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LEARNING OUTCOMES

After completing this chapter, you will be able to do the following:

● describe classifications of global fixed-income markets;

● describe the use of interbank offered rates as reference rates in floating-rate debt;

● describe mechanisms available for issuing bonds in primary markets;

● describe secondary markets for bonds;

● describe securities issued by sovereign governments, non-sovereign governments, government agencies, and supranational entities;

● describe types of debt issued by corporations;

● describe short-term funding alternatives available to banks;

● describe repurchase agreements (repos) and their importance to investors who borrow short term.

SUMMARY OVERVIEW

Debt financing is an important source of funds for governments, government-related entities, financial institutions, and non-financial companies. Well-functioning fixed-income markets help ensure that capital is allocated efficiently to its highest and best use globally. Important points include the following:

● The most widely used ways of classifying fixed-income markets include the type of issuer; the bonds' credit quality, maturity, currency denomination, and type of coupon; and where the bonds are issued and traded.

● Based on the type of issuer, the three major bond market sectors are the government and government-related sector, the corporate sector, and the structured finance sector. The major issuers of bonds globally are governments and financial institutions.

● Investors make a distinction between investment-grade and high-yield bond markets based on the issuer's credit quality.

● Money markets are where securities with original maturities ranging from overnight to one year are issued and traded, whereas capital markets are where securities with original maturities longer than one year are issued and traded.

● The majority of bonds are denominated in either euros or US dollars.

● Investors make a distinction between bonds that pay a fixed rate versus a floating rate of interest. The coupon rate of floating-rate bonds is expressed as a reference rate plus a spread. 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.

● Based on where the bonds are issued and traded, a distinction is made between domestic and international bond markets. The latter includes the Eurobond market, which falls outside the jurisdiction of any single country and is characterized by less reporting, regulatory, and tax constraints. Investors also make a distinction between developed and emerging bond markets.

● Fixed-income indices are used by investors and investment managers to describe bond markets or sectors and to evaluate performance of investments and investment managers.

● The largest investors in bonds include central banks; institutional investors, such as pension funds, some hedge funds, charitable foundations and endowments, insurance companies, and banks; and retail investors.

● Primary markets are markets in which issuers first sell bonds to investors to raise capital. Secondary markets are markets in which existing bonds are subsequently traded among investors.

● 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.

● Public bond issuing mechanisms include underwritten offerings, best effort offerings, shelf registrations, and auctions.

● When an investment bank underwrites a bond issue, it buys the entire issue and takes the risk of reselling it to investors or dealers. In contrast, in a best efforts offering, 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.

● The underwriting process typically includes six phases: the determination of the funding needs, the selection of the underwriter, the structuring and announcement of the bond offering, pricing, issuance, and closing.

● A shelf registration is a method for issuing securities in which the issuer files a single document with regulators that describes a range of future issuances.

● An auction is a public offering method that involves bidding, and that is helpful in providing price discovery and in allocating securities. It is frequently used in the issuance of sovereign 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 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. Most sovereign bonds are fixed-rate bonds, although some national governments also issue floating-rate bonds and inflation-linked bonds.

● Local governments, quasi-government entities, and supranational agencies issue bonds, which are named non-sovereign, quasi-government, and supranational bonds, respectively.

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

● Commercial paper is a short-term unsecured security that is used by companies as a source of short-term and bridge financing. Investors in commercial paper are exposed to credit risk, although defaults are rare. Many issuers roll over their commercial paper on a regular basis.

● Corporate bonds and notes take different forms depending on the maturities, coupon payment, and principal repayment structures. Important considerations also include collateral backing and contingency provisions.

● Medium-term notes are securities that are offered continuously to investors by an agent of the issuer. They can have short-term or long-term maturities.

● 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.

● 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.

PROBLEMS

This question set was developed by Michael Whitehurst, CFA (San Diego, CA, USA). Copyright © 2013 by CFA Institute.

1. In most countries, the bond market sector with the smallest amount of bonds outstanding is most likely the:

A. government sector.

B. financial corporate sector.

C. non-financial corporate sector.

2. The distinction between investment grade debt and non-investment grade debt is best described by differences in:

A. tax status.

B. credit quality.

C. maturity dates.

3. A bond issued internationally, outside the jurisdiction of the country in whose currency the bond is denominated, is best described as a:

A. Eurobond.

B. foreign bond.

C. municipal bond.

4. Compared with developed markets bonds, emerging markets bonds most likely:

A. offer lower yields.

B. exhibit higher risk.

C. benefit from lower growth prospects.

5. With respect to floating-rate bonds, a reference rate such as the London interbank offered rate (Libor) is most likely used to determine the bond's:

A. spread.

B. coupon rate.

C. frequency of coupon payments.

6. Which of the following statements is most accurate? An interbank offered rate:

A. is a single reference rate.

B. applies to borrowing periods of up to 10 years.

C. is used as a reference rate for interest rate swaps.

7. An investment bank that underwrites a bond issue most likely:

A. buys and resells the newly issued bonds to investors or dealers.

B. acts as a broker and receives a commission for selling the bonds to investors.

C. incurs less risk associated with selling the bonds than in a best efforts offering.

8. In major developed bond markets, newly issued sovereign bonds are most often sold to the public via a(n):

A. auction.

B. private placement.

C. best efforts offering.

9. A mechanism by which an issuer may be able to offer additional bonds to the general public without preparing a new and separate offering circular best describes:

A. the grey market.

B. a shelf registration.

C. a private placement.

10. Which of the following statements related to secondary bond markets is most accurate?

A. Newly issued corporate bonds are issued in secondary bond markets.

B. Secondary bond markets are where bonds are traded between investors.

C. The major participants in secondary bond markets globally are retail investors.

11. A bond market in which a communications network matches buy and sell orders initiated from various locations is best described as an:

A. organized exchange.

B. open market operation.

C. over-the-counter market.

12. A liquid secondary bond market allows an investor to sell a bond at:

A. the desired price.

B. a price at least equal to the purchase price.

C. a price close to the bond's fair market value.

13. Sovereign bonds are best described as:

A. bonds issued by local governments.

B. secured obligations of a national government.

C. bonds backed by the taxing authority of a national government.

14. Agency bonds are issued by:

A. local governments.

B. national governments.

C. quasi-government entities.

15. The type of bond issued by a multilateral agency such as the International Monetary Fund (IMF) is best described as a:

A. sovereign bond.

B. supranational bond.

C. quasi-government bond.

16. Which of the following statements relating to commercial paper is most accurate?

A. There is no secondary market for trading commercial paper.

B. Only the strongest, highly rated companies issue commercial paper.

C. Commercial paper is a source of interim financing for long-term projects.

17. Eurocommerical paper is most likely:

A. negotiable.

B. denominated in euro.

C. issued on a discount basis.

18. When issuing debt, a company may use a sinking fund arrangement as a means of reducing:

A. credit risk.

B. inflation risk.

C. interest rate risk.

19. Which of the following is a source of wholesale funds for banks?

A. Demand deposits

B. Money market accounts

C. Negotiable certificates of deposit

20. A characteristic of negotiable certificates of deposit is:

A. they are mostly available in small denominations.

B. they can be sold in the open market prior to maturity.

C. a penalty is imposed if the depositor withdraws funds prior to maturity.

21. A repurchase agreement is most comparable to a(n):

A. interbank deposit.

B. collateralized loan.

C. negotiable certificate of deposit.

22. The repo margin on a repurchase agreement is most likely to be lower when:

A. the underlying collateral is in short supply.

B. the maturity of the repurchase agreement is long.

C. the credit risk associated with the underlying collateral is high.