R40 Fixed Income Markets: Issuance Trading and Funding 2022 Level I Notes

R40 Fixed Income Markets: Issuance Trading and Funding

1. Introduction ..............................................................................................................................................................3
2. Classification of Fixed-Income Markets.......................................................................................................3
2.1 Classification of Fixed-Income Markets ...............................................................................................3
2.2 Fixed-Income Indices ....................................................................................................................................5
2.3 Investors in Fixed-Income Securities ....................................................................................................5
3. Primary Bond Markets.........................................................................................................................................5
3.1 Primary Bond Markets .................................................................................................................................5
4. Secondary Bond Markets ....................................................................................................................................7
5. Sovereign Bonds .....................................................................................................................................................8
6. Non-Sovereign, Quasi-Government, and Supranational Bonds .......................................................8
6.1 Non-Sovereign Bonds ...................................................................................................................................8
6.2 Quasi-Government Bonds ...........................................................................................................................9
6.3 Supranational Bonds .....................................................................................................................................9
7. Corporate Debt: Bank Loans, Syndicated Loans, and Commercial Paper ...................................9
7.1 Bank Loans and Syndicated Loans .........................................................................................................9
7.2 Commercial Paper ..........................................................................................................................................9
8. Corporate Debt: Notes and Bonds ............................................................................................................... 11
9. Structured Financial Instruments ............................................................................................................... 13
9.1 Capital Protected Instruments .............................................................................................................. 13
9.2 Yield Enhancement Instruments .......................................................................................................... 13
9.3 Participation Instruments........................................................................................................................ 13
9.4 Leveraged Instruments ............................................................................................................................. 14
10. Short-Term Bank Funding Alternatives ................................................................................................ 14
10.1 Retail Deposits ............................................................................................................................................ 14
10.2 Short-Term Wholesale Funds ............................................................................................................. 15
11. Repurchase and Reverse Repurchase Agreements.......................................................................... 16
Summary ...................................................................................................................................................................... 18
Practice Questions ................................................................................................................................................... 21

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R40 Fixed Income Markets: Issuance Trading and Funding 2022 Level I Notes

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R40 Fixed Income Markets: Issuance Trading and Funding 2022 Level I Notes

1. Introduction
This reading will cover:
 How the bond markets are classified.
 Who the major issuers of debt are and what types of bonds they issue.
 How new bond issues are introduced in primary markets and then traded in
secondary markets.
 Sovereign bonds and non-sovereign bonds.
 Different types of corporate debt.
 The sources of short-term funding available to banks.

2. Classification of Fixed-Income Markets

2.1 Classification of Fixed-Income Markets
Fixed-income markets are often classified based on the following criteria:
Classification by Type of Issuer
Bond markets may be divided into four categories based on the type of issuers:
1) Households
2) Non-financial corporates
3) Government
4) Financial institutions
Classification by Credit Quality
Investors face credit risk, i.e., the risk of loss if the issuer fails to make timely payments of
interest and principal as they come due. Rating agencies like Moody’s, S&P, and Fitch assign
credit ratings to bonds. Bonds with a rating of BBB or above are considered investment
grade. Bonds below this rating are considered junk bonds.
This differentiation is important as certain investors such as banks and life insurance
companies may not be allowed to invest in junk bonds but only in investment grade bonds.
Classification by Maturity
Fixed-income securities can also be classified by the original maturity of the bonds when
they are issued:
 Money market securities: They are issued with a maturity at issuance that ranges
from overnight to one year. For example, T-bills issued by the US government or
commercial paper with short maturities issued by the corporate sector.
 Capital market securities: The original maturity is usually longer than a year.
Classification by Currency Denomination
Fixed-income securities can also be classified based on the currency in which they are

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R40 Fixed Income Markets: Issuance Trading and Funding 2022 Level I Notes

issued. The bond’s price (and cash flows) is affected by the interest rates of the country
whose currency the bond was issued in.
Classification by Type of Coupon
Bonds can be classified into the following based on the coupon rate:
 Fixed-rate: In a fixed-rate bond, the coupon rate and coupon payment are fixed.
 Floating-rate: In a floating-rate bond, the coupon payment is linked to a floating rate,
which is usually a reference rate plus a spread.
There are two parts to a floating rate: a reference rate and a spread.
The reference rate is reset periodically at the coupon date. As a result, the coupon rate more
or less reflects the market interest rates. The reference rate contributes to most of the
coupon rate and is usually an interbank offered rate. The most commonly used interbank
rate is Libor.
Interbank offered rates are the average interest rates at which banks may borrow unsecured
funds from other banks. The rates differ for different periods ranging from overnight to one
year. Examples of interbank offered rates include Libor, Euribor (Euro interbank offered
rate), Mibor (Mumbai interbank offered rate), etc. The respective currencies for Euribor and
Mibor are the Euro and Indian rupee.
The spread, on the other hand, is fixed at issuance and is a function of the issuer’s credit
quality or creditworthiness. The higher the quality, the lower the spread and vice versa. It is
a small component of the coupon rate.
Classification by Geography
Fixed-income markets may be classified based on where the bonds are issued and sold (we
saw this in detail in the previous reading):
 Domestic bonds: Bonds issued in a country in that country’s currency. The issuer is
domiciled in that country. For example, Ford issuing U.S. dollar denominated bonds in
the U.S.
 Foreign bonds: Bonds issued by an entity domiciled in another country. For example,
Toyota issuing dollar denominated bonds in the U.S.
 Eurobonds: International bonds sold outside the jurisdiction of any single country.
 Investors further classify bonds into those issued by developed economies and
emerging economies.
Other classifications:
Among other classifications, we have tax-exempt bonds and inflation-linked bonds.
 Tax-exempt bonds: Bonds whose interest/coupon payments are not taxable. For
example, munis or municipal bonds issued by local governments in the United States
are tax-exempt bonds.
 Inflation-linked bonds: Bonds whose coupon and/or principal are indexed to

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R40 Fixed Income Markets: Issuance Trading and Funding 2022 Level I Notes

inflation. The objective is to give some protection (hedge) to investors against high
inflation and offer real returns in a high inflation environment.
2.2 Fixed-Income Indices
Fixed-income indices are used by investors for two purposes: to evaluate the performance of
investments and investment managers and to describe a given bond market or sector. The
index construction - security selection and weight of each security in the index- varies from
index to index.
The most popular fixed-income indices include Barclays Capital Global Aggregate Bond
Index, J.P. Morgan Emerging Market Bond Index, and FTSE Global Bond Index.
2.3 Investors in Fixed-Income Securities
Major categories of fixed-income investors include:
 Central banks: They use fixed-income securities as a tool to implement monetary
policy. Purchasing domestic bonds increases money supply. Similarly, selling bonds
decreases money supply. Central banks also buy and sell bonds denominated in other
currencies to manage the value of their currency and foreign reserves.
 Institutional investors: They are the largest group of investors in fixed-income
securities. This includes pension funds, hedge funds, endowments, charitable
foundation, insurance companies, and banks. Unlike equities that trade in primary
and secondary markets, bonds primarily trade over-the-counter. Many issues are not
liquid and tradable, making them out of reach for retail investors, but are preferred
by institutional investors.
 Retail investors: Unlike central banks and institutional investors, retail investors
primarily invest in bonds through mutual funds or ETFs. Many retail investors prefer
to invest in bonds because of the certainty of income in the form of interest payments
and principal payment at maturity. Also, fixed-income securities are not as volatile as
their equity counterparts.

3. Primary Bond Markets

Primary bond markets are markets in which bonds are sold for the first time by issuers to
investors to raise capital. Bonds can be sold initially via a public offering or a private
placement. Secondary bond markets are markets in which existing bonds are subsequently
traded among investors. After the initial offering, bonds are bought and sold among
investors in the secondary market.
3.1 Primary Bond Markets
A company/government/any entity issues bonds in two ways: public offering and private
placement.
Public Offerings

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R40 Fixed Income Markets: Issuance Trading and Funding 2022 Level I Notes

As the name indicates, in a public offering, any member of the public may invest in a new
bond issue. The issuer does not sell bonds directly to each investor. Instead, the issuer avails
the services of an intermediary called the underwriter to facilitate the selling (placement)
process. The underwriter is usually an investment bank because banks have a good
understanding of how to market a new issue, can tap their networks to locate investors, and
successfully place the issue.
The different bond issuing mechanisms are:
 Underwritten offering
 Best effort offering
 Shelf registration
 Auctions
Underwritten offerings: In an underwritten offering, an investment bank negotiates an
offering price with the issuer; the offering price is the price at which the issue will be sold. It
then buys the entire issue at the offering price and takes the risk of reselling it to investors
or dealers. Underwritten offering is also known as a firm commitment offering. The
underwriting process is graphically depicted below:

While small-size bond issue may be underwritten by a single investment bank, larger-size
bond issues are often underwritten by a group (or syndicate) of investment banks. Such
issues are called ‘syndicated offerings.’ A lead underwritten heads the syndicate and the
group collectively establishes the pricing of the issue and takes the risk of reselling it to
investors or dealers.
Best effort offering: Contrary to an underwritten offering, in a best effort offering issue, the
investment bank acts as a broker and only sells as many securities as it can instead of
committing to sell 100% of the issue. The unsold bonds are returned to the issuer. The
investment bank gets a commission for bonds sold at the offering price, faces less risk and
has less incentive to sell the issue than in an underwritten offering. Best effort offering is
usually preferred for riskier issues and corporate bonds.
Shelf registration: Shelf registration is a type of public offering where the issuer is not
required to sell the entire issue at once. The issuer files a single document with regulators
that describe a range of future issuances. The advantage is that the issuer does not have to

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R40 Fixed Income Markets: Issuance Trading and Funding 2022 Level I Notes

prepare a new document for every bond issue provided there is no change in the issuer’s
business and financial terms stated in the prospectus. This allows the issuer to save on
repeated administrative expenses and registration fees.
Auctions: Government bonds across the world are usually sold to investors via an auction.
Governments finance public debt by borrowing money through the central bank. An auction
is a public offering method that involves bidding, and is helpful in price discovery and
allocating securities. The United States follows a single-price auction method for its
sovereign securities such as T-bills, T-notes, TIPS, etc. In this method, all winning bids pay
the same price for the security and receive the same coupon rate.
Private Placement
As the name implies, the securities are not sold to the public in this type of funding. Instead,
they are sold only to a select group of investors such as institutional investors. Other
characteristics are as follows:
 It is typically a non-underwritten, unregistered offering of bonds, i.e., a private issue
need not comply with the registration requirements of a public offering such as
preparing a prospectus.
 It is also exempt from securities laws that govern a public issue.
 It can be accomplished directly between the issuer and the investor(s) through an
investment bank. Because privately placed bonds are unregistered and may be
restricted securities that can only be purchased by some types of investors, there is
usually no active secondary market to trade them.
 Institutional investors such as insurance companies and pension funds are typical
investors of privately placed bonds.

4. Secondary Bond Markets

Securities are traded among investors in the secondary market. Large institutional investors
and banks are the primary participants. Retail investors are limited here, unlike in the
equities market.
Secondary bond markets are structured as organized exchanges or as over-the-counter
markets.
 Organized exchange: Where buyers and sellers meet to arrange trades and comply
with the rules of the exchange.
 Over-the-counter (OTC) markets: Buy and sell orders are matched through a
communications network. Most bond trading happens in the OTC market.
It is important to understand the liquidity of a bond market:
 Liquidity is a measure of how quickly an investor can sell the bond and turn it into
cash. Similarly, it should also measure how quickly one can buy a bond to cover a
short position.
 Bid-ask or bid-offer spread reflects the liquidity of a market. The lower the spread,

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R40 Fixed Income Markets: Issuance Trading and Funding 2022 Level I Notes

the better the liquidity.

 Most of the liquidity in the international bond market is supplied by Eurobond
market makers.
Settlement is the process that occurs after a trade is made:
 It is usually T+1 (a day after the transaction date) for government and quasi-
government bonds and T+3 for corporate bonds.
 Cash settlement is one in which cash is paid and bond is received on the same day. It
is followed for some government and quasi-government bonds, and money market
securities.

5. Sovereign Bonds
Sovereign bonds are issued by national governments primarily for fiscal reasons. Taxes are
the primary source of revenue for a government. If tax revenue is insufficient, then a
government raises money by issuing sovereign bonds.
Sovereign securities are classified into two categories based on when they were issued: on-
the-run and off-the-run. On-the-run are recently issued sovereign securities that trade
frequently. They are also called benchmark bonds because the yields of other bonds are
determined relative to these bonds. Off-the-run refers to securities that were issued some
time ago. They are less liquid compared to on-the-run securities.
Sovereign bonds are not backed by collateral. Instead, they depend on the taxing authority,
i.e., the national government, to repay the debt. Rating agencies distinguish between a
sovereign bond issued in local currency and one in foreign currency. Local currency bonds
generally have a higher credit rating than foreign currency bonds, because if needed the
national government can print local currency to repay the bond, however it cannot print the
foreign currency.
Sovereign bonds can be fixed-rate, floating-rate or inflation-linked.

6. Non-Sovereign, Quasi-Government, and Supranational Bonds

6.1 Non-Sovereign Bonds
Non-sovereign bonds are bonds issued by the local governments such as states, provinces,
and cities, and not by the national government. The characteristics of non-sovereign bonds
are as follows:
 Credit rating is usually high as rate of default is low. However they have a higher
credit risk than sovereign bonds and therefore demand a higher yield.
 The source of revenue for these bonds is the local taxing authority and the cash flows
from the project once it is commissioned.
 Funds raised from non-sovereign bonds are used for public projects such as
highways, bridges, dams, airports, metro, sewage systems, and schools.

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R40 Fixed Income Markets: Issuance Trading and Funding 2022 Level I Notes

6.2 Quasi-Government Bonds

Quasi-government bonds are bonds issued by non-government entities, but they are usually
backed by the government. The characteristics of these bonds are as follows:
 The credit risk is low.
 Taxes are not a source of revenue. They fund specific projects and cash flows from the
project/entity are used to service the debt.
 Examples are bonds issued by Federal National Mortgage Association (Fannie Mae),
Federal Home Loan Mortgage Corporation (Freddie Mac) in the U.S.
6.3 Supranational Bonds
Supranational bonds are bonds issued by international organizations such as the World
Bank, IMF, EIB, ADB, etc. They are usually plain-vanilla bonds. Sometimes callable or floaters
are also issued.

7. Corporate Debt: Bank Loans, Syndicated Loans, and Commercial Paper

We now shift our focus from sovereign debt to corporate debt. Companies borrow primarily
from banks and only 30% of their financing needs come from the financial markets.
7.1 Bank Loans and Syndicated Loans
There are two types of bank loans: bilateral and syndicated.
 A bilateral loan is a loan from a single lender to a single borrower.
 A syndicated loan is a loan from a group of lenders, called the syndicate, to a single
borrower.
Most bilateral and syndicated loans are floating-rate loans, linked to a reference rate such as
Libor. For highly rated companies, both bilateral and syndicated loans can be more
expensive than bonds issued in financial markets.
7.2 Commercial Paper
A commercial paper is a flexible, readily available, and low-cost instrument issued by
companies to meet their short-term needs. They are issued for a short period, typically
between 15 days and one year.
A commercial paper may be regarded as the corporate equivalent of a T-bill because it is
short-term in nature. In a CP, since companies may borrow directly from the market, the cost
of borrowing is less than that of banks.
Companies use commercial paper:
 For working capital and seasonal demands for cash.
 As a source of bridge financing: CPs serve as an interim source of funding if market
conditions are not temporarily favorable to arrange permanent funding.

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R40 Fixed Income Markets: Issuance Trading and Funding 2022 Level I Notes

The characteristics of a commercial paper are as follows:

 The yield on commercial paper is greater than the yield on short-term sovereign
bonds because investors are exposed to credit risk. Credit risk varies from entity to
entity.
 Historically, the rate of default of CP is very low as they are short-term in nature, and
when CPs mature, they are usually rolled over into new CPs. It is called rolling over
the paper. The old CP is paid with the proceeds from the new CP. But what if the
issuer is unable to issue a new CP? This risk is called rollover risk. Rollover risk can be
mitigated by what is called backup lines of credit. These are backup funds from the
banks to ensure there is enough money to pay off a maturing CP.
US Commercial Paper vs. Eurocommercial Paper
The US commercial paper (USCP) market is the largest commercial paper market in the
world. Commercial paper issued in the international market is known as Eurocommercial
paper (ECP). The differences between the two are summarized in the table below:
USCP vs. ECP
Feature US Commercial Paper Eurocommercial Paper
Currency U.S. dollar Any currency
Maturity Overnight to 270 days Overnight to 364 days
Interest Discount basis Interest-bearing basis
T+2 (trade date plus two
Settlement T+0 (trade date)
days)
Can be sold to another
Negotiable Can be sold to another party
party
The key difference between a USCP and ECP is in the way interest is paid. USCP, like a zero
bond, is sold at a discount. The par value is paid on maturity. ECP, on the other hand, is sold
at par and the interest is paid along with the par value at maturity. The example below
illustrates this difference for a $100 million CP issued at 4% for 90 days.
$100 million, 90-day at 4% commercial paper
USCP: issued by U.S. Bank ECP: issued by a French
company
Interest: 100,000,000 x 0.04 x 90/360 100,000,000 x 0.04 x
= $1,000,000 90/360
= $1,000,000
At issuance, money Interest discounted from Par value: $100,000,000
received by par:
bank/company 100,000,000 –
1,000,000=$99,000,000

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R40 Fixed Income Markets: Issuance Trading and Funding 2022 Level I Notes

Bank/company pays at Par value = $100,000,000 Par value + interest =

maturity: 10,000,000 + 1,000,000 =
$101,000,000
Return on investment for 1,000,000/99,000,000 = 1,000,000/100,000,000 =
90 days 1.01% 1.00%

8. Corporate Debt: Notes and Bonds

Corporate bonds may be categorized based on several characteristics such as maturities,
coupon payment structures, and contingency provisions that we will discuss in this section.
Maturities
Short-term, medium-term, long-term: There is no formal categorization of what constitutes a
short-term, medium-term, and long-term security. But we will go with the classification
below based on common practice.
Classification of Corporate Bonds Based on Maturity
Original maturity Term What are they called?
Five years or less than five years (≤ 5) Short-term Notes
Greater than 5 and less than 12 years Medium-term
(> 5 and ≤ 12)
Greater than 12 years (> 12) Long-term Bonds
Medium-term note (MTN): The term ‘medium’ in an MTN is a misnomer because the
maturities range from 2 years to greater than 30 years.
 MTNs are continuously offered through dealers or agents.
 MTNs can be broadly classified into short-term, medium to long-term, and structured
notes.
 Yield on an MTN is higher than a comparable bond, but liquidity is lesser.
 They primarily serve to bridge the funding gap between commercial papers (short-
term) and long-term bonds.
Coupon Payment Structures
Coupon payments for corporate notes and bonds vary based on the type of bond:
Note: We have seen most of these in the previous reading, so we will just skim through them
 Conventional coupon bond/plain vanilla bond: pays fixed-rate coupon periodically.
 Floating-rate note: Coupon payment linked to a reference rate.
 Credit-linked coupon bond: Coupon payment linked to issuer’s credit quality.
 Zero-coupon bonds: Pays no coupon; one payment equivalent to par value at
maturity.
 Deferred coupon bonds: Pays no coupon initially and a higher coupon later.
 Payment-in-kind coupon bond: Pays coupon in the form of securities, not cash.

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R40 Fixed Income Markets: Issuance Trading and Funding 2022 Level I Notes

Principal Repayment Structures

Broadly speaking there are three types of principal repayment structures. These are outlined
below:
1. Serial maturity structure: The bond matures in parts on several dates throughout the
bond’s life. The principal is repaid in parts instead of paying a lump sum at maturity. For
example, if a company issues $50 million for 5 years, then traditionally it repays the
principal of $50 million at once on maturity date. But in the case of a serial bond issue,
assume $20 million matures after two years, $10 million in the third year, and so on.
Which bonds will be retired at what date, is defined at issuance.
2. Term maturity structure: The bond’s entire principal is paid at once on maturity. It
carries more credit risk.
3. Sinking fund arrangement: The issuer sets aside funds so that it can retire specific
amounts of the principal each year. This is done in two ways: by repaying principal to a
certain percentage of bondholders each year, or the issuer may deliver bonds to the
trustee equal to the amount that must be retired that year.
Asset or Collateral Backing
Unlike highly-rated sovereign bonds that carry almost no default risk, all corporate bonds
have varying amounts of default risk. The objective of asset or collateral backing is to protect
investors in the event of a default. Secured debt, i.e., debt backed by collateral, is not
completely insulated from losses, but it is considered better than unsecured debt.
Contingency Provisions
Contingency provisions are clauses defined in a bond’s indenture to protect the bondholders.
These provisions specify under what conditions a bond may be redeemed or paid-off before
maturity. Some provisions benefit the issuer while some benefit the investor. The three
contingency provisions are call provision, put provision, and a convertible bond.
Issuance, Trading, and Settlement
Major points with respect to issuance, trading, and settlement are given below:
 New bond issues are sold by investment banks who act as underwriters/brokers.
 They are settled through the local settlement system, which in turn is connected to
the two primary Eurobond clearing systems: Euroclear and Clearstream.
 Bonds are traded through dealers who make a market. Dealers interact with
bondholders and with other dealers. So, it is essentially an over-the-counter market.
 The settlement now happens electronically. For a secondary bond, settlement could
take anywhere between T + 3 to T + 7 days while issuance of a new bond takes
several days.
 Bond prices are quoted in basis points.

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R40 Fixed Income Markets: Issuance Trading and Funding 2022 Level I Notes

9. Structured Financial Instruments

Structured financial instruments represent a broad sector of financial instruments including
asset-backed securities and collateralized debt obligations. A common characteristic of these
instruments is that they repackage and redistribute risks. In this section, we focus on the
following four categories of instruments:
9.1 Capital Protected Instruments
Capital protected instruments offer different levels of capital protection, and are only as
good as the issuer of the instrument. One example of a capital protected instrument is a
guarantee certificate that offers full capital protection. This is achieved by combining a bond
and a call option.
For example, consider an investor who has $100,000 to invest. The investor buys zero-
coupon bonds that will pay off $100,000 after one year. The investor pays $99,000 for the
bond and invests the remaining $1,000 from the purchase of the bond to buy a call option on
some asset that expires one year from now. Now, let us see what happens one year from now
when the bond matures. If the price of the underlying asset on the call option increases, the
call expires in the money. The investor gets $100,000 when the bond matures and profits
from the call option. If the price of the underlying asset on the call option falls, the call
expires worthless. The investor’s capital is still protected as he gets $100,000 when the bond
matures and loses the premium paid for the call option. The downside is limited to the
$1,000 premium paid for the call option.
9.2 Yield Enhancement Instruments
Yield enhancement refers to higher risk exposure and possibly a higher expected return. A
credit-linked note is an example of a yield enhancement instrument.
The characteristics of a CLN are as follows:
 It pays regular coupons but its redemption value depends on a well-defined credit
event such as a ratings downgrade of an underlying reference asset.
 If the event does not occur, then the investor will receive par value at maturity.
However, if the event occurs, then the investor receives the par value of the CLN
minus the nominal value of the underlying reference asset.
 A CLN therefore allows the issuer to transfer the credit risk to investors. Investors are
willing to buy CLNs because they offer higher coupons as compared to otherwise
similar bonds.
9.3 Participation Instruments
A participation instrument is a type of instrument that allows investors to participate in the
return of an underlying instrument. They give investors indirect exposure to a particular
index or asset price. A floating-rate bond is an example of a participation instrument whose
coupon rate adjusts periodically to a pre-defined formula. Thus, floaters allow investors to

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R40 Fixed Income Markets: Issuance Trading and Funding 2022 Level I Notes

participate in the movements of interest rates.

Most participation instruments are designed to give investors indirect exposure to and
equity index, a specific stock, or to the price of another asset. Unlike capital-protected
instruments that offer equity exposure, participation instruments typically do not offer
capital protection.
9.4 Leveraged Instruments
Leveraged instruments are structured financial instruments that offer higher returns for
small investments. An example of a leveraged instrument is an inverse floater. Unlike a
traditional floater, the cash flows are inversely related to changes in the reference rate.
When the reference rate decreases, the coupon payment of an inverse floater increases.
Inverse floater coupon rate = C - (L * R)
where:
C = the maximum coupon rate reached if the reference rate is equal to zero
L = the coupon leverage. This indicates the multiple the couple rate will change for a 100
basis points change in the reference rate
R = the reference rate on the reset date
Inverse floaters with a coupon leverage rate greater than 0 but lower than 1 are known as
deleveraged inverse floaters. Inverse floaters with a coupon leverage rate greater than 1 are
known as leveraged inverse floaters.

10. Short-Term Bank Funding Alternatives

This section looks at where banks get their funds from in the short-term.
10.1 Retail Deposits
One of the primary sources of funds for a bank is the money deposited by retail (like you and
me) and commercial investors in their accounts. It is the lowest possible source of funding
for a bank. The three types of retail accounts and characteristics of each of these accounts
are discussed below:
Demand deposits or checking accounts
 Depositors have access to funds anytime.
 The funds may be used to pay for transactions.
 Little or no interest is paid.
Savings accounts
 Depositors have access to funds.
 Unlike checking account, savings accounts pay an interest. But they do not offer the
same transactional convenience.

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R40 Fixed Income Markets: Issuance Trading and Funding 2022 Level I Notes

Money market accounts

 Funds are available at short or no notice.
 Offer money market rates of return.
10.2 Short-Term Wholesale Funds
Central Bank Funds
 When a bank receives deposits from customers, a certain percentage of this money
must be kept as a reserve with the national central bank. The amount a bank keeps as
reserves varies based on its financial position: some have a deficit and some have a
surplus.
 The funds stashed in the central bank by all banks are collectively known as the
central bank funds market.
 Assume a bank is running low on cash and a customer wants to withdraw money
from this bank. The bank has two choices. It may withdraw cash from its reserve
account in the central bank to pay the customer, if it has sufficient funds. Or it may
borrow money from banks that have a surplus in their accounts at the central bank.
The funds, known as central bank funds, may be borrowed for a period up to one year
at rates known as central bank funds rates.
 If the borrowing is for one day, it is called overnight funds. If it is for more than one
day, then it is called term funds.
Interbank Funds
 Banks lend to and borrow from each other in the interbank market.
 It is an unsecured system of lending.
 The term may vary from overnight to one year.
 The reference rate at which they borrow is called the interbank offered rate. Or, they
may borrow at a fixed interest rate.
 Often large banks publish two rates: one at which they borrow and one at which they
lend.
Certificates of Deposit
 A certificate of deposit is a savings instrument with a maturity date, a fixed interest
rate, and can be issued in any denomination. The investor or bearer of the certificate
receives an interest at the end of the deposit period. CDs can be issued to individuals,
companies, trusts, funds, etc.
 There are two forms of CD: negotiable and non-negotiable CD.
 In a non-negotiable CD, the interest and deposit are paid at maturity. There is a
penalty if the depositor withdraws funds before maturity.
 In a negotiable CD, depositors are allowed to sell the deposits before maturity.
 There are two types of negotiable CDs:
o Large-denomination CDs: CDs of denomination of $1 million or more; often

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R40 Fixed Income Markets: Issuance Trading and Funding 2022 Level I Notes

traded among institutional investors.

o Small-denomination CDs: of lower denominations and meant for retail
investors.
11. Repurchase and Reverse Repurchase Agreements
A repurchase agreement or repo is a sale and repurchase agreement. It is an agreement
between two parties where the seller sells a security with a commitment to buy the same
security back from the purchaser at an agreed-upon price at a future date. It is similar to
borrowing funds against collateral. Assume there are two parties: banks A and B. A has a 90-
day T-bill that it sells to B for $99.50. It agrees to buy the same T-bill the next day for $99.51.
This was a means of borrowing $99.50 overnight for A. The 1¢ can be considered as the
interest for the borrowed amount.
Structure of Repurchase and Reverse Repurchase Agreements: We will look at some
terms related to repo with the help of the A and B example we saw earlier.
 Reverse repo: It was a repo arrangement from bank A’s (seller of security)
perspective. But from bank B’s perspective (purchaser of security), it is a reverse
repo.
 Repurchase price: The price at which A will buy back the security from B the next day
is called the repurchase price. The price at which the dealer repurchases the security
is called the repurchase price.
 Repurchase date: The date on which the dealer (A) repurchases the security (from B)
is called the repurchase date. In our example, it was the next day.
o Overnight repo: If the repurchase happens the next day, i.e., if the agreement is
for one day, it is called overnight repo.
o Term repo: If the repurchase happens after more than a day, it is called term
repo.
o Repo to maturity: If the agreement is honored until maturity, then it is called
repo to maturity.
 Repo rate: The interest rate negotiated between both the parties is called the repo
rate. In our example, 1¢ was the interest paid.
The factors that affect the repo rate include:
 The risk of the collateral: Highly rated collateral such as sovereign bonds exhibit low
risk and lower repo rates.
 Term of the repurchase agreement: The longer the term, the higher the rates.
 Delivery requirement: If the collateral is delivered to the lender, the rates are lower. If
the underlying collateral is not delivered to the counterparty, then the risk is higher
and so is the repo rate.
 Supply and demand: Collateral in high demand has lower repo rate. If the collateral is
scarce/low supply, the repo rate is lower.

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R40 Fixed Income Markets: Issuance Trading and Funding 2022 Level I Notes

 Interest rates of alternative financing.

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R40 Fixed Income Markets: Issuance Trading and Funding 2022 Level I Notes

Credit Risk Associated with Repurchase Agreements

Both the parties in a repo agreement face the risk of default from the counterparty. There is
credit risk even if the collateral is a highly rated sovereign bond. Let us analyze what
happens when each party defaults.

If the dealer defaults and cannot repurchase the collateral:

 The investor keeps the collateral and retains any income from the same.
 The investor is at a disadvantage if the price of the collateral falls below the
repurchase price (owed by the dealer).
If the investor defaults and cannot deliver the collateral:
 The dealer keeps the cash.
 The dealer is at a disadvantage if the price of the collateral rises above the price
quoted in the repurchase agreement. The dealer now holds less cash than the
collateral’s current value.
 The lender of funds carries a greater credit risk than the dealer. In order to protect
the investor, usually the amount lent is lower than the market value of the collateral.
 Haircut or repo margin = market value of security (collateral) – amount lent to dealer
 The amount of difference or repo margin depends on:
o Length of the repo. The longer the duration of the repo, the higher the risk and
greater the margin.
o Quality of the security used as collateral: The higher the quality, the lower the
margin.
o Creditworthiness of the dealer: The higher the creditworthiness, the lower the
margin.
o Supply and demand: If the collateral is in high demand / low supply then the
repo margin is lower.

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R40 Fixed Income Markets: Issuance Trading and Funding 2022 Level I Notes

Summary
LO.a: Describe classifications of global fixed-income markets.
Fixed-income markets are often classified based on the following criteria:
 The type of issuer: This can be further divided into four categories based on the type
of issuers: households, non-financial corporates, government, and financial
institutions.
 The bond’s credit quality. The bonds must be classified based on their
creditworthiness such as investment-grade, high-yield, or junk bonds.
 Maturity: Long term, medium term, short term.
 Currency denomination.
 Type of coupon: Bonds pay either a fixed rate or a floating rate of interest.
 Geography: Based on where the bonds are issued and sold.
 Other classifications: Among other classifications, we have inflation-linked bonds and
tax-exempt bonds.
LO.b: Describe the use of interbank offered rates as reference rates in floating-rate
debt.
Interbank offered rates are the average interest rates at which banks may borrow unsecured
funds from other banks. The rates differ for different periods ranging from overnight to one
year. Examples of interbank offered rates include Libor, Euribor (Euro interbank offered
rate), Mibor (Mumbai interbank offered rate), etc. In a floating-rate bond, the coupon
payment is linked to a floating rate that is usually a reference rate plus a spread. The
reference rate contributes to most of the coupon rate and is usually an interbank offered
rate.
LO.c: Describe mechanisms available for issuing bonds in primary markets.
Primary markets are markets in which bonds are sold for the first time by an issuer to raise
capital. Bonds may be issued in the primary market through a public offering or a private
placement.
Public offering: Any member of the public may buy the bonds.
Four types are:
 Underwritten offerings: The investment bank buys the entire issue and takes the risk
of reselling it to investors or dealers.
 Best effort offerings: The investment bank serves only as a broker and sells the bond
issue only if it is able to do so.
(Underwritten and best effort offerings are frequently used in the issuance of
corporate bonds).
 Shelf registrations: The issuer files a single document with regulators that allows for
additional future issuances.

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R40 Fixed Income Markets: Issuance Trading and Funding 2022 Level I Notes

 Auction: Price discovery through bidding. It is frequently used in the issuance of

sovereign bonds.
Private placement: Securities are not sold to the public directly, instead the entire issue is
sold to a qualified investor or to a group of investors (typically, large institutions).
LO.d: Describe secondary markets for bonds.
Secondary markets are markets in which existing bonds are subsequently traded among
investors. Most bonds are traded in over-the-counter (OTC) dealer markets. Some bonds are
traded on public exchanges. Institutional investors are the major buyers and sellers of bonds
in secondary markets.
LO.e: Describe securities issued by sovereign governments
Sovereign bonds are issued by national governments, primarily for fiscal reasons. Recently
issued sovereign securities are called on-the-run. Off-the-run refers to securities that were
issued some time ago. Sovereign bonds are not backed by collateral. Instead, they depend on
the taxing authority to repay the debt. The types of sovereign bonds include fixed-rate
bonds, floating-rate bonds and inflation-linked bonds.
LO.f: Describe securities issued by non-sovereign governments, quasi-government
entities, and supranational agencies.
Non-sovereign bonds are issued by local government instead of national government. They
have a higher credit risk than sovereign bonds and therefore demand a higher yield.
Quasi-government bonds or agency bonds are issued by quasi-government entities. These
are not government entities, but they are usually backed by the government. The credit risk
is low. They fund specific projects, and cash flows from the project are used to service the
debt.
Supranational bonds are issued by international organizations such as the World Bank, IMF,
EIB, ADB, etc. They are usually plain-vanilla bonds. Sometimes callable or floaters are also
issued.
LO.g: Describe types of debt issued by corporations.
Debt issued by companies includes the following types:
Bank loans and syndicated paper: A bilateral loan is a loan from a single lender to a single
borrower. A syndicated loan is a loan from a group of lenders, called the syndicate, to a
single borrower.
Commercial paper: It is a flexible, readily available, and low-cost instrument issued by
companies to meet their short-term needs.
Corporate notes and bonds: Corporate bonds can be categorized as short-term, medium-
term, and long-term security. Coupon payments for corporate notes and bonds vary based
on the type of bond. Principal repayment can be based on serial maturity structure, term

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R40 Fixed Income Markets: Issuance Trading and Funding 2022 Level I Notes

maturity structure, and sinking fund arrangement. Corporate bonds have a varying amount
of risk so they are backed by collateral to protect the investors. These bonds can have a call
provision, a put provision, or can be convertible bonds.
LO.h: Describe structured financial instruments
Structured financial instruments include:
 Capital Protected Instruments
 Yield Enhancement Instruments
 Participation Instruments
 Leveraged Instruments
LO.i: Describe the short-term funding alternatives available to banks.
Retail Deposits: One of the primary sources of funds for a bank is the money deposited by
retail investors in their accounts. The three types of retail accounts are demand deposits,
saving accounts, and money market accounts.
Central bank funds: When a bank receives deposits from customers, a certain percentage of
this money must be kept as a reserve with the national central bank. The funds stashed in
the central bank by all banks are collectively known as central bank funds market.
Interbank Funds: Banks lend to and borrow from each other in the interbank market. It is an
unsecured system of lending and the term may vary from overnight to one year.
Certificate of deposit: It is a savings instrument with a maturity date, a fixed interest rate,
and can be issued in any denomination. The investor or bearer of the certificate receives an
interest at the end of the deposit period. There are two forms of CD: negotiable and non-
negotiable CD.
LO.j: Describe repurchase agreements (repos) and the risks associated with them.
A repurchase agreement or repo is a sale and repurchase agreement. It is an agreement
between two parties where the seller sells a security with a commitment to buy the same
security back from the purchaser at an agreed-upon price at a future date. The interest rate
negotiated between both the parties is called the repo rate.
A haircut or repo margin is the difference between the market value of security (collateral)
and the amount lent to the dealer. Repurchase agreements are a common source of funding
for dealer firms and are also used to borrow securities to implement short positions. If you
look at the agreement from a lender’s perspective, it is a reverse repo agreement.

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R40 Fixed Income Markets: Issuance Trading and Funding 2022 Level I Notes

Practice Questions
1. Which of the following best describes a bond issued internationally, outside the
jurisdiction of any one country?
A. Eurobond.
B. Foreign bond.
C. Dual currency bond.

2. An appropriate reference rate for a floating rate note should least likely match the note’s:
A. maturity.
B. currency.
C. reset frequency.

3. In which of the following principal repayment structures bond’s entire principal is paid at
once on maturity?
A. Serial maturity structure.
B. Sinking fund arrangement.
C. Term maturity structure.

4. In which type of primary market transaction does an investment bank buy and resell the
newly issued bonds to investors or dealers?
A. Single-price auction.
B. Best effort offering.
C. Underwritten offering.

5. Transactions in the secondary bond market most likely take place through:
A. dealer markets.
B. brokered markets.
C. organized exchanges.

6. Which of the following best describes sovereign bonds?

A. Bonds backed by the revenues of a specific project of a local government.
B. Bonds backed by the collateral of a national government.
C. Bonds backed by the taxing authority of a national government.

7. A bond issued by a multilateral agency such as the International Monetary Fund (IMF) is
best described as:
A. non-sovereign government bond.
B. supranational bond.
C. quasi-government bond.

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R40 Fixed Income Markets: Issuance Trading and Funding 2022 Level I Notes

8. A bond issue where the specific bonds that will mature and be paid off each year before
final maturity is not known, most likely has a:
A. term maturity
B. serial maturity
C. sinking fund arrangement.

9. Compared to sovereign bonds, non-sovereign bonds with similar characteristics most

likely trade at:
A. a higher yield
B. a higher price.
C. a lower yield.

10. Which of the following statements about negotiable certificates of deposits is most
accurate?
A. They are typically available in small denominations.
B. They can be sold in the open market prior to maturity.
C. A significant penalty is imposed if the depositor withdraws funds prior to maturity.

11. The repo margin on a repurchase agreement is most likely to be higher when:
A. the underlying collateral is in short supply.
B. the maturity of the repurchase agreement is short.
C. the credit risk associated with the underlying collateral is high.

12. Short term wholesale funds are most likely to include:

A. reserve funds.
B. checking accounts.
C. money market accounts.

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R40 Fixed Income Markets: Issuance Trading and Funding 2022 Level I Notes

Solutions

1. A is correct. Eurobonds are issued internationally, outside the jurisdiction of any single
country. B is incorrect because foreign bonds are considered international bonds, but
they are issued in a specific country, in the currency of that country, by an issuer
domiciled in another country. C is incorrect because dual currency bonds make coupon
interest payments in one currency and the principal repayment at maturity in another
currency.

2. A is correct. An appropriate reference rate for a floating-rate note should match its
currency and the frequency of rate resets, such as 6-month U.S. dollar Libor for a
semiannual floating rate note issued in U.S. dollars.

3. C is correct. In a term maturity, bond’s entire principal is paid at once on maturity. It

carries more credit risk. In a serial maturity structure, the bond matures in parts on
several dates throughout the bond’s life. The principal is repaid in parts instead of paying
a lump sum at maturity. A sinking fund arrangement allows for the retirement of bond on
an annual basis based on a random drawing.

4. C is correct. In an underwritten offering the investment bank purchases all of the bond
issue and resells it to the investors or dealers.

5. A is correct. Transactions in the secondary bond market primarily take place through
dealers.

6. C is correct. Sovereign bonds are usually unsecured obligations of the national

government. They are not backed by collateral, but by the taxing authority of the national
government.

7. B is correct. Bonds issued by multilateral agencies that operate across national borders
are called supranational bonds.

8. C is correct. In a serial maturity structure, the bondholders know in advance which bonds
will be retired. In contrast, the bonds retired annually with a sinking fund arrangement
are designated by a random drawing. A is incorrect because a bond issue with a term
maturity structure is paid off in one lump sum at maturity.

9. A is correct. Non-sovereign bonds usually trade at a higher yield and lower price than
sovereign bonds with similar characteristics.

10. B is correct. A negotiable certificate of deposit (CD) allows any depositor (initial or
subsequent) to sell the CD in the open market prior to maturity. A is incorrect because
negotiable CDs are mostly available in large (not small) denominations. C is incorrect
because a penalty is imposed if the depositor withdraws funds prior to maturity for non-

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R40 Fixed Income Markets: Issuance Trading and Funding 2022 Level I Notes

negotiable (instead of negotiable) CDs

11. C is correct. The repo margin is the difference between the market value of the
underlying collateral and the value of the loan. The repo margin is typically higher when
the credit risk associated with the underlying collateral is high. The repo margin is
typically lower if the underlying collateral is in short supply (or if there is a high demand
for it) and when the maturity of the repurchase agreement is short.

12. A is correct. Wholesale funds available for banks include reserve funds, interbank funds,
and certificates of deposit. Retail funds include Demand deposits or checking accounts,
Savings accounts, Money market accounts.

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