Money market:

MONEY MARKET SECURITIES:

Money market securities are debt securities with a maturity of one year or less.

They are issued in the primary market through a telecommunications network by the Treasury,
corporation, and financial intermediaries that wish to obtain short-term financing

Corporations issue money market securities and use the proceeds to support their existing operations or
to expand their operations.

Money market securities are commonly purchased by households, corporations (including Financial
institutions), and government agencies that have funds available for a short-term period. Because
money market securities have a short-term maturity and can typically be sold in the secondary market,
they provide liquidity to investors.

The more popular money market securities are:

Treasury bills (T-bills)

■ Commercial paper

■ Negotiable certificates of deposit

■ Repurchase agreements

■ Federal funds

■ Banker’s acceptances

Each of these instruments is described in turn.

Treasury bills

When the U.S. government needs to borrow funds, the U.S. Treasury frequently issues Short-term
securities known as Treasury bills. The Treasury issues T-bills with 4-week,13-week, and 26-week
maturities on a weekly basis. It periodically issues T-bills with Terms shorter than four weeks, which are
called cash management bills.

Investors in Treasury Bills

Many individuals invest in T-bills indirectly by investing in money market funds, Which in turn purchase
large amounts of T-bills. Corporations invest in T-bills so that They have easy access to funding if they
suddenly incur unanticipated expenses.

Credit Risk

Treasury bills are attractive to investors because they are backed by the federal government and are
therefore virtually free of credit (default) risk

Liquidity

Another attractive feature of T-bills is their liquidity, which is due to their Short maturity and strong
secondary market.

Commercial Paper

Commercial paper is a short-term debt instrument issued only by well-known, credit-Worthy firms that
is typically unsecured. It is normally issued to provide liquidity or to Finance a firm’s investment in
inventory and accounts receivable. The issuance of commercial paper is an alternative to short-term
bank loans. Some large firms prefer to issue commercial paper rather than borrow from a bank because
it is usually a cheaper source Of funds

Denomination

The minimum denomination of commercial paper is usually $100,000, and typical denominations are in
multiples of $1 million. Maturities are normally between 20 and 45 days but can be as short as 1 day or
as long as 270 days.

Credit Risk
Because commercial paper is issued by corporations that are susceptible To business failure, commercial
paper is subject to credit risk. The risk of default is Affected by the issuer’s financial condition and cash
flow

Credit Risk Ratings

Commercial paper is commonly rated by rating agencies such As Moody’s Investors Service, Standard &
Poor’s Corporation, and Fitch Investor Service.

Placement Some firms place commercial paper directly with investors. Other firms Rely on commercial
paper dealers to sell their commercial paper at a transaction cost of About one-eighth of 1 percent of
the face value.

Backing Commercial Paper

Some commercial paper is backed by assets of the issuer. Commercial paper that is backed by assets
should offer a lower yield than if it Were not secured by assets

Negotiable Certificates of Deposit

Negotiable certificates of deposit (NCDs) are certificates issued by large commercial Banks and other
depository institutions as a short-term source of funds. The minimum Denomination is $100,000,
although a $1 million denomination is more common. NonfiNancial corporations often purchase NCDs

Maturities on NCDs normally range from two weeks to one year. A secondary market For NCDs exists,
providing investors with some liquidity.

Placement

Some issuers place their NCDs directly; others use a correspondent institution that specializes in placing
NCDs. Another alternative is to sell NCDs to securities dealers who in turn resell them. A portion of
unusually large issues is commonly sold to NCD dealers. Normally, however, NCDs can be sold to
investors directly at a higher Price.
Yield

Negotiable certificates of deposit provide a return in the form of interest along With the difference
between the price at which the NCD is redeemed (or sold in the secondary market) and the purchase
price.

Repurchase Agreements

With a repurchase agreement (or repo), one party sells securities to another with an Agreement to
repurchase the securities at a specified date and price. In essence, the repo Transaction represents a
loan backed by the securities. If the borrower defaults on the Loan, the lender has claim to the
securities. Most repo transactions use government securities, although some involve other securities
such as commercial paper or NCDs. A reverse repo refers to the purchase of securities by one party from
another with anAgreement to sell them.

Placement

Repo transactions are negotiated through a telecommunications network. Dealers and repo brokers act
as financial intermediaries to create repos for firms with Deficient or excess funds, receiving a
commission for their services.

Federal Funds

The federal funds market enables depository institutions to lend or borrow short-term Funds from each
other at the so-called federal funds rate.

This rate is charged on federalFunds transactions, and it is influenced by the supply of and demand for
funds in the federal funds market.
The federal funds rate is normally slightly higher than the T-bill rate at any given Time. A lender in the
federal funds market is subject to credit risk, since it is possible That the financial institution borrowing
the funds could default on the loan.

Commercial banks are the most active participants in the federal funds market. Federal funds brokers
serve as financial intermediaries in the market, matching up institutions that wish to sell (lend) funds
with those that wish to purchase (borrow) them. The brokers receive a commission for their service.

Banker’s Acceptances

A banker’s acceptance indicates that a bank accepts responsibility for a future payment. Banker’s
acceptances are commonly used for international trade transactions. An Exporter that is sending goods
to an importer whose credit rating is not known will Often prefer that a bank act as a guarantor.

Maturities On banker’s acceptances typically range from 30 to 270 days. Because there is a possibility
that a bank will default on payment, investors are exposed to a slight degree of credit Risk.
BACKGROUND ON BONDS

Bonds are long-term debt securities that are issued by government agencies or corporations. The issuer
of a bond is obligated to pay interest (or coupon) payments periodically (such as annually or
semiannually) and the par value (principal) at maturity.

Bonds are issued in the primary market through a telecommunications network.

Most bonds have maturities of between 10 and 30 years. Bonds are classified by the Ownership
structure as either bearer bonds or registered bonds. Bearer bonds require The owner to clip coupons
attached to the bonds and send them to the issuer to receive Coupon payments. Registered bonds
require the issuer to maintain records of who owns The bond and automatically send coupon payments
to the owners

Bonds are often classified according to the type of issuer. Treasury bonds are issued by The U.S.
Treasury, federal agency bonds are issued by federal agencies, municipal bonds are Issued by state and
local governments, and corporate bonds are issued by corporations.

TREASURY AND FEDERAL AGENCY BONDS

The U.S. government, like many country governments, commonly wants to use a fiscal Policy of
spending more money than it receives from taxes.

Government Needs to borrow funds to cover the difference between what it wants to spend versus
What it receives.

To facilitate its fiscal policy, the U.S. Treasury issues Treasury notes And Treasury bonds to finance
federal government expenditures. The Treasury notes and bonds are free from credit (default) risk, they
enable the Treasury to borrow funds at a relatively low cost.

The minimum denomination for Treasury notes and bonds is now $100.
The key difference between a note and a bond is that note maturities are less than 10 years whereas
Bond maturities are 10 years or more.

Investors in Treasury notes and bonds receive semiannual interest payments from the Treasury. , it Is
free from any state and local taxes.

Treasury Bond Auctions

The Treasury obtains long-term funding through Treasury bond offerings, which are conducted through
periodic auctions. Treasury bond auctions are normally held in the middle Of each quarter.

Trading Treasury Bonds

Bond dealers serve as intermediaries in the secondary market by matching up buyers and Sellers of
Treasury bonds, and they also take positions in these bonds

These dealers make the secondary market for the Treasury bonds. They quote a bid price for customers
who want to sell existing Treasury Bonds to the dealers and an ask price for customers who want to buy
existing Treasury Bonds from them.

Investors can contact their broker to buy or sell Treasury bonds. The brokerage firms Serve as an
intermediary between the investors and the bond dealers. Discount brokers Usually charge a fee of
between $40 and $70 for Treasury bond transactions

Stripped Treasury Bonds

The cash flows of Treasury bonds are commonly transformed (stripped) by securities Firms into separate
securities. A Treasury bond that makes semiannual interest payments Can be stripped into several
individual securities. One security would represent the payment of principal upon maturity. Each of the
other securities would represent payment Of interest at the end of a specified period.

Inflation-Indexed Treasury Bonds

These bonds, commonly referred to as TIPS (Treasury Inflation-Protected Securities), are intended for
investors who wish to ensure that the returns on their Investments keep up with the increase in prices
over time. The principal value is increased by the amount of the U.S. inflation rate every six months.

Savings Bonds

Savings bonds are issued by the Treasury, but they can be purchased from many financial institutions.
They are attractive to small investors because they can be purchased With as little as $25.

Savings bonds have a 30-year maturity and do not have a secondary market.

Federal Agency Bonds

Federal agency bonds are issued by federal agencies. The Federal National Mortgage association

Issue bonds and use the proceeds to purchase mortgages in the secondary market. Thus they channel
funds into the mortgage market,

MUNICIPAL BONDS

Municipal bond refers a bond or fixed income security that is issued by a government municipality,
township, or state to finance its governmental projects.

Municipal Bonds typically promise semiannual interest Payments. Common purchasers of these bonds
include financial and nonfinancial institutions as well as individuals.

A secondary market exists for them, although it is less active than the one for Treasury bonds. A
municipality may exercise its Option to repurchase the bonds if interest rates decline substantially
because it can then Reissue bonds at the lower interest rate and thus reduce its cost of financing.

Credit Risk of Municipal Bonds

Both types of municipal bonds are subject to some degree of credit (default) risk. If a Municipality is
unable to increase taxes, it could default on general obligation bonds. If It issues revenue bonds and
does not generate sufficient revenue, it could default on these Bonds.

Variable-Rate Municipal Bonds

In general, variable-rate municipal bonds are desirable to investors who Expect that interest rates will
rise. However, there is the risk that interest rates may Decline over time, which would cause the coupon
payments to decline as well.

Tax Advantages of Municipal Bonds

One of the most attractive features of municipal bonds is that the interest income is normally exempt
from federal taxes.

Trading and Quotations of Municipal Bonds

There are hundreds of bond dealers that can accommodate investor requests to buy or sell Municipal
bonds in the secondary market Investors who expect that they will not hold a municipal bond until
maturity should Consider only bonds that feature active secondary market trading.

Yields Offered on Municipal Bonds

The yield offered by a municipal bond differs from the yield on a Treasury bond with The same maturity
for three reasons. First, the municipal bond must pay a risk premium To compensate for the possibility
of default risk. Second, the municipal bond must pay a Slight premium to compensate for being less
liquid than Treasury bonds with the same Maturity. Third, as mentioned previously, the income earned
from a municipal bond is Exempt from federal taxes.

CORPORATE BONDS

Corporate bonds are long-term debt securities issued by corporations that promise the Owner coupon
payments (interest) on a semiannual basis. And their maturity is typically between 10 and 30 years. The
interest paid by the corporation to investors is tax deductible to the corporation, Which reduces the cost
of financing with bonds

Corporate Bond Offerings

Public Offering

Corporations commonly issue bonds through a public offering. A Corporation that plans to issue bonds
hires a securities firm to underwrite the bonds. IF the offering is too large or the price is too high,

There may not be enough investors who are willing to purchase the bonds. In this case, the Underwriter
will have to lower the price in order to sell all the bonds. For some bond offerings, the arrangement
between the underwriter and the issuer is a Firm commitment, whereby the underwriter guarantees the
issuer that all bonds will be Sold at a specified price.

Private Placement

Some corporate bonds are privately placed rather than sold in A public offering. A private placement
does not have to be registered with the SEC. Small Firms that borrow relatively small amounts of funds
(such as $30 million) may consider Private placements rather than public offerings

Credit Risk of Corporate Bonds

Corporate bonds are subject to the risk of Default, and the yield paid by corporations that issue bonds
contains a risk premium to Reflect the credit risk When the economy is strong, firms generate higher
revenue and Are better able to meet their debt payments. When the economy is weak, some firms May
not generate sufficient revenue to cover their operating and debt expenses and Hence default on their
bonds.

Bond Ratings as a Measure of Credit Risk

When corporations issue bonds, They hire rating agencies to have their bonds rated. Corporate bonds
that receive higher ratings can be placed at higher prices (lower yields) because they are perceived to
have lower Credit risk.

Junk Bonds

Corporate bonds that are perceived to have very high risk are referred to As junk bonds. The primary
investors in junk bonds are mutual funds, life insurance companies, and pension funds. Some bond
mutual funds invest only in bonds with high ratings, but there are more than a hundred high-yield
mutual funds that commonly invest in Junk bonds. High-yield mutual funds allow individual investors to
invest in a diversified Portfolio of junk bonds with a small investment. Junk bonds offer high yields that
contain A risk premium (spread) to compensate investors for the high risk.

Secondary Market for Corporate Bonds

Corporate bonds have a secondary market, so investors who purchase them can sell Them to other
investors if they prefer not to hold them until maturity. The value of all corporate bonds in the
secondary market exceeds $5 trillion.

Dealer Role in Secondary Market

The secondary market is served by bond dealers, who can play a broker role by matching up buyers and
sellers. Bond dealers also have an inventory of bonds.

•Dealers commonly handle large transactions, such as those valued at more than $1 million.

Liquidity in Secondary Market

Bonds issued by large, well-known corporations in large volume are liquid because they attract a large
number of buyers and sellers in

The secondary market.

•Bonds issued by small corporations in small volume are less liquid because there may be few buyers (or
no buyers) for those bonds in some periods

•Thus investors who wish to sell these bonds in the secondary market may have to accept a discounted
price in order to attract buyers.

Trading Online

Orders to buy and sell corporate bonds are increasingly being placed online. For example, popular online
bond brokerage websites are www.schwab.com and http://us.etrade.com.
• The pricing of bonds is more transparent online because investors can easily compare the bid and ask
spreads among brokers.

This transparency has encouraged some brokers to narrow their spreads so that they do not lose
business to competitors.

Types of Orders Through Brokers

Individual investors buy or sell corporate bonds through brokers, who communicate the orders to bond
dealers.

• Investors who wish to buy or sell bonds can normally place a market order in this case, the desired
transaction will occur at the prevailing market price.

• limit order; in this case, the transaction will occur only if the price reaches the specified limit. When
purchasing bonds, investors use a limit order to specify the maximum limit price they are willing to pay
for a bond.

Electronic Bond Networks

Electronic bond networks have recently been established that can match institutional investors that
wish to sell some bond holdings or purchase additional bonds in the over-the-counter bond market at a
lower transaction cost.

•The institutional investors that wish to purchase bonds can use the platforms to identify bond holdings
that are for sale by other institutional investors in the secondary market.

• And can purchase the bonds electronically, without relying on bond dealers.

They pay a small fee (percentage of their transactions) for the use of the trading plat-

Characteristics of Corporate Bonds

Bonds are not as standardized as stocks. A single corporation may issue more than 50 Different bonds
with different maturities and payment terms. Some of the characteristics That differentiate one bond
from another are identified here.
Sinking-Fund Provision

A sinking fund is maintained by companies for bond issues, and is money set aside or saved to pay off a
debt or bond.

Protective Covenants

Call Provisions

A call provision normally requires the firm to pay a price above par value When it calls its bonds. The
difference between the bond’s call price and par value is The call premium. Call provisions have two
principal uses. First, if market interest rates Decline after a bond issue has been sold, the firm might end
up paying a higher rate of Interest than the prevailing rate for a long period of time.

Bond Collateral

Bonds can be classified according to whether they are secured by Collateral and by the nature of that
collateral. Usually, the collateral is a mortgage on real Property (land and buildings). A first mortgage
bond has first claim on the specified Assets. A chattel mortgage bond is secured by personal property.

Low- and Zero-Coupon Bonds

Low-coupon bonds and zero-coupon bonds are Long-term debt securities that are issued at a deep
discount from par value. Investors are Taxed annually on the amount of interest earned, even though
much or all of the interest Will not be received until maturity.

Variable-Rate Bonds

Variable-rate bonds (also called floating-rate bonds) are Long-term debt securities with a coupon rate
that is periodically adjusted.

Convertibility
A convertible bond allows investors to exchange the bond for a Stated number of shares of the firm’s
common stock.

How Corporate Bonds Finance Restructuring

Firms can issue corporate bonds to finance the restructuring of their assets and to revise Their capital
structure.

Using Bonds to Finance a Leveraged Buyout

A leveraged buyout (LBO) Involves the use of debt to purchase shares and take a company private.

Using Bonds to Revise the Capital Structure

Corporations commonly issue Bonds in order to revise their capital structure. If they believe that they
will have sufficient cash flows to cover their debt payments, they may consider using more debt and Less
equity,

OTHER TYPES OF LONG-TERM DEBT SECURITIES

Structured Notes

Firms may borrow funds by issuing structured notes. For these notes, the amount of Interest and
principal to be paid is based on specified market conditions.

Exchange-Traded Notes