Inflation-indexed bonds Inflation-indexed bonds deliver coupons and principal that are indexed on the future inflation rates They are mainly issued by governments to make it clear they are willing to maintain a low inflation level An inflation-indexed bond can be used to —hedge a portfolio against a rise in the inflation rate —diversify a portfolio based on low correlation with stocks, fixed-coupon bonds and cash
Municipal Bonds Issued by state and local governments —Exempt from federal income tax —Exempt from (issuing) state local tax Not necessarily high credit ranking Types of ‘munis’ —General obligation bonds: baked by the ‘full faith of credit’ of the issuer (taxing power) —Revenue bonds (riskier): issued to finance specific projects (airports, hospital, etc.)
Municipal Bonds Who purchases municipal bonds? —T-bond pays 5% and municipal bond 3.8% —If (marginal) tax rate is 20%? 35%? After-tax return —MTR = 20%: (.05)x(.8) =.04 >.038 —MTR = 35%: (.05)x(.65) =.0325 <.038 What MTR is indifferent (‘cutoff rate’)? (.05)x(1 - t) =.038 => t =.24 = 24%
Corporate bonds Bonds issued by a corporation Typically pay semi-annual coupons 3 Sources of Risk —Interest Rate Risk —Default Risk —Liquidity Risk Bond indenture contracts stipulate collateral and specify terms Different “seniority” classes —Secured Bonds —Subordinated debentures —Debentures Preferred stocks —‘Promises’ fixed dividend = coupon rate —Cannot force bankruptcy if no dividend paid
Corporate bonds Standard & Poor, Moody’s and other firms score ‘the probability of continued & uninterrupted streams of interest & principal payments to investors’ Classes of grades —Moody’s Investment Grades: Aaa,Aa,A,Baa —Moody’s Speculative Grades: Ba, B, Caa, Ca, C —Moody’s Default Class: D Are ratings agencies better able to discern default risk or simply react to events?
Money Markets Instruments Markets for short term debt Highly marketable (liquid) Low risk Very large denominations MM mutual funds accessible Very sensitive to the central bank’s policy — open market operations — key interest rate
CDs and CPs Certificate of Deposit (CD) —Time deposit (penalty for early withdrawal) —Bearing coupons Commercial Paper —Short term, unsecured —A way of raising short-term funds or as bridge financing Banker’s Acceptances —Bank guarantees payment —No interest rate: calculated in the same manner as the price of a T-bill Interbank Deposit —LIBID/ LIBOR: the average of the rates quoted by the major banks of a market place.
Repurchase Agreements Repurchase Agreements (Repo’s) —Effectively an overnight, collateralized loan —Sell government securities, with promise to repurchase at slightly higher price tomorrow A repo is a way for an investor to borrow money —A commitment by the seller of a security (usually gvt security) to buy it back from the buyer at a specified price and at a given future date —Can be viewed as a collateralized loan, the collateral being the security Repo maturity —When repo maturity is one day, called overnight repo —When repo maturity exceeds one day, called term repo A reverse repo is a way for an investor to lend money —A reverse repo agreement is the same transaction viewed from the buyer's perspective The repo rate is computed on an Actual/360 day- count basis
An example A German investor needs money —He lends € 1 million … —… of the 10-year Bund benchmark bond (i.e., the Bund 5% 07/04/2011 with a quoted price of 104.11, on 10/29/2001) … —… over 1 month at a repo rate of 4% —There is 160 days' accrued interest as of the starting date of the transaction Cash payments —At the beginning of the transaction, investor receives an amount of cash equal to the gross price of the bond times the nominal of the loan, that is (104.11+5x160/360)x1,000,000/100= € 1,063,322 —At the end of the transaction, in order to repurchase the securities he will pay the amount of cash borrowed plus the repo interest due over the period, that is 1,063,322 + 1,063,322 x 4 x 30/360= € 1,066,866