), which pays interest at a speci fied maturity of less than a year
- Interbank (Repos)
- Central Bank Funds Market
Certificate of Deposit
Pays interest at a specified maturity less than a year
Nonnegotiable CDs cannot be sold before maturity,
and early withdrawal of funds incurs a penalty. Negotiable CDs can be sold in the open market before maturity as a means of early withdrawal of funds. At the wholesale (institutional investor) level, negotiable CDs are an important funding source for banks. They trade in domestic bond markets as well as in the Eurobond market.
Interbank Funds
Funds that are loaned by one bank to another are referred to as interbank funds. Banks lend to each other for periods of one day to a year, on either a secured or unsecured basis, at an interest rate based on a market reference rate (MRR) that varies across markets. The most common type of secured interbank borrowing and lending is carried out through repurchase agreements (repos).
Central Bank Funds Market
Banks with excess reserves lend them to banks that need funds at the central bank funds rate, which is strongly in fluenced by the central bank’s open market operations and by the availability of short-term funds. The central bank may act as the lender of last resort (“discount window lending”) to banks struggling to access liquidity. This will likely be made at a higher rate than the central bank funds rate and may bring extra scrutiny and restrictions on the activities of the borrower.
Asset-Backed Commercial Paper (ABCP)
Short Term Asset backed security
Creation Process:
1. A financial institution transfers collateral (usually existing short-term loans made by the bank) to an SPE, in return for cash.
2. The SPE sells ABCP to investors, who accept the risk and return of the collateral backing the ABCP. The sponsoring f inancial institution provides a backup credit liquidity line.
Repurchase Agreement (Repo)
an arrangement by which one party sells a security to a counterparty with a commitment to buy it back at a later date at a prespeci fied higher price. The original purchase price is effectively a loan by the security buyer to the security seller, with the security as collateral. The difference between the repurchase price and the original purchase price accounts for the interest paid to the security buyer. The annualized interest rate implied by the difference between the two prices is called the repo rate.
Initial Margin
To protect the lender against a potential decrease in the value of the securities posted as collateral, the borrower typically must post extra collateral above the loan amount (the purchase price). In practice this means the loan amount will be a discount to the value of the securities.
= Market Value of Securities/Purchase Price
Haircut
The discount applied to the market value of collateral to get the purchase price is referred to as a haircut.
= 1 - (1/Initial Margin)
Variation Margin
The loan value increases during its life at the repo rate. Should the market value of the collateral fall below this value times the initial margin, the lender will ask the borrower for more collateral, known as variation margin.
Adjusted Loan amount = Amount of loan after a certain period has passed
(higher than original purchase price)
= (Initial Margin x adjusted purchase price) - market value of collateral
Overnight Repo
A repurchase agreement for one day
Term Repo
An agreement covering a longer period (>1 day)
General Collateral Repo
The collateral used in the repo may involve a speci fic security or a general type of security (e.g., Treasury bonds of a certain range of maturities), in which case it is known as a general collateral repo
Master Repurchase Agreement
The details of the contractual terms of the repo are contained in the master repurchase agreement between the counterparties.
Repo Applications
- Financial Inst: To finance trading activities
- MF/PF: To earn repo rate on excess short term funds
- Central Bank: To enact monetary policy, increase money supply
- HF: To speculate/short sell
Reverse Repo
HF execute short selling like this:
1. Buy securities/lend in a repo.
2. Short sell the securities in the open market.
3. Buy back the securities in the open market later (before the repo term ending).
4. Deliver the securities back to the repo counterparty at the maturity of the repo.
The hedge fund earns the repo rate from being the lender in the repo, and gains if the security value decreases over the repo term. When the motivation to enter a repo is to borrow a security in this way, the participant is said to be entering a reverse repo.
High Interest Rate for alternatives = ____ Repo Rate
Higher
Higher the credit Quality of collateral = ____ Repo Rate
Lower
Longer Term = ____ Repo Rate
Higher
Collateral in high demand/low supply = ____ Repo Rate
Lower
Undercollateralized = ____ Repo Rate
Higher
Repo Risks
- Default Risk
- Collateral Risk (value attained in case of default)
- Margining Risk (timely & accurate calc)
- Legal Risk (unenforceable contracts)
- Netting Risk (ability to net off payments across different contracts with same nondefaulting counterparty)
- Settlement Risk (ability to settle cash and collateral transactions underlying the repo)
Tri-Party Repo
Many of the risks of a repo agreement listed can be mitigated through using tri-party repos, which employ a third-party intermediary (usually a custodian bank or clearinghouse) as an agent to arrange and administer repo transactions. While this does not reduce credit risk, it does likely improve cost eff iciencies with respect to access to collateral and counterparties, and the valuation and safekeeping of assets.
Bilateral Repo
A repo agreement that is struck directly between two parties without a third party is referred to as a bilateral repo.
Default risk is higher for (Investment Grade/High Yield) Securities
High Yield
Loss given deafult is higher for (Investment Grade/High Yield) Securities
High Yield
Credit Rating related risk is higher for (Investment Grade/High Yield) Securities
Investment Grade
Credit Spread are higher for (Investment Grade/High Yield) Securities
High Yield
Restrictive Covenants are higher for (Investment Grade/High Yield) Securities
High Yield
Requirement of Collateral is higher for (Investment Grade/High Yield) Securities
High Yield
Standardization is higher for (Investment Grade/High Yield) Securities
Investment Grade
Flexibility is higher for (Investment Grade/High Yield) Securities
Investment Grade
Equity like returns are higher for (Investment Grade/High Yield) Securities
High Yield
Developed Market Sovereign Issuers
Developed market sovereign issuers have stable, diversi fied economies with consistent and transparent f iscal policy. Debt is denominated in a reserve currency
Emerging Market Sovereign Issuers
Emerging market sovereign issuers typically have faster growing, less stable, and more concentrated economies and, consequently, less stable tax revenues, which are sometimes tied to a dominant industry or commodity. Emerging market debt is often raised to fund investment in economic growth and can be domestic debt or external debt.
Domestic Debt (Sovereign Issuer)
Domestic debt is issued in the nation’s home currency and is held by domestic investors. That currency might not be freely convertible into other currencies due to illiquidity or restrictions on capital lows.
External Debt (Sovereign Issuer)
External debt is debt owed to foreign creditors and may be denominated in the government’s home currency or a foreign reserve currency. When external debt is denominated in a reserve currency, foreign investors avoid the direct currency risk of the issuer’s currency weakening, but the investor still faces indirect currency risk related to the emerging market government generating enough lows of the reserve currency to make repayments on its external debt.
Debt Management Policy
A government’s debt management policy sets out the amount and type of securities the government intends to issue.
Government should be indifferent among maturities given taxer:
- will increase savings when they expect higher future taxes.
- have rational expectations, expecting tax decreases in the present to be offset by tax increases in the future.
- can borrow and lend in capital markets that have no transactions costs.
- can and will pass tax savings on to future generations.
*NOT PRAGMATIC
Non-Sovereign Government Bonds
Issued by states, provinces, counties, and entities created to fund and provide services (e.g., for the construction of hospitals, airports, and other municipal services).
Agency Bonds/Quasi Government Bonds
Issued by entities that national governments create for specif ic purposes, such as financing infrastructure investment or providing mortgage financing. When they are backed by the sovereign entity, agency bonds typically have yields and credit ratings closely aligned with those of the government.
General Obligation Bonds/ Revenue Bonds
Local and regional government authorities may issue debt raised for general public spending backed by local tax raising powers (referred to as general obligation bonds or GO bonds), or debt issued to fund a specif ic project (called revenue bonds) where the source of repayment is fees from the use of the infrastructure funded by the bond issue (e.g., a toll road or bridge).
Supernational Bonds
issued by international institutions such as the World Bank, the IMF, and the Asian Development Bank, which have been set up by multiple sovereign governments to promote economic cooperation, trade, or economic growth. Bonds issued by supranational agencies typically have high credit quality and some issues are highly liquid.
Competitive Bids v Non-Competitive Bids
Competitive bids are used to set the price of the debt issue, while noncompetitive bids are guaranteed to have their allocation met at the price determined by the competitive bids. The auction is conducted by first allocating bonds to noncompetitive bids. Then, competitive bids are ranked in order of highest price (lowest yield). Bonds are allocated to competitive bids starting with the highest price and moving through the auction order book until the offering amount is met.
Cut-off yield
The yield of the successful competitive bid with the lowest price is referred to as the cut-off yield.
Single Price Auction
All investors pay the price associated with this cut-off yield, regardless of the yield they actually bid.
Multiple Price Auction
successful competitive bidders actually pay the price that they bid.
Primary Dealers
A sovereign issuer typically designates certain inancial institutions as primary dealers that are required to make competitive bids in auctions, submit bids in auctions on behalf of third parties, and act as counterparty to the central bank when it buys and sells securities to carry out monetary policy.
“noneconomic” objectives of investing in gov bonds
Central banks: to conduct monetary policy;
Foreign governments purchase sovereign bonds of other nations as reserves; F inancial institutions: are required to hold government bonds to comply with regulations.
The presence of such investors decreases the yields of sovereign bonds relative to those of non-sovereign issuers.
