bond markets (print)

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Fixed Income and Risk Management

Bond Markets

Fall 2004, Term 2

© Michael W. Brandt, 2004 All rights reserved without exception

Notes:



− 2 − Bond Markets© Michael W. Brandt 2004

Agenda and key issues

• Introduction to bonds

– Definition – Types

• U.S. Treasury securities

– Importance

– Types

– Auctions

– Quotes and trading

• Repurchase agreements – Definition

– Importance

– Financing a bond purchase

– Specials

Notes:



Introduction to bonds

Notes:




Definition

• A bond is a financial security in which issuer promises to makeinterest and principal payments to holder

• Bonds are primarily characterized by

– Maturity date = date of last promised payment

– Face, par, or principal value = promised payment at maturity

– Coupon = promised payments prior to maturity

• There are other differentiating features: embedded options,special tax treatments, inflation protection, seniority, etc

I n t r o d u c t i o n t o b o n d s

Notes:




Repayment types

• Pure discount or zero-coupon bonds

– Pay no coupons prior to maturity – Pay principal of bond at maturity

• Fixed-rate or coupon-bearing bonds

– Pay fixed coupon at periodic intervals prior to maturity

– Pay principal of bond at maturity

• Floating-rate bonds

– Pay variable coupon linked to reference rate

– Pay principal of bond at maturity


Notes:




Repayment types (cont)

• Perpetual or consol bonds

– No maturity date – Pay fixed coupon at periodic intervals

• Annuities or self-amortizing bonds

– Pay fixed amount at periodic intervals prior to maturity consistingof coupon and partial principal payment

– Principal is repaid over time rather than as lump sum at maturity


Notes:




Bond issuers


Foreign govt of emerging marketsBrady bonds

Foreign govt, banks, and corpsEuro bonds

Banks and corpsAsset backed securities

Foreign govtSovereign bonds

State and local govtMunicipal bonds

CorpsCorporate bonds

……

Govt and govt-sponsored agenciesMortgage backed securities

U.S. Treasury and govt agenciesGovernment bonds

Primary issuerBonds

Notes:




U.S. bond market in Jun 04

Source: The Bond Market Association, “Research Quarterly” (http://www.bondmarkets.com/assets/files/ResearchQuarterly0804.pdf)


Notes:




Risks associated with bonds

• Interest rate risk

– Price risk – Reinvestment risk

• Default risk

• Liquidity risk

• Inflation risk

• Volatility risk

• Political risk

• Currency risk

• Model risk


Notes:



U.S. Treasury securities

Notes:




Importance of U.S. Treasury securities

• U.S. Treasury is the largest debt issuer in the world

• Issue amounts determined by federal budget fundingrequirements, monetary policy, and liquidity concerns

• Treasuries are very liquid

– Large amounts of recent issues can be traded easily

– Low bid/ask spreads of recent issues ($1/32 per $100)

• Default-free and mostly option-free easy to price

• Treasuries are used as benchmarks for other interest rates

U .S . T r e a s u r y s e c u r i t i e s

Notes:




Marketable U.S. Treasuries

NoSemi-annual≥ 10 yr, ≤ 30 yr TIPS**

No*Semi-annual> 10 yr, ≤ 30 yr T bond

NoZero≥ 6 m, ≤ 30 yr STRIPS***

No*Semi-annual> 1 yr, ≤ 10 yr T note

NoZero≤ 1 yr T bill

CallableCouponInitial maturityType

* Except for a few specific issues** “Treasury Inflation Protected Securities”** “Separate Trading of Registered Interest and Principal of Securities”


Notes:




Outstanding U.S. Treasuries in Sep 04


574TIP bonds

462?Non marketable

55253T bonds

16610TIP notes

4,308?Total

2,11085T notes

96143T bills

Face value ($Bil)# of issuesType

Source: Bureau of the Public Debt, “Monthly Statement of the Public Debt” (www.publicdebt.treas.gov/opd/opddload.htm)

Notes:




Trends in marketable U.S. Treasuries



Notes:




Features of U.S. Treasuries

• Minimum investment of $1,000

• Essentially no default risk

• Eligible as tax and margin collateral

• Some state and local interest tax exemptions

• Traded over-the-counter (OTC) through network of dealers andelectronic systems or bought directly from U.S. Treasury

• Auctioned regularly by U.S. Treasury

• Active when-issued market which can be squeezed – E.g., Salomon Brothers alleged squeeze of 2-yr T note in 91


Notes:




U.S. Treasury auctions

• Treasuries are sold initially through auctions

• Bids are submitted directly to Treasury or through dealers

• Competitive and non-competitive bids

– Competitive bid = bidder bids for amount and price

– Non-competitive bid = bidder bids for quantity (up to $1M for billsand up to $5M for notes and bonds) at clearing price

• Single-price auction mechanism (since Nov 98)

– Every bidder pays same market clearing price

– Non-competitive bids are subtracted from supply of Treasuriesand competitive bids are used to construct demand schedule

– The market clearing price sets supply (less non-competitive bids)equal to demand (from competitive bids)

• Issues are periodically reopened through further auctions


Notes:




Treasury auction schedule

• The offered amount is announced the week prior to auction

• Securities are settled a few days after auction


Middle of Jul10-yr and 20-yr TIP

Middle of Feb, May, Aug, and Nov3-yr, 5-yr, and 10-yr T note

Every Tuesday4-wk T bill

Discontinued in 0152-wk T bill

Every Monday13-wk and 26-wk T bill

Discontinued in 0130-yr TIP

Discontinued in 0130-yr bond

End of each month2-yr T note

General auction scheduleSecurity

Notes:




One-the-run vs off-the-run

• The most recently auctioned Treasuries for given maturity are“on-the-run” and the remaining issues are “off-the-run”

• The current (Oct 22, 04) on-the-run Treasuries are


$14B$ 9B

8/15/049/15/04 (reopened)

8/15/144 1 /410-yr T note

$35B10/15/0410/15/093 3 /85-yr T note

2/15/018/15/01 (reopened)

9/30/0410/21/04

7/22/0410/21/04 (reopened)

5/20/048/19/04 (reopened)

10/21/04 (reopened)

Issue date

$24B4/21/05 –26-wk T bill$24B9/30/062 1 /22-yr T note

$10B$ 5B

2/15/315 3 /830-yr T bond

$23B$26B

1/20/05 –13-wk T bill

$21B$26B$12B

11/18/04 –4-wk T bill

AmountMaturityCouponSecurity

Notes:




Quotes for selected Treasuries (Oct 22, 04)

Source: Bloomberg “PX1 <Go>”. For a security description, double click on a security and then type “DES <GO>”


Notes:




T bill quotes

• T bills are quoted on bank discount basis, not on price basis

• The price of a T bill is calculated per $100 face value as

– t = number of calendar days between settlement and maturity

– d = bank discount

• For example, for the on-the-run 6-month T bill due 4/21/05

– Ask discount (assuming we want to buy) is d = 2.00%

– With “t+1 settle” on 10/25/04, t = 178 days (6+30+31+31+29+31+21)


Notes:




T note and bond quotes

• T notes and bonds are quoted on flat price basis

• The invoice price includes accrued interest paid to seller

Invoice Price = Flat Price + Accrued Interest

• Accrued interest is the pro-rata share of the coupon, based on thefraction of time the security is held by seller since last coupon


Notes:




T note and bond quotes (cont)

• For example, for the on-the-run 30-yr T bond due 2/15/31

– Flat Price = $109-7 = $109 7/32 = $109.219 – Last coupon date : 8/15/04

– Next coupon date: 2/15/05 (184 days since 8/15/04)

– Settlement date: 10/25/04 (71 days since 8/15/04)

– Coupon = 5 3/8% = 5.375%

– Accrued Interest = $5.375 ×1/2 ×

71/184 = $1.037

– Invoice Price = Flat Price + Accrued Interest= $109.2188 + $1.0370 = $110.256


Notes:




Bloomberg’s bond calculators

• T notes and bonds: “BC1 <Go>”

• T bills: “BC2 <Go>”


Notes:



Repurchase agreements

Notes:




Definition and importance

• A repurchase agreement (“repo”) is a sale of a security withcommitment by seller to buy back the security in the future at

– Specified price (repurchase price)

– Specified date (repurchase date)

Overnight repo: repurchase date is next day

Term repo: repurchase date is later than next day

• A repo is essentially a collateralized loan

• The rate on this loan is the repo rate

• The repo market provides financing for the Treasury market andis therefore critical for its liquidity

R e p u rc h a s e a g r e em e n t s

Notes:




Repo vs reverse repo

• A repo refers to someone putting up (“repoing out”) a security ascollateral for a loan

– E.g., dealer borrows to finance a position or company borrows topay corporate taxes

• A reverse repo refers to someone taking in (“repoing in”) asecurity as collateral for a loan

– E.g., dealer or company lends to someone at higher yield


Notes:




Size of repo market

• Roughly 10% of all outstanding Treasuries are involved in repos



Notes:




Example

• A dealer buys $10M of a Treasury security yielding 7% at par

• The purchase is financed using an overnight repo

– The dealer puts up the security as collateral for a bank loan

– The bank gives the dealer a loan for an amount equal to thecollateral less a haircut, say $9,900,000

– The repo rate is 5%


Notes:




Example (cont)

• On day 0

• On day 1

Dealer Bank

Puts up $10M bondas collateral

Lends $9,900,000

Dealer Bank

Repays $9,900,000 + interest

Returns collateral


Notes:




Repo interest

• The interest on a repo is calculated as

Interest for 1 day = loan amount × repo rate × 1/360

• In the example

– Repo interest for 1 day = $9,900,000 × 0.05 ×1/360 = $1,375

– Repayment on day 1 = principal + interest = $9,901,375


Notes:




Carry

• “Carry” is the difference between interest earned (accrued) on abond and repo interest paid for financing the bond

• In the example

– Interest accrued at 7% = $10,000,000 × 0.07 ×1/360 = $1,917.81

– Repo interest paid at 5% = $9,900,000 × 0.05 ×1/360 = $1,375.00

– Carry = $542.81 ≈ 2%

• Positive carry occurs when yield curve is upward sloping

• Negative carry occurs when yield curve is downward sloping


Notes:




Repo gains and losses

• If the bond price increases overnight, the dealer makes

Gain = capital gain on entire bond + carry

• Suppose in the example the price increases by 0.1% overnight

– Capital gain = $10M × 0.001 = $10,000.00

– Carry = $542.81

– Total gain = $10,542.81 ⇒ 10.54% return on $100,000

• If the bond price decreases overnight, the dealer makes

Loss = capital loss on entire bond + carry

• Suppose in the example the price decreases by 0.1% overnight

– Total loss = -$9,457.19 ⇒ -9.46% return on $100,000


Notes:




Haircut and margin calls

• The haircut provides protection against default

• If dealer defaults

– Bank has to sell the collateral

– Value of the collateral may have fallen (it typically will)

• The haircut is a safety cushion for the bank

• If proceeds from sale of collateral exceeds loan + interest, bankreturns excess amount to defaulted dealer

• Repos can be “rolled over” if both parties agree to new terms

• If value of the collateral has declined, borrower may have to addmoney to haircut (i.e., partially pay back loan) margin call


Notes:




General collateral repo

• “General collateral” repo rate

– Applies to typical securities – Tied to Fed funds rate


Source: Michael W. Brandt, Kenneth A. Kavajecz, and Shane Underwood, “An Analysis of the Repurchase Agreement Market”

Notes:




Repo specials

• Specific issues are sometimes more desirable and thereforehave a lower repo rate “repo special”

– Cheapest to deliver against CBOT T bond futures

– Liquidity (on-the-run vs off-the-run)

Over-night General Collateral and On-the-Run 5-Year REPO Rates

0.000

1.000

2.000

3.000

4.000

5.000

6.000

7.000

8.000

8 / 1 / 1 9 9 6

1 0 / 1 / 1 9 9 6

1 2 / 1 / 1 9 9 6

2 / 1 / 1 9 9 7

4 / 1 / 1 9 9 7

6 / 1 / 1 9 9 7

8 / 1 / 1 9 9 7

1 0 / 1 / 1 9 9 7

1 2 / 1 / 1 9 9 7

2 / 1 / 1 9 9 8

4 / 1 / 1 9 9 8

6 / 1 / 1 9 9 8

8 / 1 / 1 9 9 8

1 0 / 1 / 1 9 9 8

1 2 / 1 / 1 9 9 8

2 / 1 / 1 9 9 9

4 / 1 / 1 9 9 9

6 / 1 / 1 9 9 9

8 / 1 / 1 9 9 9

1 0 / 1 / 1 9 9 9

1 2 / 1 / 1 9 9 9

2 / 1 / 2 0 0 0

4 / 1 / 2 0 0 0

6 / 1 / 2 0 0 0

8 / 1 / 2 0 0 0

1 0 / 1 / 2 0 0 0

1 2 / 1 / 2 0 0 0

2 / 1 / 2 0 0 1

4 / 1 / 2 0 0 1

6 / 1 / 2 0 0 1

Time (Daily 8:30AM)

P e r c e n t

G en er al Co ll ater al 5 -Yea r REPO

Over-night General Collateral and On-the-Run 10-Year REPO Rates

0.000

1.000

2.000

3.000

4.000

5.000

6.000

7.000

8.000

8 / 1 / 1 9 9 6

1 0 / 1 / 1 9 9 6

1 2 / 1 / 1 9 9 6

2 / 1 / 1 9 9 7

4 / 1 / 1 9 9 7

6 / 1 / 1 9 9 7

8 / 1 / 1 9 9 7

1 0 / 1 / 1 9 9 7

1 2 / 1 / 1 9 9 7

2 / 1 / 1 9 9 8

4 / 1 / 1 9 9 8

6 / 1 / 1 9 9 8

8 / 1 / 1 9 9 8

1 0 / 1 / 1 9 9 8

1 2 / 1 / 1 9 9 8

2 / 1 / 1 9 9 9

4 / 1 / 1 9 9 9

6 / 1 / 1 9 9 9

8 / 1 / 1 9 9 9

1 0 / 1 / 1 9 9 9

1 2 / 1 / 1 9 9 9

2 / 1 / 2 0 0 0

4 / 1 / 2 0 0 0

6 / 1 / 2 0 0 0

8 / 1 / 2 0 0 0

1 0 / 1 / 2 0 0 0

1 2 / 1 / 2 0 0 0

2 / 1 / 2 0 0 1

4 / 1 / 2 0 0 1

6 / 1 / 2 0 0 1

Time (Daily 8:30AM)

P e r c e n t

General Collateral 10-Year REPO

Source: Michael W. Brandt, Kenneth A. Kavajecz, and Shane Underwood, “An Analysis of the Repurchase Agreement Market”


Notes:

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