Examen CFA Nivel I

“Fixed Income”

Prof. Raúl Calle, CFA

Reading 43: FIXED-INCOME MARKETS: ISSUANCE,
TRADING, AND FUNDING

Focus on different types of issuers, features of the various debt security

structures, and why different sources of funds have different interest costs.
Understand well the differences between fixed-rate and floating-rate debt and
how rates are determined on floating-rate debt and for repurchase agreements.

Programa de preparación: Examen CFA nivel I

 Study Session 14, Fixed Income:

Reading 43: Fixed-Income Markets: Issuance, Trading and Funding.

43.a) Describe classifications of global fixed-income markets.

43.b) Describe the use of interbank offered rates as reference rates in floating-rate debt.
43.c) Describe mechanisms available for issuing bonds in primary markets.
43.d) Describe secondary markets for bonds.
43.e) Describe securities issued by sovereign governments
43.f) Describe securities issued by non-sovereign governments, quasigovernment entities, and
supranational agencies.
43.g) Describe types of debt issued by corporations.
43.h) Describe structured financial instruments.
43.i) Describe short-term funding alternatives available to banks.
43.j) Describe repurchase agreements (repos) and the risks associated with them.

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Programa de preparación: Examen CFA nivel I
43.a) Describe classifications of global fixed-income markets.
• Type of issuer: government and government related, corporate, structured finance
(securitized bonds).

• Credit quality: Standard & Poor’s (S&P), Moody’s ad Fitch.

• Original maturities:
Maturities <= 1 year : money market securities.
Maturities > 1 year: capital market securities.

• Coupon structure: fixed rate vs. floating rate.

• Currency denomination.

• Geography: national, foreign, eurobonds, developed/emergin markets.

• Indexing: e.g. inflation-indexed bonds.

• Tax Status: municipal bonds.

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43.b) Describe the use of interbank offered rates as reference rates in
floating-rate debt.
The most widely used reference rate for floating-rate bonds is the London Interbank Offered Rate
(LIBOR), although other reference rates, such as Euribor, are also used.

The rates are based on expected rates for unsecured loans from one bank to another in the
interbank money market. An average is calculated from a survey of 18 banks’ expected borrowing
rates in the interbank market, after excluding the highest and lowest quotes.

For floating-rate bonds, the reference rate must match the frequency with which the coupon rate
on the bond is reset. For example, a bond denominated in euros with a coupon rate that is reset
twice each year might use 6-month euro LIBOR or 6-month Euribor as a reference rate.

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43.c) Describe mechanisms available for issuing bonds in primary markets.
Primary Markets -> public offering or private placement.

In a public offering of bonds in the primary market is typically done with the help of an investment
bank. The investment bank has expertise in the various steps of a public offering, including:
• Determining funding needs.
• Structuring the debt security.
• Creating the bond indenture.
• Naming a bond trustee (a trust company or bank trust department).
• Registering the issue with securities regulators.
• Assessing demand and pricing the bonds given market conditions.
• Selling the bonds.

Underwriting offering vs. best efforts offering.

U.S. Treasury securities are sold through single price auctions with the majority of purchases made by
primary dealers.

In a shelf registration, a bond issue is registered with securities regulators in its aggregate value with
a master prospectus. Bonds can then be issued over time when the issuer needs to raise funds.
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 43.d) Describe secondary markets for bonds
Secondary markets refer to the trading of previously issued bonds. While some
government bonds and corporate bonds are traded on exchanges, the great majority of
bond trading in the secondary market is made in the dealer or over-the-counter market.

43.e) Describe securities issued by sovereign governments.

National governments or their treasuries issue bonds backed by the taxing power of the
government that are referred to as sovereign bonds. Bonds issued in the currency of the
issuing government carry high credit ratings and are considered to be essentially free of
default risk.

Trading is most active and prices most informative for the most recently issued
government securities of a particular maturity. These issues are referred to as on-the-run
bonds and also as benchmark bonds because the yields of other bonds are determined
relative to the “benchmark” yields of sovereign bonds of similar maturities.

Sovereign governments issue fixed-rate, floating-rate, and inflation-indexed bonds.

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 43.f) Describe securities issued by non-sovereign governments,
quasigovernment entities, and supranational agencies.
Non-sovereign government bonds are issued by states, provinces, counties, and
sometimes by entities created to fund and provide services such as for the construction
of hospitals, airports, and other municipal services.
Non-sovereign bonds are typically of high credit quality, but sovereign bonds typically
trade with lower yields (higher prices) because their credit risk is perceived to be less
than that of non-sovereign bonds.

Agency or quasi-government bonds are issued by entities created by national

governments for specific purposes such as financing small businesses or providing
mortgage financing. In the United States, bonds are issued by government-sponsored
enterprises (GSEs), such as the Federal National Mortgage Association and the Tennessee
Valley Authority.

Supranational bonds are issued by supranational agencies, also known as multilateral

agencies. Examples are the World Bank, the IMF, and the Asian Development Bank. Bonds
issued by supranational agencies typically have high credit quality and can be very liquid,
especially large issues of well-known entities.

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 43.g) Describe types of debt issued by corporations

Bank Debt:
Most corporations fund their businesses to some extent with bank loans. These are
typically LIBOR-based, variable-rate loans. When the loan involves only one bank, it is
referred to as a bilateral loan. In contrast, when a loan is funded by several banks, it is
referred to as a syndicated loan and the group of banks is the syndicate. There is a
secondary market in syndicated loan interests that are also securitized, creating bonds
that are sold to investors.

Commercial Paper:
Short-term unsecured debt instruments (in US. 270 days or less, in other countries as
long as 364 days) issued by corporations. Normally used to fund working capital. Debt
that is temporary until permanent financing can be secured is referred to as bridge
financing. In US. is typically issued as a pure discount security, ECP may be cuoted as
discount yield or an add-on yield.

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Programa de preparación: Examen CFA nivel I
 43.g) Describe types of debt issued by corporations

Corporate Bonds:
With a serial bond issue, bonds are issued with several maturity dates so that a portion of
the issue is redeemed periodically. Investor knows at issuance when specific bonds will
be redeemed. A bond issue that does not have a serial maturity structure is said to have a
term maturity structure with all the bonds maturing on the same date.

Short term bonds < 5 years

5 years < Medium term bonds < 12 years
Long term bonds > 12 years.

Corporations issue debt securities called medium-term notes (MTNs), which are not
necessarily medium-term in maturity. MTNs are issued in various maturities, ranging from
nine months to periods as long as 100 years. Can be customized to meet investor
specifications.

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Programa de preparación: Examen CFA nivel I
 43.h) Describe structured financial instruments.

Structured financial instruments are securities designed to change the risk profile of an
underlying debt security, often by combining a debt security with a derivative.

Structured instruments (others than ABS an collateralized obligations):

1. Yield enhancement instruments:

Credit-linked-notes (CLN) has regular coupon payments, but its redemption value
depends on whether a specific credit event occurs. If the credit event (e.g., a credit
rating downgrade or default of a reference asset) does not occur, the CLN will be
redeemed at its par value. If the credit event occurs, the CLN will make a lower
redemption payment. The yield on a CLN is higher than it would be on the note
alone, without the credit link. This extra yield compensates the buyer of the note
(seller of the CDS) for taking on the credit risk of the reference asset.

2. Capital protected instruments:

Offers a guarantee of a minimum value at maturity as well as some potential
upside gain. If guaranteed payoff is equal to the initial cost of the structured
security the security is called guarantee certificate.

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 43.h) Describe structured financial instruments.
3. Participation instruments :
A participation instrument has payments that are based on the value of an
underlying instrument, often a reference interest rate or equity index.
Participation instruments do not offer capital protection. One example of a
participation instrument is a floating-rate note.

4. Leveraged instruments :
An inverse floater is an example of a leveraged instrument. An inverse floater has
coupon payments that increase when a reference rate decreases and decrease
when a reference rate increases, the opposite of coupon payments on a floating-
rate note. A simple structure might promise to pay a coupon rate, C, equal to a
specific rate minus a reference rate, for example, C = 6% − 180-day LIBOR. When
180-day LIBOR increases, the coupon rate on the inverse floater decreases.
Inverse floaters can also be structured with leverage so that the change in the
coupon rate is some multiple of the change in the reference rate.
• Leveraged inverse floater -> multiplier is greater or equal than 1.
• Deleveraged inverse floater -> multiplier is less than 1.

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 43.i) Describe short-term funding alternatives available to banks.
Customer deposits (retail deposits) are a short-term funding source for banks. In addition
to funds from retail accounts, banks offer interest-bearing certificates of deposit (CDs)
that mature on specific dates and are offered in a range of short-term maturities.
Nonnegotiable CDs cannot be sold and withdrawal of funds often incurs a significant
penalty.

Another source of short-term funding for banks is to borrow excess reserves from other
banks in the central bank funds market. In the market for central bank funds, banks with
excess reserves lend them to other banks for periods of one day (overnight funds) and for
longer periods up to a year (term funds). Central bank funds rates refer to rates for these
transactions, which are strongly influenced by the effect of the central bank’s open
market operations on the money supply and availability of short-term funds.

Other than reserves on deposit with the central bank, funds that are loaned by one bank
to another are referred to as interbank funds. Interbank funds are loaned between banks
for periods of one day to a year.

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Programa de preparación: Examen CFA nivel I
 43.j) Describe repurchase agreements (repos) and the risks
associated with them.
A repurchase (repo) agreement is an arrangement by which one party sells a security to a
counterparty with a commitment to buy it back at a later date at a specified (higher)
price.
The percentage difference between the market value and the amount loaned is called the
repo margin or the haircut.

Viewed from the standpoint of a bond dealer, a reverse repo agreement refers to taking
the opposite side of a repurchase transaction, lending funds by buying the collateral
security rather than selling the collateral security to borrow funds.

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Programa de preparación: Examen CFA nivel I
 ¡GRACIAS!

Programa de preparación: Examen CFA nivel I