Public Debt Market (5)

Question 1

What is the SECONDARY PUBLIC DEBT MARKET?

Answer 1

The market where public fixed income securities are traded.

“Public Fixed Income Debt” = pre-defined fixed income securities issued exclusively by the state. They include a coupon, which is not continuous and might depend on some variable. (periodic payments + repayment of principal)

Question 2

Which are the two main ACTORS in the 2ndary public debt market?

Answer 2

BANK OF SPAIN
responsible for organising the 2ndary market where securities are traded, but direct financing of the Treasury is prohibited.

TREASURY
responsible for financing the needs of the state and issuing securities.

• to achieve stable and continuous financing
  (ensures transparency, issues calendar, controls refinancing risk and smooths maturity profile)
• to reduce the cost of financing
  (manages debt through the repurchase policy, the interest rates swaps and the issuance policy spread along the curve)
• to maintain an adequate level of liquidity
  (increasing the size of issues (> 10 bill) and exchanging/repurchasing issues with low liquidity to concentrate dent into a limited number of securities)
• to offer investors attractive financial instruments
  (tailor instruments according to investors interests)

Question 3

What INSTRUMENTS can we observe in the 2ndary public debt market?

Answer 3

BILLS - ST (1-18 months)

• issued through auction at discount (P < NV)
• NV = 1000
• (P - NV) = implicit interest rate or return

NOTES - MT (18 months, 5-10 years)

• issued via auction
• NV = 1000

BONDS - LT (> 5-10 years)

• issued via auction
• NV = 1000
• coupons are paid annually or twice a year
• perpetuities = one special type of bonds with no maturity

TIPS (5, 10, 20 and 30 years)

• Treasury Inflation-protected Securities
• coupon is defined in real terms instead of nominal
• buyer will receive a rate + inflation

STRIPS

• Separate trading of registered interest and principal securities
• offer the option of separating each bond into “n” securities (the so called STRIPS)
• one for each payment or coupon (5 year bond = 6 STRIPS)
• each STRIP can be traded independently
• this operation transforms note/bond into zero-coupon bond
• STRIPS are a way of covering that demand without the need to increase the range of securities issued by the securities
• it allows the inverse operation as well, to reconstitute the original instrument from the zero-coupon bonds

Question 4

What is the IRR of a bond?

Answer 4

that is the discount rate that makes the market P today the same as the current value of all cash flows the bond will pay in the future.

Question 5

How does the PRIMARY MARKET work?

Answer 5

The government decides to issue debt with different maturities and forms through the Treasury.

It does so through competitive tender, and once bids are received, the Bank of Spain sets the volume to be offered, marginal P and weighted average P

• Competitive Bids: volume & P – filled with P >= marginal P
• Non-competitive Bids: volume – filled with weighted average P

the loan entities that attend the tender can later redistribute the debt purchased or sell it to third parties. In general, a single issue will be offered in successive competitive tenders.

Question 6

What is the P of a bond?

Answer 6

The P of a bond is the discounted current value to future coupons and principal.

note. ..
- the coupon of a bond is not a return, is not guaranteed
- bliss are quoted in interest rates (ordinary)
- notes/bonds are quoted at the P without accrued interest, to separate the effects of interest rates fluctuations from yield of the coupon

FINAL P (dirty P) = clean P + accrued interest

Question 7

Which are the main SOURCES OF RISK IN BONDS?

Answer 7

INTEREST RATES AND PRICE RISKS

• linked to the evolution of IR and shape and movement of yield curve
• possibility that when investors wants to sell, selling P < buying P

REINVESTMENT RISK

• generated when the instrument acquired has a shorter life than the investment term sought, so at maturity we must buy another until this period is complete
• return offered on that date < return obtained initially with this maturity

LACK OF LIQUIDITY RISK

• penalisation in the P if it should be necessary to make a quick a sale
• extreme cases = impossible to recover your money
• some instruments include penalty clauses

CREDIT RISK OR INSOLVENCY

• risk that the issuer cannot meet their obligations / delay
• ratings agencies exist who issue an opinion on the quality of the entities

Question 8

Types of OPERATIONS carried out in the public debt market?

Answer 8

ORDINARY OPERATIONS
cash operations where the buyer receives full rights to the security
(transfer of security, coupons, value of securities on maturity)
- ordinary cash operations (settled in 5 subsequent days to the transaction)
- forward cash operations (those settled later)

REPO OPERATIONS
those in which the investors perform two simple operations: one of purchase and one of sale. in general one of the operations will be made in cash and the other one in forward.

the day of the operation the conditions for both simple operations are setted

the buyer has full availability of the securities regardless of the date of returning therefore absolute freedom to sell before expedition of the agreement

–> “Implied REPO rate”
rate of return that can be earned by simultaneously selling a bond futures or forward contract, and then buying an actual bond of equal amount in the cash market using borrowed money.
The bond is held until it is delivered into the futures/forward contract and the loan is repaid.

Question 9

How does the SECONDARY MARKET work?

Answer 9

there are 4 trading systems...
1st TIER - WHOLESALE MARKET
- "blind" market
- via intermediaries or blind brokers
- MM trade PD electronically without knowing the counterpart

2nd TIER - BILATERAL TRADING SYSTEM
- trading can be direct or via intermediaries

intermediary: matches operations, informs parties and counterparts and these inform TARGET2 for subsequent compensation and settlement

ELECTRONIC PUBLIC DEBT EXCHANGE - MULTILATERAL TRADING SYSTEM

• continuous electronic trading and real time reporting of all activity
• min size of the operation is 1000
• blind market

PORTFOLIO/FUND MANAGERS - CUSTOMERS
- covers transactions between this two kinds of parties

Question 10

What types of OPERATORS can we distinguish in the SECONDARY MARKET?

Answer 10

MARKET MAKERS

• fulfill the purpose of favouring liquidity
• cooperate with the General Direction of the Treasury and Financial Policy in external and internal diffusion of State Debt
• exclusive 2nd round PD tenders
• exclusive last min petitions DEADLINE

PROPIETARY ENTITIES
operate on their own behalf

MANAGEMENT ENTITIES
may operate on their own behalf or on behalf of 3rd parties
- full capacity
- restricted capacity