FIXED-INCOME MARKETS: ISSUANCE,

TRADING, AND FUNDING

CHAPTER 2

© 2016 CFA Institute. All rights reserved.

TABLE OF CONTENTS
01 INTRODUCTION
02 OVERVIEW OF GLOBAL FIXED-INCOME MARKETS
03 PRIMARY AND SECONDARY BOND MARKETS
04 SOVEREIGN BONDS
05 NON-SOVEREIGN GOVERNMENT, QUASI-GOVERNMENT, AND
SUPRANATIONAL BONDS
06 CORPORATE DEBT
07 SHORT-TERM FUNDING ALTERNATIVES AVAILABLE TO BANKS
08 SUMMARY

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 1. INTRODUCTION
•Global fixed-income markets represent the largest subset
of financial markets in terms of number of issuances and
market capitalization.
•In 2010, global fixed-income markets were three times
larger than global equity markets.
•Understanding how fixed-income markets are structured
and how they operate is important for debt issuers and
investors.
- Debt issuers have financing needs that must be met.

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 2. OVERVIEW OF
GLOBAL FIXED-INCOME MARKETS
•Common criteria to classify fixed-income markets:

Type of issuer

Bond maturity, credit quality, geography, currency

denomination, and type of coupon

Bond issue and trading location

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CLASSIFICATION OF FIXED-INCOME MARKETS
Supranational

Government-r
National
elated sector

Structured Local
Type of Issuer finance
(securitized)
sector
Financial
Corporate
sector
Non-financial

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CLASSIFICATION OF FIXED-INCOME MARKETS
Maturity

• Maturities range from overnight to perpetuity:

• Money market securities are fixed-income securities with
maturity up to one year.
• Capital market securities are fixed-income securities with
maturity longer than one year.

Credit Quality

• Credit quality is either investment grade or

non-investment grade.

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CLASSIFICATION OF FIXED-INCOME MARKETS
Geography

• The largest markets are the US (40%), Japan (19%),

and the UK (6%), followed by the continental European
countries.
Currency Denomination

• The most popular currencies are the EUR, USD, GBP,

and JPY.
Type of Coupon

• Coupons are either fixed rate or floating rate.

• The market’s demand and supply of fixed- versus
floating-coupon bonds are determined by the risk
management considerations of participants.
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CLASSIFICATION OF FIXED-INCOME MARKETS
Reference Rates
• Different reference rates are used depending on where
the bonds are issued and the currency denomination.
• The choice of reference rate is very important because
it determines the issuer’s cost of financing and the
investor’s return.
• Libor (London interbank offered rate) is the common
reference rate for floating-rate notes (FRNs), particularly
in the Eurobond market.
• Libor rates reflect the rates at which a select set of
banks believe they could borrow unsecured debt from
other banks.
• interbank money market

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CLASSIFICATION OF FIXED-INCOME MARKETS

Fixed-Income Indices
• A fixed-income index is a multi-purpose tool used by
investors and investment managers to describe a given
bond market or sector, as well as to evaluate the
performance of investments and investment managers.
• Most fixed-income indices are constructed as portfolios
of securities that reflect a particular bond market or
sector.
• Index weighting may be based on price or value
(market capitalization).

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CLASSIFICATION OF FIXED-INCOME MARKETS
Investors in Fixed-Income Securities

• invest directly in fixed-income securities

Central • use open market operations to implement
banks monetary policy

Institutional • invest directly in fixed-income securities

investors
• invest indirectly through fixed-income mutual
Retail funds or exchange-traded funds (ETFs)
investors because of the higher complexity and
diversity of bond markets

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3. PRIMARY AND SECONDARY BOND MARKETS

Primary Secondary
bond bond
markets Issuers first sell markets Existing bonds
bonds to are subsequently
investors to raise traded among
capital. investors.

A bond issue in primary markets

can be sold via

a public offering (or public offer), a private placement, in which

in which any member of the OR only a selected group of
public may buy the bonds, investors may buy the bonds.
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 PRIMARY BOND MARKETS
Public Offerings

Underwritten
Best effort offerings Auctions
offerings

The investment bank These are bond

The investment bank only serves as a issuing mechanisms
guarantees the sale broker. It only tries to that involve bidding.
of the bond issue at sell the bond issue at In many countries,
an offering price that the negotiated most sovereign
is negotiated with the offering price if it is bonds are sold to the
issuer. able to for a public via a public
commission. auction.

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 PRIMARY BOND MARKETS
Underwritten Offerings
• Underwritten offerings are typical bond-issuing mechanisms for
corporate bonds, some local government bonds, and some
securitized instruments.
• The underwriting process typically includes six phases:

Determining Structuring the Issuing the

funding needs transaction bonds

Selecting the Pricing the bond Delivering

underwriter issue the bonds

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 PRIMARY BOND MARKETS

• A shelf registration allows certain authorized issuers to offer

additional bonds to the general public without having to prepare
a new and separate offering circular for each bond issue.
• Rather, the issuer prepares a single, all-encompassing offering
circular that describes a range of future bond issuances, all
under the same document.

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 SECONDARY BOND MARKETS
•There are two main ways for secondary markets to be
structured:
An organized
exchange provides a
place where buyers and
In contrast, in
sellers can meet to
over-the-counter (OTC)
arrange their trades.
markets buy and sell
Although buy or sell
orders initiated from
orders may come from
various locations are
anywhere, the
matched through a
transaction must take
communications
place at the exchange
network.
according to the rules
imposed by the
exchange.

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 4. SOVEREIGN BONDS
•Sovereign bonds are the bonds issued by national
governments. Bond names vary depending on the country
of issue and the bond’s maturity.

In the United States, Treasury bills (T-bills) are one year or

shorter, Treasury notes (T-notes) have maturity between 1
year and 10 years, and Treasury bonds (T-bonds) have an
original maturity of longer than 10 years.

•The majority of the trading in secondary markets is of

sovereign securities that were most recently issued. These
securities are called “on the run.”

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 SOVEREIGN BONDS
•Sovereign bonds are usually unsecured obligations of the
sovereign issuer. That is, they are not backed by collateral
but by the taxing authority of the national government.

Local currency Foreign currency

sovereign bonds have sovereign bonds’ credit
low(er) credit risk risk depends on the
because of the taxing and strength of the national
money-issuing power of economy and
the government. government finances.

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 SOVEREIGN BONDS
•National governments issue different types of bonds, such
as the following:
Fixed-rate bonds are by far are the most common type
of sovereign bond. Two types of fixed-rate bonds are
common: zero-coupon bonds (or pure discount bonds)
and coupon bonds.
Some national governments around the world issue
bonds with a floating rate of interest that resets
periodically based on changes in the level of a
reference rate, such as Libor.

Many national governments issue inflation-linked

bonds, or linkers, whose cash flows are adjusted for
inflation.

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5. NON-SOVEREIGN GOVERNMENT,
QUASI-GOVERNMENT, AND SUPRANATIONAL
BONDS

Non-sovereign
government Issued by governments
bonds below the national level,
such as provinces, regions,
states, and cities.

• These bonds are typically issued to finance public projects, such as schools,
motorways, hospitals, bridges, and airports.
• The sources for paying interest and repaying the principal include the taxing
authority of the local government, the cash flows of the project the bond issue
is financing, and special taxes and fees established specifically for the purpose
of making interest payments and principal repayments.

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5. NON-SOVEREIGN GOVERNMENT,
QUASI-GOVERNMENT, AND SUPRANATIONAL
BONDS
Quasi-gover
nment Issued by quasi-government
bonds organizations, which are established
to perform some functions for the
government.
• Most quasi-government bonds do not offer an explicit guarantee by the national
government, although investors often perceive an implicit guarantee.
• Quasi-government entities typically do not have direct taxing authority; instead,
bonds are repaid from the cash flows generated by the entity or from the
project the bond issue is financing.

Supranational
bonds
Issued by supranational agencies, such as the
World Bank, the International Monetary Fund (IMF),
and the Asian Development Bank (ADB).

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 NON-SOVEREIGN GOVERNMENT,
QUASI-GOVERNMENT, AND SUPRANATIONAL
BONDS
Quasi-gover are issued by quasi-government organizations, which
nment bonds are established to perform some functions for the
government.

Most quasi-government bonds do not offer an explicit

guarantee by the national government, although
investors often perceive an implicit guarantee.

Quasi-government entities typically do not have direct

taxing authority; instead, bonds are repaid from the
cash flows generated by the entity or from the project
the bond issue is financing.

Supranational are issued by supranational agencies, such as the

bonds World Bank, the International Monetary Fund (IMF),
and the Asian Development Bank (ADB).

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 6. CORPORATE DEBT
Companies raise debt as part of their overall capital
structure, both to fund short-term spending needs (e.g.,
working capital) as well as long-term capital investments.

Sources of debt
capital for
companies:

Bank loans and Corporate notes

Commercial paper
syndicated loans and bonds

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 CORPORATE DEBT

• A bilateral loan is from a single lender to a single

borrower.
Bilateral • Bank loans are the primary source of debt
loan financing for small and medium-size companies
as well as for large companies in countries where
bond markets are underdeveloped.

• A syndicated loan is from a group of lenders,

called the “syndicate,” to a single borrower.
Syndicated • Syndicated loans are primarily originated by
loan banks, and the loans are extended to companies
but also to governments and government-related
entities.

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 CORPORATE DEBT
• Commercial paper is a short-term, unsecured
promissory note issued in the public market or via
a private placement that represents a debt
obligation of the issuer.
• It is a valuable source of flexible, readily available,
and relatively low-cost short-term financing.
• It is a source of funding for working capital and
Commercial seasonal demands for cash.
paper • The maturity of commercial paper can range from
overnight to one year, but a typical issue matures in
less than three months.
• The largest issuers of commercial paper are financial
institutions, but some non-financial companies are
also regular issuers of commercial paper.
• Most commercial paper is of high credit quality.

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 CORPORATE DEBT
• Corporate notes and bonds are the debt instruments issued by
private companies and have the following characteristics:

Can be privately placed or sold in public markets

Range in maturity from 1 to over 30 years

May have fixed, floating, payment-in-kind (PIK), or
zero-coupon structures
May have a serial or term maturity structure

May be unsecured or backed by collateral of various forms

May have various contingency provisions

Mostly traded over the counter

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 7. SHORT-TERM FUNDING ALTERNATIVES
AVAILABLE TO BANKS
•Financial institutions, such as banks, have larger financing
needs than non-financial companies because of the nature
of their operations.

Banks have access to funds from these sources:

The wholesale market—for

The retail market—for example, central bank funds,
example, deposits from their interbank deposits, certificates
customers of deposit, and repurchase
agreements

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 SHORT-TERM FUNDING ALTERNATIVES
AVAILABLE TO BANKS
Repurchase agreements

Repurchase agreements are an important source of

funding not only for banks but also for other market
participants.

A repurchase agreement, or repo, is the sale of a

security with a simultaneous agreement by the seller
to buy the same security back from the purchaser at
an agreed-on price and future date.
A repurchase agreement can be viewed as a
collateralized loan in which the security sold and
subsequently repurchased represents the collateral
posted.

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 SHORT-TERM FUNDING ALTERNATIVES
AVAILABLE TO BANKS
Repurchase • Price at which the dealer repurchases the
price security

Repurchase • Date when the security is repurchased, often the

date next business day

• Interest rate on a repurchase agreement

• Affected by the risk associated with collateral,
Repo rate the repo term, the delivery requirement, the
supply and demand conditions of the collateral,
and the interest rates of alternative financing
• Difference between the market value of the
Repo margin security used as collateral and the value of the
loan

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 8. SUMMARY
Classifications of fixed-income markets

• The most widely used ways of classifying fixed-income

markets include the type of issuer; bond maturity, credit
quality, geography, currency denomination, and type of
coupon; and where the bonds are issued and traded.

Use of interbank offered rate as a reference rate

• Interbank offered rates, such as Libor, are the most

commonly used reference rates for floating-rate debt and
other financial instruments.
• Interbank offered rates are sets of rates that reflect the rates
at which banks believe they could borrow unsecured funds
from other banks in the interbank market for different
currencies and different maturities.

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 SUMMARY
Bond issuance in primary markets
• There are two mechanisms for issuing a bond in primary
markets: a public offering, in which any member of the public
may buy the bonds, or a private placement, in which only an
investor or small group of investors may buy the bonds either
directly from the issuer or through an investment bank.
Secondary markets for bonds
• Most bonds are traded in over-the-counter (OTC) markets, and
institutional investors are the major buyers and sellers of bonds
in secondary markets.
Sovereign bonds
• Sovereign bonds are issued by national governments primarily
for fiscal reasons. They take different names and forms
depending on where they are issued, their maturities, and their
coupon types.
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 SUMMARY
Non-sovereign government and supranational bonds
• Local governments, quasi-government entities, and
supranational agencies issue bonds, which are named
non-sovereign, quasi-government, and supranational bonds,
respectively.

Corporate bonds
• Companies raise debt in the form of bilateral loans,
syndicated loans, commercial paper, notes, and bonds.

Banks’ funding alternatives

• Financial institutions have access to additional sources of
funds, such as retail deposits, central bank funds, interbank
funds, large-denomination negotiable certificates of deposit,
and repurchase agreements.

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 SUMMARY
Repurchase agreements

• A repurchase agreement is similar to a collateralized loan.

• It involves the sale of a security (the collateral) with a
simultaneous agreement by the seller (the borrower) to buy
the same security back from the purchaser (the lender) at an
agreed-on price in the future.
• Repurchase agreements are a common source of funding for
dealer firms and are also used to borrow securities to
implement short positions.

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