Fixed Income
From SquadLimberWiki
Basics
- principal : the amount that is being lent.
- coupon : interest that will be paid.
- maturity : the date that the amount must be returned.
- issuer : the entity (company or govt.) who is borrowing the money (issuing the bond) and paying the interest (the coupon).
- issue : another term for the bond itself.
- indenture : contract that states all of the terms of the bond.
Issuance
Bonds are issued either as public issues or private placements.
Public Issues
Listed on stock exchanges.
Sold by corporation or government on the open market.
Widely distributed.
Private Placements
Not listed on stock exchanges.
Sold directly to institutional investors e.g. banks.
Not widely distributed.
Primary Market
Government bonds
Issued by auction.
Issue Form - book-entry - tranasactions recorded in investors and issuers account or by clearing house.
Single Price Auction
Prices fall and the lowest accepted price bid e.g. 98% of $10000 will clear the auction (or the highest accepted yield bid e.g. 3.8% for $10000).
The auctioner sets the price per bond then lowers it until all the allocation is gone - all bidders are charged this lowest price e.g. If the first bidder bid USD 99 per bond, the second bidder bid USD 98.80 per bond, and the last bidder bid USD 98.75 per bond. All bidders would be sold the bonds at USD 98.75 regardless of how much they bid.
Multiple Price Auction
The issuer accepts the best bids until the allocation is gone.
Competitive Bidding
- Price basis - issued to highest bidders.
- Yield basis - issued to lowest yield bidders.
Non-competitive bidding - a particular amount is bought at the average successful competitive bid.
Auction Process
Before the auction the maturity and size of issue is announced and investors begin bidding.
On auction day the investors continue to bid and the results are announced.
The issues are settled after the auction (usually T+3).
Non-government bonds
Small issues - private placement - offered to select investors.
Larger issues - public placement - offered to institutional and individual investors through a securities house.
Non-government bond - Origination
Origination - bank underwrites (purchases) the issue, so that the borrower avoids risk of having unsold bonds.
The bank may invite other banks to share the risk and sell the issue.
The borrower may request banks bid for the opportunity to issue the bond.
Non-government bond - Syndication
Syndication - bank may form syndicate with other banks to purchase the issue and sell it on. (They may not have enough money to underwrite the whole issue themselves). Syndicate members make profit by buying the issue a t discount from the borrower.
best efforts basis - syndicate will sell as much as they can and return the rest to the borrower.
The process
- Announcement Day - Bank invites other institutions to join the syndicate.
- Offering Day - the prospectus (price is fixed) is handed out, and the subscription agreement (outlining the contract) is signed by the underwriters.
- Closing Day - Lead bank in the syndicate purchases the bonds from the borrower.
Pricing
Syndicate sells the issue at the highest price possible, dependent on issuers rating etc...
Bonds can be priced at par, premium or discount.
The bank aims to price bonds as close to par as possible by looking at the markets current trends of yield etc...
Yields vary depending on interest rates.
If the market yield is greater than the coupon, the bond trades below par.
If the yield is smaller than the coupon, the bond trades above par.
Banks choose a coupon so that the new issue price will be as close as possible to, but lower than, par.
Yield = Coupon / PurchasePrice
Non-government bonds are riskier than government bonds so they are priced to give a higher yield.
Banks determine the yield on a new issue by considering, yield spread on similar issues, gray market prices, comparable bonds on the market...
Listing
Most bonds are sold OTC because it is cheaper and more flexible.
Syndicates may list on the stock exchange to:
- Offer the issue to widest possible range of investors.
- Provide good value to the borrower.
- To advertise.
Non-government bond - Distribution
After Closing Day, the issue is distributed to syndicate members and advertisements are usually put in the financial pages.
Settlement
Settlement takes place after the trade which involves the transfer of the bond to the investor through a clearing system (a system for recording the transfer of bonds).
Underwriting Fees
- Management Fee - The managers of each of the various syndicate managers, receive a fee, the lead syndicate member receives the praecipium (or first share).
- Selling Fee - For selling agents.
- Underwriting fee - Proportional to the amount underwritten.
- Legal Costs
- Printing Costs - e.g. for the prospectus.
Pricing Practices
- Traditional Open Pricing - price can be changed any time before Offering Day e.g. to reflect supply & demand.
- Bought Deal - An institution bids for the whole issue from the issuer at a fixed price.
- Fixed Price Re-Offer - The underwriting banks sell the bonds at no less than an agreed price. The price is usually fixed for 24 hours. This practice ensures transparency in the primary market as investors are assured they can't get bonds cheaper from another dealer.
- Pot Deal - Allocation to investors is set aside in a pot which has orders contributed to it by syndicate memebers - so that other members of the syndicate cannot influence the final allocation.
- 100% pot - 100% allocated to investors (only lead manager can allocate the issue).
- Retention Bonds - some bonds are retained to be allocated by syndicate members
- Incentive Pot - Part is reserved for orders from other syndicate members.
- Strategic Reserve - The issuer reserves part for orders from syndicate members.
- Selling Group - A group selected by lead syndicate manager who take and pay for allocation.
- Price Stabilization - The issue price is only allowed to move within a certain price range. The lead manager stabilizes the price by buying back or over-allotting the issue to influence supply & demand.
Secondary Market
The secondary market gives a price to bonds so that they can be sold before maturity between investors, the original investor is not involved.
Brokers
Acts as an intermediary between buyers & sellers. Never own bonds, charge commision.
Dealers
Buys and resells bonds, make money by marking up the price by 1-5%.
Dealers also speculate by selling short or selling long.
Market Makers
Dealer, or financial institution that resells for profit. They make a market by continuously buing and selling.
Inter-dealer Brokers
Act as intermediaries between market makers, enabling to retain anonymity. They make money through commision and never own bonds.
Broker-dealers
Buy and sell for their own account as well as for clients.
Over The Counter (OTC)
Banks and brokerages buy and sell over phone and computer networks.
Most common method of trading on the secondary market.
Stock Exchange
Many bonds are listed on the stock exchange however, volumes are tiny compared to the OTC market.
Deals, prices and volumes can be observed in exchange markets but not on the OTC market.
Bond Trading Systems
- TradeWeb - leading platform for global bond markets. Market data, trade execution, and straight through processing (STP - automatic processing from initiation to settlement).
- eSpeed - one of the leading system for US Treasuries.
- NYSE Automated Bond System (ABS) - system for trading bonds listed on NYSE.
- Eurex Bonds - bond trading platform of Eurex, the German stock exchange.
Settlement
On the secondary market, settlement occurs through electronic clearing systems e.g. Euroclear. Typically takes T+3.
Taxation
Some countries charge withholding tax on interest payments and capital gains tax on captial gains.
Gray Market
Bonds are traded before the initial offering on the gray market.
Once the issue has been announced, brokers begin quoting prices on their screens. These prices are an indication of market sentiment towards the issue.
Transactions in the gray market are to be settled subject to subsequent availability. In most cases, issues can be canceled up to the closing date.
Syndicate members who cannot place all of their portion of an issue often use the gray market.
Yield
The coupon yield is the yearly total of coupons (or interest) paid divided by the Principal (Face) Value of the bond.
The current yield is those same payments divided by the bond's spot market price.
The yield of a bond is inversely related to its price today: if the price of a bond falls, its yield goes up. Conversely, if interest rates decline (the market yield declines), then the price of the bond should rise.
Relationship between yield to maturity and coupon rate
When a bond sells at...
- discount : YTM > current yield > coupon yield
- a premium : coupon yield > current yield > YTM
- par : YTM = current yield = coupon yield.
Issuers
Agency
Group of financial services corporations created by the United States Congress. Their function is to reduce interest rates for specific borrowing sectors of the economy, farmers, and homeowners.
List of agencies:
- FHLB - Federal Home Loan Banks
- FHLMC - Federal Home Loan Mortgage Corporation (Freddie Mac)
- FNMA - Federal National Mortgage Association (Fannie Mae)
- FFCB - Federal Farm Credit Banks
- FAMC - Federal Agricultural Mortgage Corporation (Farmer Mac)
Corporate
Issued by a corporation.
Municipal
Issued by a non state-level government entity. e.g. cities, counties, redevelopment agencies, school districts, publicly owned airports and seaports.
Treasury
Government bonds issued by the US Treasury.
Treasury bills - T-bills - mature in one year or less. They are like zero-coupon bonds in that they do not pay interest prior to maturity; instead they are sold at a discount of the par value.
Treasury notes - T-notes - mature in 2-10 years. They have a coupon payment every six months, and are commonly issued with maturities dates of 2, 3, 5 or 10 years, for amounts from $1,000 to $1,000,000.
Treasury bonds - T-bonds - mature in 10-30 years. They have coupon payment every six months like T-Notes, and are commonly issued with maturity of thirty years.
Gilts
A goverment bond issued by the UK is known as a gilt-edged bond or Gilt.
A U.S government bond is known as a Treasury bond.
Eurobonds
A Eurobond is a bond that has been issued in one country's currency but is traded outside of that country and in a different monetary system and regulatory system. Eurobonds are named after the currency they are denominated in. For example, Euroyen and Eurodollar bonds are denominated in Japanese yen and American dollars respectively.
Advantages
- Able to choose a country of issue based on regulatory constraints.
- Able to choose a currency.
- High liquidity.
- Small par values.
Interest
Interest rates paid on a bond are usually fixed for the life of the bond (this is why it is called the fixed income market).
Floating Rate Notes - FRNs - The interest rate is linked to market rates through an index. e.g. rate on T-Bills.
Treasury Inflation-Indexed Securities - The coupon and principal are automatically increased to compensate for inflation by tracking the Consumer Price Index (CPI).
Day Count Basis
The value of the interest payment on a bond may be different for the same principal and rate, because of the Day Count Basis.
Actual / 365 - bond basis - Used for semi-annual yields e.g. T-Bonds, T-Notes.
Actual / 360 - money market basis - Used to calculate yields on commercial papers e.g. T-Bills.
Actual / Actual - Leap years count for 366 days.
30 /360 - All months are assumed to have 30 days. - Used to calculate yields on Eurobonds, US corporates and some foreign bonds.
Dirty & Clean Prices
When a bond is sold on the secondary market the seller is entitled to accrued interest since the last payment date.
Clean price - excludes accrued interest
Dirty price - includes accrued interest
See Dirty Price for more details.
Bonds are usually quoted clean and settled dirty - so the price you see is not the price you pay.
Securitization
Pooling and packaging of similiar loans in to securities e.g. bonds. Bond issues are generated in a variety of loan types e.g. mortgages, car loans.
The advantage is that it creates liquid securities out of illiquid assets.
Ownership
Bearer Bonds
Possession is only proof of ownership, Interest is paid when the owner presents a physical coupon. Owner is not registered and is anonymous.
Registered Bonds
Owner listed on issuers register. Name of the owner is printed on the bond - can only be transferred with owners permission.
