CHAPTER 8 FIXED - INCOME MARKETS

Overview of the Money Market Short-term debt market -- most under 120 days. A few high quality borrowers. Many diverse investors. Informal market centered in New York City. Standardized securities -- one security is a close substitute for another.

Overview of the Money Market (concluded) Good marketability -- secondary market. Large, wholesale open-market transactions. Many brokers and dealers are competitively involved in the money market. Payment in Federal Funds -- immediately available funds. Physical possession of securities seldom made -- centralized safekeeping.

Economic Role of Money Market (MM) The money market is a market for liquidity –Liquidity is stored in MM by investing in MM securities. –Liquidity is bought in MM by issuing securities (borrowing).

Characteristics of Money Market Instruments Low default risk. Short maturity. High marketability.

Money Market Balance Sheet Position of Major Participants

Commercial Banks -- Most Important Participant in the MM Bank assets or investments –Treasury bills. –Agency securities. –Bankers' acceptances (from other banks). –Federal Funds sold. –Repurchase agreements (securities purchased under agreements to resell).

Commercial Banks -- Most Important Participant in the MM (concluded) Bank liabilities or borrowing –Negotiable CDs. –Commercial paper. –Bankers' acceptances. –Federal Funds purchased. –Repurchase agreements (securities sold under agreements to repurchase). MM securities provides sources and uses of liquidity due to wide fluctuations in loans and deposits.

The Federal Reserve in the Money Markets Money market securities is the major asset category of the Fed. Open-market operations (buying and selling of MM securities by Fed) is the primary tool for implementing monetary policy. –Purchase -- increases member bank reserves. –Sale -- decreases member bank reserves.

Dealers in U.S. Securities -- Involved in both primary and secondary markets. Purchases new treasury debt and resells it (primary). "Makes a market" by buying/selling (dealer) securities (bid/ask). Purchases are financed by repurchase agreements or fed funds.

Treasury Bills -- Ideal Money Market Instrument Characteristics –Sold on discount basis. –Maturities up to one year. –Denominations are in multiples of $1000. Pricing Treasury Bills –Treasury bills are priced on a bank discount rate basis, a traditional yield calculation. –The bank discount rate, r d, is:

Treasury Bills -- Ideal Money Market Instrument (concluded) –The Wall Journal lists T-Bill yields on a bond equivalent basis where the discounted price is the denominator and 365 days is used as the annualizer. –The effective annual yield assuming compounding a year is: Effective Yield = [(Face Value/Price) 365/D -1] x 100%.

Auctioning New Bills Weekly sale by U. S. Treasury of three- and six- month maturities; longer-term bills, monthly or quarterly. Competitive vs. noncompetitive bid: states both the quantity of bills and bid price. Large bids. Multiple bids. Noncompetitive bid: states only the quantity of bills requested at weighted average price. Smaller bids.

Book-entry Securities No physical securities: only record entries. Book-entry record keeping only since Most of marketable Treasury debt is now in book- entry form.

Types of Federal Agencies Farm credit agencies -- loans to farmers. Housing credit agencies -- loans and secondary market support for mortgage market. Other agencies – (SBA)special purposes. Federal financing bank -- purchases securities of agencies and issues its own obligations (clearinghouse).

Characteristics of Agency Debt Most are not guaranteed by federal government; federal guarantee implied, not explicit. Marketability varies with the development of the secondary market. Yields are higher than T-Bills. –Slightly greater default risk. –Slightly lower marketability.

Negotiable Certificates of Deposit – Major Source of Funds for Large Money Center Banks Characteristics of Negotiable CDs –Large denomination time deposit, less than six month's maturity. –Negotiable -- may be sold and traded before maturity. –Issued at face value with coupon rate. Development of the CD Market –Issued by Citibank in –Offset declining demand deposits as a source of funds.

Negotiable Certificates of Deposit (concluded) The CD Market –Rate negotiated between buyer and seller. –Market is sensitive to rates above or below the market rates. –Rates are lower for money center banks and are tiered upward for regional banks. –Purchased mainly by corporate businesses.

Characteristics of Commercial Paper Short term -- one to 270 days. Unsecured. Large denominations -- $100,000 and up. Issued by high-quality borrowers (GMAC). A wholesale money market instrument -- few personal investors. Sold at a discount from par. Directly or dealer sold. Backed by bank lines of credit.

The Commercial Paper Market Major investors –Commercial banks. –Insurance companies. –Nonfinancial business firms. –Bank trust departments. –State and local pension funds. Banks are involved –Backup lines of credit. –Act as agents in issuance. –Hold notes in safekeeping. –Facilitate payment in Federal Funds.

The Commercial Paper Market (concluded) Credit ratings are available for commercial paper. Backup lines of credit from banks support or guarantee quality. Placement –Directly by a sales force of the borrowing firm. –Indirectly through dealers.

Characteristics of Bankers‘ Acceptances Time draft -- order to pay in future. Drafts are drawn on and/or accepted by commercial bank. Direct liability of bank. Mostly relate to international trade. Secondary market -- dealer market. Discounted in market to reflect yield. Standard maturities of 30, 60, or 90 days -- max of 180.

Creating a Banker's Acceptance Importer initiates purchase from foreign exporter, payable in future. Importer needs financing; exporter needs assurance of payment in future. Importer's bank writes irrevocable letter of credit for exporter –Specifies purchase order. –Authorizes exporter to draw time draft on bank.

Creating a Banker's Acceptance (concluded) Importer's bank accepts draft (liability to pay) and creates a banker's acceptance. Advantage of a banker's acceptance (BA) –Exporter receives funds by selling BA in the market. –Exporter eliminates foreign exchange risk. –Importer's bank guarantees payment of draft in future.

Federal Funds Characteristics of Federal Funds –Market for depository institutions. –Most liquid of all financial assets. –Related to monetary policy implementation. Yields related to the level of excess bank reserves. Originally a market for excess reserves -- Now a source of investment (federal funds sold) and continued financing (federal funds purchased).

Federal Funds (concluded) Most Are One-day, Unsecured Loans. Bookkeeping Entry, Interest Paid Separately. Traded in Fed Funds or Immediately Available Funds.

Repurchase Agreements (Repo) Financing -- Source of funds –Security sold under agreement to repurchase at given price in future. –Way to include corporate business in Federal Funds market. –Negotiated market rate. Investment -- Use of Funds (Asset) –Security purchased under agreement to resell at given price in future. –Smaller banks are able to invest excess liquidity in a secured investment.

Repurchase Agreements (Repo) (concluded) Repos are used by the Federal Reserve in open market operations.

Interrelationship of Money Market Interest Rates Various MM instruments are close substitutes in investment portfolios. Interest rates move together over time. Deviations from traditional spreads are quickly eliminated by interest rate arbitrage.

Capital Markets Economic purpose -- brings together long-term (over 1 year) borrowers and long-term investors. Major Issuers (borrowers) –Households - mortgages. –Business. –Governments -- federal, state, and local. Major Investors –Households (directly or through Financial Intermediary). –Foreign Investors.

Types of Capital Market Claims corporate stock -- studied in Chapter 9. bonds -- studied here in this chapter. mortgages -- studied in Chapter 10.

U.S. Government and Agency Securities U.S. Government Issues -- Notes and Bonds –Coupon issues. –Notes -- one to ten-year maturity. –Bonds -- over ten-year maturity. –Sold by auction by the Federal Reserve banks. –Trend is toward more money market financing and less capital market financing.

Corporate Bonds Debt contracts (indenture) requiring borrower to make periodic payments of interest and repay principal, usually $1,000, at maturity date. Types of ownership record –Bearer bonds -- coupon bond owned by bearer. –Registered bonds -- owner noted by records. Maturity –Term bonds -- all bonds mature at future date. –Serial bonds -- bonds mature at varying future dates. Municipals

The Bond Indenture (or Contract) Collateral –Mortgage bond -- real assets pledged. –Equipment trust certificates -- specific, titled, or identifiable equipment. –Collateral bonds -- secured by financial assets. –Debentures -- unsecured bonds. Claim on assets –Senior debt -- first priority to general assets. –Subordinated -- asset claim ranking of unsecured debentures below senior or specific creditors.

The Bond Indenture (concluded) Means of principal payment –Sinking fund -- building a sum for retirement or the periodic retirement of a number of bonds selected randomly. –Call provision -- borrower right to retire bond before maturity.

Investors in Corporate Bonds Major investors include: –life insurance companies. –pension funds. –households. –Foreign Investors. Investor requirements: –long-term investment horizon. –liquidity not always needed -- hold to maturity. –safety -- investment grade. –tax considerations.

The Market for Corporate Bonds Public sale -- open to all interested buyers. –Competitive sale -- public auction among underwriters. –Negotiated sale -- underwriting contract signed with specific underwriters. Private placement -- sold to limited number of sophisticated buyers, avoiding SEC registration. –private placements have increased relative to public sale. –when interest rates are high and/or when capital market conditions are unstable, private placements increase.

The Market for Corporate Bonds (concluded) –SEC Rule 144a (1990) liberalized the regulation of private placements. It allows secondary market trading of private placements. Most secondary trading of corporate bonds occurs through dealers vs. exchanges. –the volume of trading is low--a thin market, thus there is a wide bid/ask differential in the market. –corporate bonds are less marketable than money market instruments.

Junk bond issuance was very popular in the 1980s Junk bonds are low rated (high default risk) corporate bonds. Development of the junk bond primary market was enhanced by the secondary market maintained by Drexel, Burnham and Lambert in the early 1980s. Increased Liquidity. Higher risk firms found they could issue longer term, more flexible securities in the high-yield market rather than borrowing from commercial banks.

Junk bond issuance was very popular in the 1980s (concluded) Many financial institutions, such as S&L's and life insurance companies, with high cost sources of funds, became major junk bond investors. Junk bonds fueled the merger mania of the 1980s.

State and Local Government Bonds -- Municipal Bonds Types of Municipal Bonds –General obligation -- backed by taxing power of political entity. –Revenue -- financed and paid back from a specific project. –Industrial development bonds (IDB) -- public financing of private business.

State and Local Government Bonds -- Municipal Bonds (continued) The Relation between Municipals and Taxable Yields –Interest on municipal bonds is exempt from federal tax on coupon interest payments. –Muni bonds and taxable corporates are similar except for the taxation of interest. –The yield on municipals equals the yield on taxables times one minus the marginal tax rate. im = it (1-T).

State and Local Government Bonds -- Municipal Bonds (continued) Three groups of investors in municipal bonds whose demands are affected by their high federal tax exposure are: –Commercial banks -- the Tax Reform Act of 1986 ended the tax deductibility of interest expense incurred on borrowing for the purchase of tax exempt securities. –Households -- affected by income level and marginal tax rates. –Casualty insurance companies -- investment determined by industry profitability.

State and Local Government Bonds -- Municipal Bonds (concluded) The Market for Municipal Bonds –Primary market. Many individual smaller issuers. Underwritten by investment bankers--from local to national markets. –Secondary market not well-developed -- OTC market made by dealers.

The Role of Financial Guarantees Cover the payment of principal and interest in the event of default. Substitutes the credit standing of the guarantor for that of the security issuer. Provided for a fee by –Commercial banks - letters of credit to back commercial paper or swaps. –Insurance companies - insurance policies to back bond issues.