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27 Cards in this Set
- Front
- Back
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Repos and Reverses
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◦Typically short-term borrowing with the borrowingperiod being days, weeks or a few months◦The dealer“sells” treasuries for stated period of time, say 51 days◦With theagreement to buy them back in 51 days at a higher price◦The treasuriestherefore as act as collateral for the loan
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◦Uses of repos |
◦Most (large) financial institutions, that do nothaving deposit taking arms, need funding for trading purposes◦These (large) financial institutions have large amounts of treasuries on hand and are willing to“sell” or “borrow”against them in order to purchase another security◦Traders need cash so repos are one of the common ormost common ways of funding trading◦Central banks, such as the Fed, make extensive use ofrepos to conduct monetary policy◦“Sucking money up/Draining liquidity” – repo; “Addingliquidity” – reverse repo◦◦Approximatesize of the US repo and reverserepo markets - $4.6T◦Amount of all treasuriesoutstanding - $12.3T |
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Fed Funds |
◦Each memberbank of the Fed needs to keep a specified amount of reserves based on itsdeposit balances , i.e. the $ amt in checking and such – M1◦The bank’sreserve account is called Fed Funds◦The history ofFed Funds◦Though thereserve rate at this point is set at 10%, it has at times been set lower◦Such as whenthe market needs liquidity◦3% in 2007 –2008◦The Fedtherefore uses the reserve requirement, in part, to withdrawn and add liquidityto the systemo |
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Fed Funds – So back to how FF are typically used |
◦In “normal”times, FF are a way for banks to:◦Earn intereston excess reserves by placing them in the Fed Funds “pool”/market◦In this way,member banks who need overnite funding can go to the Fed Funds market as lateas 6 PM Eastern time◦ And fundthemselves overnite◦The nominalrate for FF is set by the Fed Governors at each meeting◦However, eachtrade can go off at a rate, typically slightly different from the nominal rate |
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◦FF are a way for banks to raiseliquidity quickly
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◦For example, abank may want to finance a major loan but may not have the time to wait for deposits orinterest (on loan payments) to come in◦In such cases thebank can quickly raise the amount fromother banks at an interest rate equal to or higher than the FF rate. |
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Broker Calls |
◦Borrowing money to buy stocks on margin (a leveragedtransaction)◦The borrower(Broker) borrows the funds from a bank◦Agreeing topay them back immediately (“at call”) if the bank requests it◦A major way offinancing stock purchases◦And a majorindicator of stock investor sentiment_ |
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London Interbank Offering Rate – LIBOR |
◦The rate atwhich banks in London are willing to lend money to each other◦It can oftenbe seen as an indicator of counter-bank credit worthiness◦Has been amajor benchmark for decades◦But is now indisrepute due to pricing fixing amongst the large banks◦Was the basisof determining short term liquidity in the market◦But now, giventhe price fixing, OIS – Overnite Index Swaps – are being increasingly used as ameasure of short-term liquidity C0֝^ 5 |
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A Quick Look at Signals of Liquidityl> |
◦Bid-Ask spread is a good initial way of determining asecurity’s liquidity◦A narrower spread versus a large spread means thenarrower bid-ask security is (for the moment) more liquid◦Are theremarket-wide measures of liquidity?◦If we stickwith money market instruments – especially T-bills and Eurodollars – the answeris yes◦A commonlyused measure is 3M Eurodollars less 3M T-Bills; often called the TED spread◦There is alsoa growing use of OIS (Overnite Interest Rate Swaps) to measure overnite to 1week liquidityu |
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Treasury Market
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◦We’ve alreadycovered short-term US debt (bills)◦Now notes andsbonds◦Typical tenors for notes are: 2, 3, 5,7 and 10 years◦Bonds: 30 years◦New notes andbonds are issued every month◦As with bills,notes are sold at auction (a dutch auction) |
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The BondMarkets |
◦The risk ofdefault is small if the firm is viewed as having a small risk of not paying◦While the riskis large if the firm has a larger risk of defaulting◦The typicalcredit spread for the firms who are least likely to default is approx. 0.75%◦For firms,where the is a much larger possibility of default, the credit spread is,typically 2% or more◦These kinds ofbonds are often referred to as high yield debt◦Countriesoutside of G-7 have a spread on their Govt debt somewhat under 2% and possiblyas high as several %◦This isbecause, even Govt debt, in none G-7 countries, has a possibility of default6 |
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Dutch Auction |
◦An auction where the price of the offering is set after taking in all bids◦In the bill, note and bond auctions, investorsplace a bid for the amount they are willing to buy in terms of quantity andprice◦The US Treasury (the “auctioneer”) then determines thehighest priceat which the total offering can be sold |
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A little bit of bond math and related mechanics |
◦Bondstypically make two kind of payments◦A couponpayment – the payment of interest on a fixed schedule (often semi-annually)◦And the returnof principle at maturity ◦Prices are stated a percentage of par◦For example a price of 110.07 means you will pay$11,007.00 for a $10,000.00 note ◦This bond is trading at a premium, i.e. you arepaying more than its par value◦If the price was 98.17, the bond would be trading at adiscount◦The yield tomaturity (YTM) of a bond is calculated first by determining the semi-annualyield and the doubling it%ٛ!ʠ |
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YTM |
◦The rate of return(expressed onan annual basis) of a bond assuming it isheld until maturity ◦The YTMcalculation takes into account the bond’s current market price, par value,coupon interest rate and time remaining to maturity◦YTM alsoassumes that allcoupon payments are reinvested at the same rate as the bond’s current yield◦YTM is an accurate calculation ofa bond’s return that helps investors compare bonds with different maturitiesand coupons. |
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Federal Agency Bonds |
◦Bonds ofGovernmental Agencies established by Congress to, at least in part, channelcredit to a particular sector of the economy◦An example ofthis kind of bond is Federal Farm Credit paper◦The 3 mostfamiliar issuers of agency bond are: Fannie Mae (FNMA - Federal NationalMortgage Association), Freddie Mac (FHLMC - Federal Home Loan MortgageCorporation) and Ginnie Mae (GNMA - Government National Mortgage Association)◦Total AgencyBonds outstanding - $2T◦FNMA and FHLMCportion – approx. $700B |
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Corporate Bonds |
◦The single biggest difference between Corp Bonds andTreasury Bonds is default risk◦If a business comes to market with a new 7 year Bondissue, the business’ bankers tack onto the 7 year treasury rate a credit spreadthat reflects this default risk◦As the coupon payments are fixed, e.g. $xxx every 6months, any change in default risk will be reflected in the price◦A secured corporate bond has specific collateralassigned to it in the event of bankruptcy◦Debentures have no collateral◦Holders of subordinated debentures are lower down thefood chain if the firm goes belly up◦Size of the USCorp Bond market - $7.7T DTˎ |
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Going back to our discussion on credit spread |
◦As there isthe possibility of default in corporate bonds◦All corporate bonds have a default spread◦This, as youwill see, will be true for every other bond type we discuss |
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Another pause to look at Liquidity |
◦The totalbonds outstanding in the US is $38.7T◦The amountthat trades daily is about $800B◦Therefore,most bonds do not trade every day◦As a matter offact◦Some marketshave just 5% of the outstanding issues trading on any one day◦And even thetreasury market often has 50% or more of its issues not trading daily◦This lack ofdaily pricing is reflected in the bid-ask spread of the bond◦So there are bonds that aremore costly—in terms of wide bid-ask spreads—due to low liquidityyˎ |
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A further look at Liquidity |
◦While thereare stocks that also have low liquidity and wide bid-ask spreads, bonds tradeover the counter and, therefore, there is no formalized exchange where tradingtakes place◦Thus trading activity canvary widely across bonds and this mayeven be the case for the bonds of well-known corporations◦It may bedifficult to sell a holding in inactive markets and, as a result, you may haveto accept an outlier (potentially costly) bid to liquidate your positionh/{ |
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Municipal Bonds |
◦Bonds issuedby a municipality that typically are triple-tax free (federal, state and local)◦There are 4 broad categories of munis:◦General Obligations (GOs) – backed by the taxescollected by the issuer◦Revenue Bonds – used to finance particular projects(stadiums, airports) and are backed by either the revenue from the project ofby the agency operating the project◦Industrial Development Bonds (IDB) – a revenue bondthat finances a commercial enterprise, such as a factory to be operated by aprivate firm◦These private purpose bonds give firms access to themunicipalities ability to borrow at tax-free rates◦And the US government limits the amount that may beissued◦Tax Anticipation Notes – this security is issued topay for expenses before the actual collection of taxes◦The USgovernment issues similar short term bond. It is often referred to a Cash Management paper◦The size ofthe muni market is $3.6T |
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Credit Spread on Muni Bonds |
◦As themarket’s view of the ability of a state to pay its debt varies◦So does thestate’s debt spread over Treasuries◦The creditspread, within a state, based upon the type of bond issued:◦GeneralObligations (GOs) ◦Revenue BondsIndustrial Development Bonds (IDB) – a revenue bond that finances a commercialenterprise, such as a factory to be operated by a private firm◦TaxAnticipation Notes – this security is issued to pay for expenses before theactual collection of taxesReflects thecredit risk of defaultTypically,GO’s have the smallest credit spreadAnd TaxAnticipation notes the largest |
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Municipal Bond |
◦The key feature of muni Bond is its tax-free nature◦In order to compare taxable and tax-free bonds, we’lldo a little bond math◦Let’s determine the interest rate needed on a taxablebond that will provide an after tax return equal to a similarly dated muni bond◦To derive this, we set the after-tax yields equal andsolve for the equivalent taxable yield on the tax-exempt bond◦If t your tax rateand r is the totalbefore tax rate of return for a taxable bond◦r(1-t)Is the aftertax rate on the taxable security◦And if r_m, the rate onthe muni, is smaller than r(1-t) you would do better holding the taxable bond |
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Muni Bonds |
◦By doing a little algebra, r(1-t)=r_m can be re-arranged to t=1-r_m/r◦The yield ratio r_m/r is a keydeterminate of the attractiveness of a muni bond◦The higher the yield ratio, the lower the cutoff taxbracket becomes◦Hence, the more the individual will begin to preferthe muni |
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Mortgage Backed Securities (MBS) |
◦MBS arecollateralized bonds where the collateral are single-family homes◦MBS come in 2flavors – conforming and nonconforming◦Conforming MBSare typically issued by FNMA, FHLMC and GNMA◦The source ofthe loans are mortgages originated by mortgage lenders◦A conformingis one where the dollar amount of the mortgage is no higher the agency’s upperlimit◦In 2016, thatupper limit will be something more than $400K◦The conforminglimit is based upon the median home prices of the prior year |
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Mortgage Backed Securities (MBS) II |
◦Non-conformingor jumbo loans are also pooled and issued as MBS◦They areissued as white labelleddeals◦This is theterm used to describe the selling of the pool to a single firm, such as GoldmanSachs, or to a small number of investors (less than 100)◦◦There are manymore forms of MBS such as selling tranches and designing an MBS that fits aparticular client’s investment needs◦Most of theseother forms involve estimating the future cash flows of the pool and thencutting the cash flows up and creating securities◦◦Size of theMBS market - $8.7TB |
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So what is the credit spread for MBS? |
Those MBS issued by an entity such as FNMA, typicallyhave a spread over Treasuries of about 0.75% As the MBS become more “exotic” The spread increases for 2 reasons◦Liquidity –there is little chance of “bailing out” of the position◦And, theremaybe a higher possibility of default◦i.e, the folkswho pay the mortgage are, or maybe, more likely to default, versus an FNMA MBS |
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what happened during the credit crisis of 2007 – 2008 |
Bond investors we’re looking for a better spread thanTreasuries and low default debt prior to 2007 Remember, Govt interest rates were so low that, on anannual basis, 10Y Treasuries were yielding 5% in July 2007 While High Yield bonds were yielding 6.7% And “exotic” MBS were offering even more The Fed had been “flooding” the market with money So there was a lot of liquidity sloshing around That liquidity had to go somewhere And it typically went to higher credit spread debt Why? Nobody thought the U.S. economy was near “tanking”/jv̱ |
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Final comments on the Money and Bond Markets |
◦The US money andbond markets is one of themost active markets in the world, with more than $830B traded daily◦For investors,bonds can bean effective portfolio diversifier and a strong income-generating asset◦Bonds are typicallyless volatile than stocks and they tend to have a lower rate of return◦In the weeksto follow, we will be using money market and bond market instruments to buildportfolios=25��r�ˎ
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