Reading 52 LOS's

Question 1

LOS 52a: Describe classifications of global fixed-income markets

Answer 1

They may be classified in the following ways:

1) Type of Issuer Supranational - Sovereign - Non Sovereign - Quasi Gov - Corporate Sector - Structured Finance (bonds that have been securitized)

2) Credit Quality Investment grade - High yield or junk bonds - default

3)Maturity Less than 1 year is money market - 1 year or more is capital market

4) Currency Denomination

5) Geography Domestic Bonds (entities in country) - Foregin Bonds (entities outside of country) - Eurobonds (bonds issued in different currency)

6) Other classifications Inflation linked bonds - Tax exempt bonds

Question 2

LOS 52b: Describe the use of interbank offered rates as reference rates in floating-rate debt

Answer 2

For FRNs the floating rate is based off some reference rate with a spread. The rates will follow this spread and reset periodically.

Question 3

LOS 52c: Describe mechanisms available for issuing bonds in primary markets

Answer 3

Public Offerings all any member of the public to purchase the bonds. The bond issuers are usually assisted by investment banks. Mechanisms for issuing the bond include the following:

• Underwritten offerings - the bond issuer negotiates an offering price with the investment bank, who then gurantees the sale of the issue at that price, putting the risk of selling the bonds on the bank. This process involves:
  
  • Determing the funding needs of issuer
  • Selecting the underwriter
  • Structuring the transaction
  • Preparing and submitting regulatory findings, appointing a trustee, and launching the offering
  • Assessing market conditions by holding discussion with anchor buyers (large institutional investors) and analyzing the grey market (forward market for bonds that help determine offer price)
  • Pricing the issue
  • Issuing the bond

Best efforts offering- the investment bank only acts as a broker and tries its best to sell the bond at the negotiated offering price for a commission

Auctions bonds are sold to investors through a bidding process, which helps in price discovery and allocation of securities

Shelf Registration allows certain (authorized) issuers to offer additional bonds to the general public without having to prepare a new and seperate prospectus for each bond issue.

Private Placements only a select group of qualified investors (typically large institutional investors) are allowed to invest in the issue

• The bonds are neither underwritten nor registered, and can be relatively illiquid as there is usually no secondary market for them
• Investors are usually able to influence the terms of issue, since they have such great purchasing power

Question 4

LOS 52d: Describe secondary market for bonds

Answer 4

Secondary markets are those in which the existing bonds are traded among investors. They may be structured in the following ways:

• Organized exhanges these are places where buyers and sellers can meet to arrange their trades
• Over the counter markets (OTC) in these markets, buyers and sellers submit thier orders from various locations through electronic trading platforms. The vast majority of bond trading occurs here.

Question 5

LOS 52e: Describe securities issued by sovereign governments, non-sovereign governments, government agencies, and supranational entities

Answer 5

Sovereign Bonds are bonds that are issued by a country’s central government. They are backed by the taxing authority. They can be issued in the country’s currency or in foreign currency. Those issued in local currency will typically carry a higher credit rating

Nonsovereign Bonds typically issued to finance projects such as schools and can be financed through taxes, cash flows from the project, or special taxes/fees. They are of high credit, but trade at higher yields than sovereign

Quasi-Gov (USPS or Fannie Mae) are issued to fund specific finance needs. They may be guranteed by the government. They are serviced by cash flows from the entity. They may be backed by collateral

Supranational- (World Bank, IMF) the are issued as plain vanilla bonds and are typically highly rated and issued in large sizes.

Question 6

LOS 52f: Describe types of debt issued by corporations

Answer 6

Bank Loans and Syndicated Loans

• 2 types of bank loans:

1. A bilateral loan is a loan from a single bank
2. A syndicated loan is a loan from a group of lenders, which are often securitized

• Most bank loans are floating-rate loans
• they can be customized to borrower requirements
• Access to bank loans depends on 1) the company’s financial position and 2) the market conditions and capital availability.
• Bank loans are usually for small companies as large companies with higher rankings are able to borrow cheaper by issuing bonds

Commercial Paper

• Commercial paper is an unsecured debt instrument that is popular among issuers because it is a source of flexible, readily available, and relatively low-cost financing.
• It can be used to meet seasonal demands for cash
• Is usually “rolled over” by issuers, that is it is used to pay for previous issued commercial paper. To deal with rollover risk issuers maintain a backup line of credit
• Terms to maturity can range from overnight to 1 year
• Historically default has been very rare as there is short maturity and you can rollover if needed
• Most investors hold on until maturity, making very little secondary market

Corporate Notes and Bonds

• Corporate bonds can differ based on several characteristics:
  
  • Coupon payment structures
  • Principal payment structures ( serial maturity structure has maturity dates spread over the life of the bond while term maturity has one lump sum paid at maturity)
  • Terms to maturity
  • Asset or collateral backing
  • Contingency provisions

Medium Term Notes (MTNs)

• MTNs are called such because when they were initially issued, they were meant to fill the funding gap between commercial paper and long-term bonds
• They are unique in that they are offered continuously to investors by the agent of the issuer
• Primary issuers tend to be financial institutions with the primary invetors being pension funds, life insurance companies
• they can be customized to meet the investor requirements

Question 7

LOS 52g: Describe short-term funding alternative available to banks

Answer 7

Retail deposits these include funds deposited at the bank by individuals and commercial depositors and include:

• Checking accounts
• money market accounts, which pay money market rates of return
• savings accounts

Short-term wholesale funds:

• Central Bank Funds- these are the market reserves required by the Fed. Those banks with excess funds can lend to those in need of fudns, at a rate known as the central bank funds rate (Fed Funds rate)
• Interbank funds- these are loans and deposits between banks
• Certificates of Deposit (CDs)- these are issued by a bank to a client when she deposits a specified sum of money for specified maturity date and interest rate
  
  • a non-negotiable CD is one in which the deposit and the interest is paid to the investor at maturity
  • a negotiable CD provides the depositor with the option to sell the CD in the open market if she wishes to liquidate before maturity

Question 8

LOS 52h: Describe repurchase agreements (repo) and their importance to investors who borrow short term

Answer 8

A repurchase agreement is an arrangement between two parties, where one party sells a security to the other with a commitment to buy it back at a later date for a predetermined higher price. The difference between the (lower) selling price and the (higher) repurchase price is the interest cost of the loan. The annualized interest cost of the loan is called the repo rate. Some terms to takeaway:

• repo margin or haircut- is the difference between the market price of the security and the amount for the loan. This serves to protect the lender against a decline in the value of the collateral
• Reverse repo- when you agree to buy the securities and sell them back at a specific date for a price– these are used to cover short positions

Repo Rate depends on the following factors:

• Risk associated with the collateral
• term of the repurchase agreement
• delivery requirement for the collateral
• supply and demand conditions of the collateral
• interest rates on alternative sources of financing

The repo margin is a function of the following factors:

• the length of the repurchase agreement
• quality of the collateral
• credit quality of the counterparty
• supply and demand of the collateral