L4 - A Detailed look at the Debt Market Flashcards
What is the Debt Market?
- Debt markets are used by governments (central and local) and firms (including banks) to raise funds for long-term purposes. Bonds are long term borrowing instruments that facilitate this.
- Corporate bonds can be issued against company assets in which case they are known as debentures (British definition) whereas unsecured loans are referred to as loan stock. Unsecured bonds offer a higher return.
- So called straight bonds (straights) carry a fixed rate of interest and have a specified redemption date - sometimes 30 years in the future
What are some different types of Bonds?
Within this generalised categorisation, we can identify several types of bonds:
- Callable and putable bonds
- Convertible bonds
- Eurobonds
- Euro bonds
- Floating Rate Notes (FRNs)
- Foreign bonds
- Index-Linked Bonds
- Junk bonds
- Strips
What are Callable and Putable Bonds?
- Callable bonds are a tool used by issuers, especially at times of high prevailing interest rates, where such an agreement allows the issuer to buy back or redeem bonds at some time in the future. In this case, the bondholder has essentially sold a call option to the company that issued the bond, whether they realize it or not.
- putable bonds provide more control of the outcome for the bondholder. Owners of putable bonds have essentially purchased a put option built into the bond. Just like callable bonds, the bond indenture specifically details the circumstances a bondholder can utilize for the early redemption of the bond or put the bonds back to the issuer. Just like the issuer of the callable bonds, putable bond buyers make some concessions in price or yield (the embedded price of the put) to allow them to close out the bond agreements if rates rise and invest or loan their proceeds in higher-yielding agreements.
- issued at the buyer or sellers discretion
- Have a fixed redemption date which can be redeemed by the buyer or seller (depending whether they are callable or putable) before this redemption date
What are Convertible bonds?
- A convertible bond has an embedded option that combines the steady cash flow of a bond, allowing the owner to call on-demand the conversion of the bonds into shares of company stock at a predetermined price and time in the future.
- The bondholder benefits from this embedded conversion option as the price of the bond has the potential to rise when the underlying stock rises. For every upside, there is always a downside risk, and for convertibles, the price of the bond may also fall if the underlying stock does not perform well.
What are Eurobonds?
- A Eurobond is debt instrument that’s denominated in a currency other than the home currency of the country or market in which it is issued. Eurobonds are frequently grouped together by the currency in which they are denominated, such as eurodollar or Euro-yen bonds.
- Since Eurobonds are issued in an external currency, they’re often called external bonds. Eurobonds are important because they help organizations raise capital while having the flexibility to issue them in another currency.
- Issuance of Eurobonds is usually handled by an international syndicate of financial institutions on behalf of the borrower, one of which may underwrite the bond, thus guaranteeing the purchase of the entire issue.
What are Euro Bonds?
- bonds issued in Euros outside the Euro zone
What are Floating Rate Notes (FRNs)?
floating-rate note (FRN) is a debt instrument with a variable interest rate. The interest rate for an FRN is tied to a benchmark rate. Benchmarks include the U.S. Treasury note rate, the Federal Reserve funds rate—known as the Fed funds rate—the London Interbank Offered Rate (LIBOR), or the prime rate.
Floating rate notes or floaters can be issued by financial institutions, governments, and corporations in maturities of two-to-five years.
What are Foreign bonds?
A foreign bond is a bond issued in a domestic market by a foreign entity in the domestic market’s currency as a means of raising capital. For foreign firms doing a large amount of business in the domestic market, issuing foreign bonds, such as bulldog bonds (London), Matilda bonds (Austrialian), and samurai bonds (Japan), is a common practice. Since investors in foreign bonds are usually the residents of the domestic country, investors find the bonds attractive because they can add foreign content to their portfolios without the added exchange rate exposure.
What are Index-Linked Bonds?
An index-linked bond is a bond in which payment of interest income on the principal is related to a specific price index, usually the Consumer Price Index (CPI). This feature provides protection to investors by shielding them from changes in the underlying index. The bond’s cash flows are adjusted to ensure that the holder of the bond receives a known real rate of return. An index-linked bond is also known as a real return bond in Canada, Treasury Inflation-Protected Securities (TIPS) in the U.S., and a linker in the U.K.
What are Junk Bonds?
Junk Bonds – These are the bonds that pay high yield to bondholders because the borrowers don’t have any other option. Their credit ratings are less than pristine, making it difficult for them to acquire capital at an inexpensive cost. Junk bonds are typically rated ‘BB’ or lower by Standard & Poor’s and ‘Ba’ or lower by Moody’s
What are Strips?
- STRIPS (Separate Trading of Registered Interest and Principal of Securities) are debt securities that are created through the process of coupon stripping.
- They are essentially traditional Treasury bonds, except that the bond’s principal (its corpus) has been separated–stripped–from its interest (its coupon). Investors may then choose to purchase securities based on either the principal or interest of the bond.
- STRIPS take the form of zero-coupon securities. That is, they make no periodic interest payments, as most bonds do. Instead, you buy them at a deep discount from their face value, which is the amount you receive when they mature.
- This means that investors know exactly how much they will earn from their STRIPS investments. This, along with the high security of the bonds that back them, make STRIPS popular with some investors.
What are the different two different markets within the Debt Market?
- Debt markets consist of a primary market where newly issued instruments are bought and a secondary market where existing instruments are traded.
Why is the Regulation of the sale of Government Debt important?
The vast majority of world bond markets have different institutional arrangements for the sale of government debt. Governments need to finance their deficits to ensure their can finance their expenditures. The same is true of bodies corporate, but the implications of governments failure to raise funds are far more serious than the failure of a company to raise funds. To ensure an active market with high rated participants, government bond markets are subject to a relatively high level of regulation and supervision by the central bank.
Regulation and supervision are also important because government bonds serve as benchmarks for pricing other assets and they provide benchmark risk free rates.
Why is the non-government bond market important?
- By far the largest portion of the debt market is government debt. However, the non-government bond market is also important and is dominated by bank debt securities.
- This segment of the market includes unsecured debt securities and covered bonds. The latter are claims against the issuing agent. They are collateralised against a separate pool of assets. In case of default by the issuer, the pool can be used to cover claims at any time.
- Financial institutions purchase investments that produce cash flows, typically mortgages or public sector loans. These investments can then be assembled together enabling the bank to issue bonds covered by the cash flows from the investments.
- Covered bonds have increased in popularity in recent years because they allow financial institutions to buy and sell assets to improve credit quality and through this, lower borrowing costs.
What was the impact of the introduction of the Euro?
- The introduction of the euro in 1999 had a major impact on the operations of the DMO. The disappearance of exchange rate risk within the euro area created conditions for a pan-European capital market.
- Consequently, debt managers became players in a larger European market and increasingly turned their focus to credit risk and liquidity.
- Simultaneously bond portfolios became increasingly diversified along international lines stimulating a more efficient primary market and a deeper, more liquid, secondary market.
How do you value a coupon bond?
Fair value –> price is reflected by the underlying fundamentals
- This the the Clean price of bonds –> the price at which the bond is quoted –> this works well assuming it is held for a full six months to the next payment period
