Topic 2

Fixed Income Instrument Overview

FINA 4120 – Fixed Income 1

 Outline

• Fixed income securities;

– Cash flow terms *
– Discount rate: risks
• Fixed income markets/issuers;
– Treasury bonds*

• Different price quotations

FINA 4120 – Fixed Income 2

 Overview
• Recall that bond price is a function of:
– Cash flows
• What are the different cash flow patterns?
• Features of debt instruments

– Discount rates
• Related to risk --- high risk => high discount rate
• What are the risks associated with bond investment

• What are the major debt markets & instruments?

FINA 4120 – Fixed Income 3

Features of Fixed Income Instruments

FINA 4120 – Fixed Income 4

 Other Coupon Features (1)

• Zero Coupon Bond

– No coupon payments
• Step-Up Notes
– Coupon rates “steps up” over time
• Deferred Coupon Bond
– No coupon payments for the deferred period
• Payment-in-kind (PIK) Bond
– Coupon is paid in cash or new bond

FINA 4120 – Fixed Income 5

 An example of PIK bond

• Glazer family bought Manchester United in a £790M LBO

in 2005.

• Glazer issued a PIK facility with 14.5% coupon rate to

finance the LBO

• It started out as a £138M loan. As of Nov 2010, the loan

stood at £210M.

FINA 4120 – Fixed Income 6

 Other Coupon Features (2)

• Floating Rate Securities

– Coupon rate = reference rate + quoted margin
• Coupon rate = 5-year Treasury yield + 90 basis points
– Treasury Inflation Protection Securities (TIPS) and
Inflation-linked (-indexed) Bond
• Reference rate is an inflation index
– Inverse (Reverse) Floater
• Coupon rate = K – L∙(reference rate)
– Caps and Floors
• Impose maximum and minimum coupon rate
FINA 4120 – Fixed Income 7
 Practice Question

• Identify the following bonds

– Coupon rate = 32% - 2∙(5-year Treasury rate)
– Coupon = 5.1% (year 1-3), 5.7% (year 4-9) and 6.2%
(year 10-20)
– Coupon = change in consumer price index + 3.1%

FINA 4120 – Fixed Income 8

 Answer

– Inverse floater
– Step-up note
– Inflation-linked bond

FINA 4120 – Fixed Income 9

The Orange County Bankruptcy

FINA 4120 – Fixed Income 10

 Inverse Floater and Orange County

• Time is the beginning of 1994

• County treasurer Robert Citron has enjoyed long
periods of success and is now managing a $7.5b
investment pool
• Interest rate is at historical low
• How to “enhance” investment rate of return?
(sounds familiar now? ;) )
• Inverse Floater comes to rescue…

FINA 4120 – Fixed Income 11

 Inverse Floater and Orange County

• Robert Citron invested large amount in Inverse

Floater
• Not only that, he levered up
• But from February 1994, the Federal Reserve
Bank began to raise US interest rates
• The rest is in history book

FINA 4120 – Fixed Income 12

 A Tale of Two Men

Robert Citron
John Moorlach

FINA 4120 – Fixed Income 13

 Inverse Floater and Orange County

• Orange County suffered loss around $1.6billion

• On December 6 1994, it declared bankruptcy
• In 1998, Orange County reaches a $400 million
settlement of its lawsuit against Merrill Lynch
• Orange County repays averaged $68 million a
year, and fully repaid in 2017 (22 years!)

FINA 4120 – Fixed Income 14

 Other Bond Features (1)
• Call Provision allows the issuer to repurchase the bond at
a specified call price before the maturity date
Callable Bond Price vs . Inte re s t Rate
Bond
Price
5000

4000

3000

2000

1000

0
0 5 10 15
Inte re s t Rate

FINA 4120 – Fixed Income 15

• Bonds are most likely to be called when the price
exceeds the call price
– It implies that premium bonds will likely be called at the earliest
date when the bond becomes callable
• Two U.S. Treasury bonds of same maturity from July
1, 2004 WSJ:
Maturity Asked
Rate Bid Ask
Mo/Yr Yield
4 3/4 May 14 n 101:15 101:16 4.56
13 1/4 May 14 142:03 142:04 3.71

The first bond has a coupon rate of 4.75%, and yields 4.56%
The second bond has a coupon rate of 13.25%, and yields only
3.71% --- Why (!!!)

FINA 4120 – Fixed Income 16

• The difference is that the second bond is CALLABLE!!!
– It was issued as a 30yr bond in May of 1984, and is callable at par value
in 25 years, i.e. in May of 2009
– Now it is almost 100% certain that it will be called, hence it now trades
as bond maturing in 2009. See below

Maturity Asked
Rate Bid Asked
Mo/Yr Yield
3 7/8 May 09 n 100:22 100:23 3.71
5 1/2 May 09 n 108:02 108:03 3.67

FINA 4120 – Fixed Income 17

 Calculator Example: Mortgage

You have managed to save $50,000 and are buying

your first house for $250,000. You are offered a 9%
APR (compounded monthly) 30 year mortgage.

a) What is your monthly payment?

b) How long would it take you to pay back the
mortgage if you are willing to cut back on your
monthly expenses and increase the monthly
payment by $200?
c) What will be the mortgage balance at the end of
second month?
FINA 4120 – Fixed Income 18
 Calculator Example: Bond

20-year bond with par value of $1,000 with a coupon

rate of 8% (semi-annual payment). If the bond price
is $950, what is the bond equivalent and effective
annual yield to maturity?

FINA 4120 – Fixed Income 19

 Other Bond Features (2)

• Put Provision allows a bondholder to sell the bond back

to the issuer at a specified put price on designated dates
• Convertible Provision allows a bondholder to exchange a
bond for common stock
– Typically are callable as well
• Secured Bonds have specific collaterals for bonds
• Sinking Funds guarantee gradual repurchase of corporate
bonds by the issuer

FINA 4120 – Fixed Income 20

Risk associated with Bond Investment

FINA 4120 – Fixed Income 21

 Risks (1)
• Interest rate risk
– Bond price fluctuates with market interest rates
– The price sensitivity of a bond to change in yield is
measured by duration (will be discussed later)

• Yield curve risk

– For a portfolio of bonds with different maturities, its
value will be affected by the entire yield curve
– Need fancy math models
– Since the shift in yield curve is not necessarily parallel
FINA 4120 – Fixed Income 22
Historical Yield curve shifts

FINA 4120 – Fixed Income 23

 Risks (2)
• Reinvestment risk
– The intermediate cash flows might be reinvested at
lower interest rates
– To address this issue, do a total return analysis (will be
discussed later)
• Call and Prepayment Risk
– When interest rate is low, bond will be called and
mortgage will be prepaid
– This is good for the bond issuer and home owner, but
bad for the bond holder and mortgage holder.

FINA 4120 – Fixed Income 24

 Risks (3)
• Credit Risk
– Default Risk
• What if the bond issuer refuses to pay?
– Credit spread risk
• What if the compensation for default risk goes up? (A higher
discount rate)
– Downgrade risk
• What if the default risk of Bond A suddenly increases?

FINA 4120 – Fixed Income 25

 Risks (4)
• Liquidity Risk
– What if you have to incur a large discount in price
when selling a bond?
• Exchange Rate or Currency Risk
– When the cash flow payment is not in the domestic
currency
• Inflation or Purchasing Power Risk
– Consider the recent collapse in the oil price

FINA 4120 – Fixed Income 26

 Risks (5)
• Event Risk
– Natural disaster
– Corporate restructure
– Regulatory change

• Sovereign Risk
– What if a country defaults on its debt?

FINA 4120 – Fixed Income 27

 Event Risk

• LIBOR Scandal
• LIBOR
• http://www.nytimes.com/interactive/2012/07/10/b
usiness/dealbook/behind-the-libor-scandal.html
• Benchmark rates for many securities
• “This dwarfs by orders of magnitude any financial
scam in the history of markets.”
• Andrew Lo, MIT Professor of Finance
FINA 4120 – Fixed Income 28
Sovereign Risk

FINA 4120 – Fixed Income 29

 Hard to Liquidate

• It might work for some weak countries

– Hedge funds tried to collect assets from Argentina
– Included one Navy vessel, and failed…

FINA 4120 – Fixed Income 30

 Hard to Liquidate

• It might be tricky for some other ones…

FINA 4120 – Fixed Income 31

Chinese Debt Crisis?

FINA 4120 – Fixed Income 32

Chinese Debt Crisis?

FINA 4120 – Fixed Income 33

 Practice Question

• A British portfolio manager is considering

investing in Japanese government bonds (JGBs)
denominated in yen. What are the major risks
associated with this investment?

FINA 4120 – Fixed Income 34

 Answer

– foreign exchange risk

– interest rate risk
– reinvestment risk
– small credit risk
– minimal sovereign risk

FINA 4120 – Fixed Income 35

Bond Market Classification and Instruments

FINA 4120 – Fixed Income 36

 Bond Markets

• External vs. Internal; Domestic vs. Foreign

• Primary v.s. Secondary
• Classified by issuer:
– Treasury
– Agency
– Municipal
– Mortgage-backed
– Corporate
• Money Market Instruments (maturity < 1 yr)
FINA 4120 – Fixed Income 37
 External vs. Internal

• External Bond Market (aka Eurobond Market)

– A bond issued and traded in a market but is
denominated in a currency other than the home
currency of the market
– Mostly for regulation or market liquidity
– Eurodollar Bond (US$), Euroyen Bond (¥)
– Example: BMW issued a 5.5y $750M Eurodollar
underwritten by BNP Paribas, Dresdner Kleinwort, JP
Morgan and Royal Bank of Scotland

FINA 4120 – Fixed Income 38

 External vs. Internal

• Internal Bond Market

– Domestic Bond
– Foreign Bond
• A bond that is issued in a domestic market by a foreign entity

Yankee Bond Bulldog Bond Samurai Bond

FINA 4120 – Fixed Income 39

 Question from previous mid-term,

• If McDonald’s Corp issues a Japanese Yen denominated

bond in Japan, the bond will be called:

(a) Big Mac Bond

(b) Euroyen Bond
(c) Yankee Bond
(d) Samurai Bond

FINA 4120 – Fixed Income 40

 Answer

– (d)

FINA 4120 – Fixed Income 41

 Primary Market vs. Secondary Market
• Primary market is where securities are initially
offered and sold
– where firms and governments raise money
– treasury auctions, stock IPO and SEO, and debt
offerings
• Secondary market is where financial securities are
traded among investors
– NYSE, NASDAQ, etc
– Provides liquidity to financial securities

FINA 4120 – Fixed Income 42

 Primary Market of Debts
• Treasuries are sold to investors directly through
treasury auctions in primary market
• Other bonds are sold to investors either directly or
indirectly
– Public issue: Securities issued to a disperse group of
investors. Needs to be registered with SEC
– Traditional Private issue: Securities sold to a small
group of investors or to an investment bank. Not
registered with SEC

FINA 4120 – Fixed Income 43

 Secondary Market
• Secondary market participants include:
– investors
– brokers
– dealers
• Organized exchanges
– NYSE, AMEX
– Specialists system
• OTC market
– NASDAQ
– Multiple dealers
FINA 4120 – Fixed Income 44
 Secondary Market

• Bid-ask spread: the difference between dealer’s

bid price and ask price
– Profits to dealers
– compensate for dealer’s transaction cost
– compensate for dealer’s inventory cost
– compensate for dealer’s risk of trading with informed
traders

FINA 4120 – Fixed Income 45

 Secondary Bond Market
• The secondary markets for most corporate bonds
are very difficult for individuals to trade bonds
– No significant centralized exchange.
– Markets are highly fragmented.
– Price information is not transparent. No rules to govern
what price a broker gets.
– Most corporate bonds are very illiquid
– Liquidity improves after the introduction NASDAQ
TRACE (Trade Reporting and Compliance Engine)
Bond Prices

FINA 4120 – Fixed Income 46

 Big Players on the Bond Market

• Mutual Funds
• Insurance Companies
• Pension Funds
• Savings & Loan Associations
• Federal Reserve System

FINA 4120 – Fixed Income 47

• Recall Bond Market Classified by Issuer:
– Treasury
– Agency
– Municipal
– Mortgage-backed
– Corporate

FINA 4120 – Fixed Income 48

 The Treasury Market

• The U.S. Treasury market is among the largest and most

liquid securities market in the world, with billions of
dollars of transactions daily

• New issues account for a small fraction of the huge daily

trading volume, which occurs primarily in the secondary
(resale) market

• It is where the federal government finances the budget

deficit and the over $18 trillion national debt held by the
public

FINA 4120 – Fixed Income 49

Drone Killed, Yield Sank

Soleimani killed

FINA 4120 – Fixed Income 50

 Who Sets (Short-term) Interest Rates?
• The Fed is not the Treasury!

• The Federal Reserve controls two key short-term rates:

– Discount rate
• Rate for loans from Fed to temporarily illiquid banks

– Federal funds rate target

• Inter-bank overnight lending rate
• Determined by supply/demand and credit quality in the market
for bank reserves
• Fed keeps rate near target by injecting/withdrawing reserves
(buying/selling Treasury bonds)

Link to NY Fed

FINA 4120 – Fixed Income 51

Overnight Repo

FINA 4120 – Fixed Income 52

 FOMC

• The Federal Open Market Committee

– meets at least eight times a year
– consists of twelve members
– reviews economic and financial conditions
– determines the appropriate stance of monetary policy
– assesses the risks to its long-run goals of price stability
and sustainable economic growth
– sets the Fed Fund Rate Target and provide guidance for
the future
– http://www.federalreserve.gov/FOMC/#calendars
FINA 4120 – Fixed Income 53
 FOMC
• How to kick-start the economy?
– Lower real interest rate
– Real rate = nominal rate – inflation

• Lower Nominal rate

– Is there a limit?
– Can interest rate be negative?

• Higher inflation
– QEs / OT

FINA 4120 – Fixed Income 54

Provide guidance by making long-run rate
forecasts

Basically, Fed is
sending a
credible signal
that rates will be
low for a long
long time!!!

FINA 4120 – Fixed Income 55

Shifting Guidance

FINA 4120 – Fixed Income 56

 Press Conference

ECB Announcement and Press Conference

FINA 4120 – Fixed Income 57

 FOMC

FINA 4120 – Fixed Income 58

Interest rate cut or up? (2019.08.01)

FINA 4120 – Fixed Income 59

 Cut! 

FINA 4120 – Fixed Income 60

 Limitation of Central Bank Policy

• Central bank independence

– Pros: less affected by political incentives
– Cons: no synergy with other policies
• Monetary policy and fiscal policy
– Euro sovereign debt crisis
• Other political tricks…
• Central bank limited capacity

FINA 4120 – Fixed Income 61

Next Monday after the Fed cut (Aug. 5)

USD/CNY Spot and PBOC fixings

FINA 4120 – Fixed Income 62

Show Time!

FINA 4120 – Fixed Income 63

 Who is the target?

• China?
– All potential punishments have been done in trade
war…
– Except IMF investigation (if you pretend you care…)
• Fed?
– Increase the market concern
– Push the rate cut
• Direct pressure
• Indirect market belief

FINA 4120 – Fixed Income 64

 Connecting the knots

• Treasury Department
– “In recent days, China has taken concrete steps to
devalue its currency, while maintaining substantial
foreign exchange reserves despite active use of such
tools in the past…”
• On the same day
– All four former still-living Fed chairs—Paul Volcker,
Alan Greenspan, Ben Bernanke and Janet Yellen made
their case Monday for the central bank to remain free
from short-term political pressures.
FINA 4120 – Fixed Income 65
 BTW…

• JP Morgan “Volfefe” index (google covfefe)

• Based on Trump’s tweets
• Most Market Moving Words:
– China
– Billion
– Products
– Democrats
– Great

FINA 4120 – Fixed Income 66

 Market Operations

• There’s a limit for market operations (Japan)

FINA 4120 – Fixed Income 67

Bank of Japan

FINA 4120 – Fixed Income 68

 Who Sets Interest Rates?
• Short term rates: A combination of
– Fed (indirectly) through Fed Funds market
– Markets: Through connection between Fed Funds and other short term
(money) markets

• Long term rates: Set by markets through

– Expectations of
• Future interest rates
• Future inflation
• Expected Fed policy important to both
– Supply and demand for L/T bonds and alternative investments (short
run effect)

• Bottom line
– Fed can influence expectations and short-term rates (to some extent),
but Markets determine interest rates

FINA 4120 – Fixed Income 69

 US Treasuries
• BILLS (quoted at a discount) UP TO 1 YEAR
– 4 week
– 3 Month Bills are issued with 13 weeks or 91 days to maturity.
– 6 Month Bills are issued with 26 weeks or 182 days to maturity.
• NOTES (semi-annual coupons) 1 TO 10 YRS
• BONDS (semi-annual coupons) OVER 10 YRS
– most nominal
– TIPS are indexed
• Recent phase-outs include 1-year, 7-year, 30-year
• But the 30-year is coming back!

FINA 4120 – Fixed Income 70

 Risk
• Treasury securities are considered safe from default risk
because they are backed by the full faith and credit of the
U.S. government

• Investors in Treasury’s face “price risk”: as interest rates

rise, bond prices fall

• Investors in Treasury’s face “reinvestment risk”: coupon

payments must be reinvested at a lower rate if interest rates
fall

• These risks are relatively small for T-bills because of the

short-term nature of these securities
FINA 4120 – Fixed Income 71
Same Riskless, Different Prices

Risk-free rate implied from different securities

FINA 4120 – Fixed Income 72

 Risky US Treasuries?

CDS premium for US Treasuries in the Euro Market

FINA 4120 – Fixed Income 73

 Players

• Issuer:
– The Treasury issues bills, bonds and notes to finance the national
debt of the U.S. government.

• Lenders:
– The Federal Reserve
– Commercial Banks
– Mutual Funds
– Corporations
– Individuals
– Foreigners

FINA 4120 – Fixed Income 74

 Primary Market for Treasury Securities
• How does U.S. Treasury go about borrowing money
(issuing debt)?
– Every week the Treasury sells a previously announced quantity of 91 and
182 day bills in a sealed auction

– Longer bills and bonds are also sold at regular but less frequent intervals

– In the Treasury bill auction, bills are distributed to bidders, at the market
clearing yield, in the order of priority:
• (1) The Fed
• (2) Non-competitive bids (up to $1 million)
• (3) Competitive bids

FINA 4120 – Fixed Income 75

 Auction Example
$10 billion issue, $1 billion of non-competitive bids, $2 billion purchase from
Federal Reserve, $7 billion left for competitive bids
Offers: $0.5 billion @ 3.10%
$0.6 billion @ 3.11%
$1.4 billion @ 3.12%
$2.6 billion @ 3.13%
$3.2 billion at 3.14%
• Accepted yield is 3.14%, the rate necessary to sell the whole issue.
• 3.13% would have been sufficient for $5.1 billion of competitive bids.
• 3.14% is sufficient for $8.3 billion.
• All bidders offering to accept a rate lower than 3.14% are accepted.
• Only $1.9 billion of $3.2 billion bid at 3.14% is needed, so competitive
bidders at this rate receive 1.9/3.2 = 59.375% of the amount bid for
• Noncompetitive bids, nonpublic purchases, and all accepted competitive bids
will receive notes with a yield of 3.14%.

FINA 4120 – Fixed Income 76

 Treasury Bill Sale
WSJ, 01/17/17

WASHINGTON -- The Treasury will auction $112 billion in new debt.

Tuesday: $45 billion in 4-week bills, dated Jan. 19, 2017, maturing Feb.
16, 2017. Cusip: 912796KH1. Noncompetitive tenders must be
received by noon EST Tuesday; competitive tenders, by 1 p.m.

Auction results

FINA 4120 – Fixed Income 77

FINA 4120 – Fixed Income 78
 Auctions
• Movie
• Two types of auctions:
– Discriminatory auction: Each bidder pays price bid. “You
get what you asked for”.
– Dutch Auction: also called a single price auction. Each
bidder pays price of lowest accepted bid.
• Which would Treasury prefer?
– Treasury wants to maximize revenue.
– Discriminatory auctions suffer from Winner’s curse
• “if you won, you paid too much”. Bidders will tend to shave
bids, or offer lower bids.
– Dutch auction doesn’t suffer from this problem.
FINA 4120 – Fixed Income 79
 The Salomon Brothers Scandal

• Spring 1991
• I-banks buy securities at auction to resell to clients
• Can “squeeze” the market if can buy enough of the auction to make it
difficult for other investment banks to fulfill their obligations to
customers
• Treasury rule: No one bank can take more than 35% of the auction
• Mozer’s action: Made unauthorized bids in name of customer
(Warburg). Action was uncovered
• Consequences: Mozer was fired, Chairman and CEO were forced to
resign in disgrace, Salomon’s reputation never recovered
• What almost brought them down: Failure to report the illegal action
promptly to the Treasury.

FINA 4120 – Fixed Income 80

 The Secondary Market of Treasuries
• Very active OTC secondary market made by dealers and
brokers
– Market makers stay in close contact over telephone and computer links
– The most liquid in the world.
– Average daily volume = $500 billion
– A typical trade is $10-$250 million
• Biggest volume of trade (2x retail market) is between dealers
in this market
• The Fed uses about 22 "primary dealers" to carry out “open
market operations”
– Fed traders traded $4.5 trillion, but they don’t have year-end bonus

FINA 4120 – Fixed Income 81

• Why market trust US treasuries?

FINA 4120 – Fixed Income 82

 Agency

• Issued by federal or local agencies.

– Examples: Federal Home Loan Bank (FHLB),
Tennessee Valley Authority (TVA), Federal National
Mortgage Association (Fannie Mae), Sallie Mae,
Freddie Mac.
– Quasi-private. Issued by a private agency, but
sponsored and backed by the government.
– Typically geared towards specific projects. E.g., low
income loans, mortgages.
– Virtually default free, but future cash flows can be
uncertain (due to pre-payment risk).
FINA 4120 – Fixed Income 83
 Federal Agency Securities

• Federally Related Institutions

– arms of the federal government, such as the Export-Import bank,
Tennessee Valley Authority, Government National Mortgage
Association (Ginnie Mae)
– Most federally related institutions do not issue securities directly
in the marketplace, except TVA
• Government Sponsored Enterprises (GSEs)
– privately owned, publicly chartered entities
– Created by Congress to reduce the cost of capital for certain
borrowing sectors

FINA 4120 – Fixed Income 84

 Federal Agency Securities
• Government Sponsored Enterprises (GSEs)
– There are five GSEs that issue debt to investors:
• Federal Farm Credit Bank System
• Federal Home Loan Bank System (FHLBS)
• Federal National Mortgage Association (Fannie Mae)
• Federal Home Loan Mortgage Corporation (Freddie Mac)
• Student Loan Marketing Association (Sallie Mae)

FINA 4120 – Fixed Income 85

 Federal Agency Securities

– Ginnie Mae, Fannie Mae and Freddie Mac, and FHLBS

• Created by congress to provide liquidity and lower interest
rates in US residential mortgage debt market
• Big players in the Mortgage backed securities market
• Each plays a different roles in the MBS market
• Details later

FINA 4120 – Fixed Income 86

 Federal Agency Securities

• Credit Risk
– Securities issued by GSEs are generally not backed
explicitly by the full faith and credit of the US
government
– However, most investors assume (correctly) that the US
government will bail out GSEs when they are in trouble
– Credit risk is relatively small, but not negligible

FINA 4120 – Fixed Income 87

 Municipal

• Issued by state and local governments.

– Sometimes called “MUNIs”.
– Interest payments typically exempt from federal income
taxes and in-state taxes.
– Backed by the taxing power of local authority.
– Not default-free

FINA 4120 – Fixed Income 88

 Municipal Bonds

• Bonds issued by state and local governments and

governmental entities
• Short-term Munis are issued to cover seasonal and
temporary imbalances between expenditure and tax
revenues
• Long-term Munis are issued to finance long-term capital
projects and long-term budget deficits

FINA 4120 – Fixed Income 89

 Investors in Muni’s
• Individuals investors, commercial banks, and insurance
companies dominates the Munis markets.
• Wealthy individual investors hold Munis either directly or
through mutual funds to reduce their tax liability.
• Commercial banks hold Munis for two reasons:
– use them as collateral against deposits
– as a market maker of Munis
• Insurance companies increase their holding of Munis when their
profits are up, vice versa.

FINA 4120 – Fixed Income 90

 Risks of Munis

• Credit Risk
– Risk of default, though low, is not negligible
– Revenue bonds generally have higher credit risk

• Tax Risk
– Lower tax rate will make Munis less attractive
– Uncertainty of the tax-exempt status of some Munis

FINA 4120 – Fixed Income 91

 Primary Markets for Munis

• Munis can be offered publicly or privately

– If offered publicly, a issue is usually underwritten by
investment bankers and/or commercial banks
– Public offerings may be marketed by either competitive
bidding or direct negotiations with underwriters

• Issuer (local government) needs to prepare an

official statement describing the issue

FINA 4120 – Fixed Income 92

 Secondary Markets for Munis

• Munis are traded in the over-the-counter market supported

by municipal bond dealers
– Larger issuers (or general names) are supported by the national
brokerage firms and banks
– Smaller issuers (or local general credits) are supported by regional
brokerage firms and local banks.

• Trade size is usually large

– For individual investors, the minimal trade size is usually $25,000
– For institutional investors, the minimal trade size is usually
$100,000

FINA 4120 – Fixed Income 93

 Stock and bond in the long run, after tax
Business week

• We know that over the long run, stock outperforms bond

by a large margin.
• Is it still true after-tax for high net-worth investor in high-
tax state
– S&P500 has 9.15% annual return from 1957 to 2008
– After federal taxes, return drops to 6.62%
– Deducting California state tax (10%), return drops further to 5.95%
– If you invest via a high-turnover mutual fund, after-tax return is
only 4.59%
– Annualized return is 5.45% for tax-free munis with much less risk

FINA 4120 – Fixed Income 94

 Mortgage-backed

• Issues backed by a “pool” of mortgages.

– Pool is like a portfolio of assets bundled together.
– Process of bundling called “securitization”.
– Often backed by guarantee from an agency.
– But Cash flow uncertainty arises from pre-payment
risk.
• Prepayment risk arises when borrowers decide to pay off or
refinance debt early. When could this happen?

FINA 4120 – Fixed Income 95

 Corporate

• Issued by corporations.
– Not default free, but often low risk.
– Classified by rating agencies assessment of default risk:
• Above investment grade = “normal” corporate debt. Typically
senior claim with little chance of default.
• below investment grade (BIG) = “junk” debt. Often junior
claim with high chance of default. Security starts to look like
stock.

FINA 4120 – Fixed Income 96

 Money Market Instruments

• Debt (and its derivatives) with < 1 year maturity

– Treasury Bills - short term debt obligation of the U.S. Treasury
– Federal Funds - loans between depository institutions used to meet
reserve requirements
– Negotiable Certificates of Deposit (CDs) - large denomination time
deposit issued by banks
– Repurchase Agreements (repo or RP) - way to borrow a given set of
funds by selling securities and then simultaneously agreeing to buy
the securities back on a pre-specified date at a pre-specified price
– Commercial Paper - short-term debt issued by corporations

FINA 4120 – Fixed Income 97

 Money Market Rate

• Discount Rate (d)

– Discount rate (d) is a percentage of par that money
market instrument is selling below the par, adjusted for
maturity.
 360   Par  P 
d   
 t   Par 

– Quoted by T-bills and commercial paper

FINA 4120 – Fixed Income 98

 Money Market Rate
– Example: p=98, t=90, par=100
 360  100  98 
d     0.08
 90  100 

– Advantages
• Easy to calculate
– Disadvantages:
• 360 days
• Rate is calculated as a percentage of the par
• Not comparable to interest rate quoted on coupon bearing
bonds

FINA 4120 – Fixed Income 99

 Money Market Rate
• Add on Rate (a)
– Add on rate (a) is a percentage of the selling price that the money
market instrument is selling below the par value, adjusted for
maturity.

 360   Par  P 
a
 t   P 

– Quoted by Fed Funds, and repos

FINA 4120 – Fixed Income 100

 Money Market Rate
– Earlier example: d=8%, par=100, p=98, t=90
– a=8.16%
– Advantages
• Easy to calculate
– Disadvantages
• 360 days
• Not comparable to interest rate quoted on coupon bearing
bonds

FINA 4120 – Fixed Income 101

 Money Market Rate
• Bond Equivalent Yield (r)
– Bond equivalent yield is similar to add on rate, but it uses 365 days
in a year.

 Par  P   365 
r  t 
 P  
– Wall Street Journal gives bond equivalent yield on T-bills
– This is different from the BEY for coupon bond!

FINA 4120 – Fixed Income 102

 Money Market Rate
– Earlier example: d=8%, par=100, p=98, t=90
– r=8.28%
– Advantages:
• Relatively easy to compute
– Disadvantages:
• Not comparable to interest rate quoted on coupon bearing
bonds

FINA 4120 – Fixed Income 103

 Money Market Rates

• What should we do?

– Keep in mind that quoted interest rates on different money market
instruments may not be comparable
– Try to convert all money market rates to “effective annual yield” to
be consistent and comparable to coupon bearing bonds

FINA 4120 – Fixed Income 104

 Example: WSJ quote
Below is a WSJ T-bill quote on Friday 9/8/00:

Maturity Days to Bid Asked Chg. Ask

Mat. Yld.
Oct 05’00 27 5.96 5.88 -0.01 5.99

• Recall for T-bills, the bid price (at which you can sell) and
ask price (at which you can buy) are quoted as a discount
from the face value, d.

FINA 4120 – Fixed Income 105

 Example: WSJ quote (2)

• Therefore, the prices are:

 27 
Ask  100   1  0.0588   $99.559
 360 
 27 
Bid  100   1  0.0596   $99.553
 360 

– These are prices per $100 principal

– Ask price > Bid price
• That is how the dealer makes money

FINA 4120 – Fixed Income 106

 Example: WSJ quote (3)

• The “Ask Yield” listed by WSJ is the BEY:

365  100  99.559 

BEY     5.99%
27  99.559 

• The “effective Annual Yield” is:

365
 100  27
Effective Annual Yield     1  6.16%
 99.559 

– Can be compared to effective annual yields of other bonds

FINA 4120 – Fixed Income 107

 Summary

• Topic 2 covered:
– Different bond features
– Various risks associated with bond investment
– Bond markets
• External vs. Internal, Primary vs. Secondary
– Bond Instruments
• Treasury, Agency, Muni, MBS, Corp
• Money Market Instruments

FINA 4120 – Fixed Income 108