Unit 54_Overview of Bond Sectors & Instruments_2013

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Overview of Bond Sectors & Instruments

Reading - 54

Fixed Income


Overview of the Bond Market

Bond Market Sectors

Internal Bond Market

Domestic Bond Market

Foreign Bond Market

External Bond Market


Sectors of Bond Market

Internal Bond Market

It is also known as national bond market.

Divided into two parts:

Domestic Bond Market: It is the market of a country where the bond issued by the issuers of same country are traded.

Foreign Bond Market: It is the market of a country where the bond issued by the issuers of other country are traded.

External Bond Market

Features of bonds in external bond market:

Underwritten by an international syndicate.

Offered simultaneously to investors in a number of countries.

Issued outside the jurisdiction of any single country.

They are in unregistered form.


Sovereign Bonds

These are the bonds issued by a countrys central government. The bond can issued in any currency.

Credit Risk

The risk that the issuer of the bond will not be able to fulfill its promises is know as credit risk.

As Sovereign Bonds are issued by central government of a country, it is considered to be credit risk free.

Rating agencies assign two types of rating to a sovereign debt namely:

Local currency debt rating

Foreign currency debt rating

Note:The reason for assigning two typesof debt rating is that becausedefault frequency differs by thecurrency denomination of the debt


Sovereign Bonds

Methods to issue sovereign bonds:

1. Regular auction cycle Single Price: Under this method the debt is auctioned periodically according to a cycle and the highest price (lowest yield) at which the entire issue to be auctioned can be sold is awarded to all bidders.

2. Regular auction cycle Multiple Price: Under this method, winning bidders receive the bonds at the price that they bid.

3. Ad-hoc auction system: It refers to a method where the central government auctions new securities when it determines market conditions are advantageous.

4. Tap system: It refers to the issuance and auction of bonds identical to previously issued bonds. Under this system, bonds are sold periodically no according to regular cycle.


Sovereign Bonds

Treasury Securities: These are issued by U.S. Treasury and are considered to be free from credit risk.

Types of Treasury

Securities

Treasury Bills: These have maturities of less than one year. They do not make

any coupon payment but they pay the maturity amount. These bonds are sold at a

discount to par value.

Treasury Notes: These securities have maturities

ranging from one to ten years. They make semi annual

coupon payments at a rate that is fixed at issuance

Treasury Bonds: These are coupon-bearing securities

whose terms to maturity exceed ten years.


Securities

Inflation-Indexed Treasury Securities: These type of securities provide protection against inflation.

On-the-Run versus Off-the-Run Issues:

On-the-Run issues: These are the most recently auctioned issues. These issues are more actively traded and therefore more liquid.

Off-the-Run issues: These are the older issues that have been replaced by on-the-run issues as the most recent issues.

Treasury Strips: The demand for longer maturity zero-coupon bonds led to the creation of Treasury STRIPS (Separate Trading of Registered Interest and Principal Securities.) In this, the coupons can be stripped from principal and can be traded as zero coupon bonds.


Securities

Agency Bonds: These are issued by the agencies of U.S. Government , but not all of them are guaranteed by the U.S. Government. Federal agencies are classified into:

Federally related institutions

Government sponsored enterprises

Mortgage Loans:

It is a borrowing that is secured by some form of real estate.

In case of default by the borrower, the lender has the right to seize the property.

The interest rate on the mortgage loan is called mortgage rate.


U.S. Agency Mortgage-Backed Securities

Mortgage Pass-through Securities: A mortgage pass-throughsecurity is one in which home owners payments pass throughthe government agency on to investors.

Collateralized Mortgage Obligations: A collateralized mortgageobligation (CMO) has different tranches, each of which isexposed to a different level of prepayment risk.

Stripped Mortgage-Backed Securities:

These are Mortgage-Backed Securities that are divided intoPrincipal Only (PO) and Interest Only (IO) strips, which areaffected differently by prepayments.

PO strips are entitled to all the principal paymentsrepayments and prepayments where as IO strips are onlyentitled to interest payments from the mortgage loans.


Collateralized mortgage obligations (CMOs)

They are created from mortgage pass-through certificates and referred to as derivative mortgage-backed securities.

Rationale for creating CMOs:

Redistribute the prepayment risk

Create securities with various maturity ranges.

Facts:

CMO structure takes the cash flows from the mortgage pool and in a simple structure, allocates any principal payments sequentially over time to holders of different CMO tranches, rather than equally to all security holders.

Creation a CMO does not alter the alter overall risk of prepayment, it redistributes prepayment risk.


Municipal Bonds

Facts:

These are the debt securities issued by state and local government in the United States.

These bonds are often issued as serial bonds, i.e. a larger issue is divided into a series of smaller issues, each with its own maturity date and coupon rate.

Types:

Tax-exempt Bonds: These are exempt from income taxes but not from capital gain tax.

Taxable Bonds: A bond must meet certain standards to qualify as a tax exempt failing to which the interest earned is taxed.


Tax-backed versus Revenue Bond

Tax-backed debt: These are also called General Obligation (GO) bonds. It is issued by states, towns, cities etc. It is backed by full faith, credit and taxing power of the issuing authority.

Types of Tax-Backed debt:

1. Limited tax GO debt

2. Unlimited tax GO debt

3. Double-barreled bonds

4. Appropriation-backed obligations

Revenue Bonds:

These types of bonds are issued by finance specific projects and are serviced by the revenues generated from the projects themselves.

Issuer will be obligated to make the payments on these bonds only if sufficient revenues are generated fro the projects.


Insured Bonds & Prerefunded Bonds

Insured Bonds:

These type of bonds are insured or guaranteed by third party.

The insurer commits to make the interest and principal payments to investors in a timely manner if the issuer fails to do so.

The insurance coverage is for the term of the bond and cannot be cancelled by the insurance firm.

Prerefunded Bonds:

These are collateralized by U.S. treasuries that have already been purchased in an escrow account.

These bonds have little or no credit risk and usually receive very high credit ratings.


Corporate Bonds

Secured debt: It is backed by some form of collateral. If the issuer defaults on payments, investors can seize the collaterals.

Unsecured Debts: It is not backed or pledged by any specific collateral. They are also known as debentures.

Credit Enhancements: It refers to guarantees made by third parties that the obligations of a loan agreement will be fulfilled. Credit enhancements include:

Third party guarantees

Letter of credit

Bond insurance


Medium-Term Notes Vs. Commercial Papers

Medium-Term notes:

These are self-registered securities that do not need to be issued all at once.

These are issued by companies because they enable them to obtain cash flows as financing arises.

Commercial papers:

It is a short term, unsecured debt instrument that is issued by the companies in open market at rates lower than bank rates.

Commercial papers are usually issued as zero-coupon instrument with a term to maturity of 270 days or less.


Negotiable CDs and Bankers Acceptance

Certificates of deposits (CD):

It is issued by banks to its clients when they deposit money.

It bears an interest rate and a maturity date and can be issued in any denomination.

Negotiable CD:

It is the one in which an early withdrawal penalty is imposed if the depositor wishes to withdraw funds prior to the maturity date.

Bankers Acceptance:

These are basically guarantees made by banks that a loan will be repaid


Asset-Backed security (ABS) & Collateralized Debt Obligation

Asset-Backed Securities:

The securities that back an ABS are pools of loans or receivables including auto loans and leases, consumer loans, commercial assets, credit cards etc.

The rationale for issuing an asset-backed security is to minimize borrowing costs.

Collateralized Debt Obligation (CDO):

It is an investment product that is backed by a diversified pool of assets which can include investment grade bonds, high-yield corporal bonds, emerging market bonds, ABS and even other CDOs.

Types of CDOs:

Arbitrage CDOs

Balance sheet CDOs


Primary and Secondary market for Debt

Primary Markets: It deals with securities that are newly issued to investors and corporations.

Secondary Markets:

It includes exchanges and over-the-counter (OTC) markets.

It offers liquidity to bondholders.

It provides about the fair value of the securities and reduce the costs of search for bond participants.

Documents

Unit 54_Overview of Bond Sectors & Instruments_2013