(An excerpt from my MSc dissertation)
The fixed income market includes both the money market and the bond market, in fact all forms of debt instruments. The money
markets handle borrowing and lending requirements in the short term, usually up to
one year, and the bond markets address medium and long term borrowing and
lending. The shortest term of all is “call money”, which is not represented by a
tradable security, and is inter-bank. The money may be borrowed or lent overnight,
or for a period of three to seven days, but may be recalled at any time, and is carried
on the balance sheet as “money at call and short notice”. The overnight rate between
banks is averaged into a market benchmark, for example, EONIA (Euro Over Night
Indexed Average), from which other interest rates are derived.
The inter-bank money market also has a high volume of trades with terms ranging
from call money periods to one year. This is the mechanism by which banks are able
to put their spare liquidity to work, and as this is a marginal cost, the rates at which
banks lend money to their commercial customers are higher. In the wholesale
market, the deposit rate offered by a bank is called the “bid”, and the lending rate is
called the “offer”. This is unlike the usual meanings of these terms in securities
markets, where the “bid” is the buying rate offered by a market maker, and “offer” is
the selling rate. The inter-bank rates in London are therefore LIBOR (London Inter
Bank Offer Rate) and LIBID (London Inter-bank BID rate). LIBOR is quoted at 3
months by default, and can refer to any of the currencies traded in London, for
example the offered rate on Sterling in the money markets is likely to be different
from Japanese Yen. Therefore, the rates at which commercial money is lent will be
LIBOR (which is the cost to a bank of new money) plus a spread, with the rate
resetting every three or six months to whatever the current LIBOR is, plus an
additional margin. The inter-bank market deals also deals with cash rather than
tradable securities.
However, there are varieties of money market instruments that are tradable. There is
no single regulated exchange for each type of instrument, as there is for futures or
common stock trading. These instruments include Treasury Bills, local authority and
public utility bills, also known as “municipals”, certificates of deposit, commercial
paper, and bills of exchange. Governments use treasuries as a way to balance uneven
tax receipts and expenditures in the short term. This differs from longer-term
government borrowing, through “gilts” in the UK, which are used by governments
to fund capital investment or deficit spending, rather than simply to even out cash
flow. In the UK, three and six month bills are sold to banks every Friday, in an
auction, or “tender” process. This is because for such short terms, it is inconvenient
to pay interest, which is usually calculated on an annual basis. Therefore, the bills
are sold at a discount to their nominal (or “par”) value, with the difference between
the face value and the actual price paid is called the “discount rate”. The discount
rate is not the same as the “yield”, which is the discount rate expressed in terms of
the actual rather than the nominal price. The yield would be used to benchmark the
bills against the market, and would inform the discount rate that the bank would
factor into its bid for the bill. The allocations to buyers may be done in two different
ways, either all buyers get the bills at the price they bid (assuming that the auction is
not over-subscribed), or everyone who bids above a “strike price” pays that price,
and anyone who bid below gets nothing. These are known as “bid price auctions”
and “strike price auctions” respectively, since in different markets, both types are
referred to as “Dutch auctions”, this term is likely to cause confusion.
A municipal bill is similar to a Treasury, but rather than being issued by a national
government, it is issued by a smaller governmental unit such as a city, or by a public
utility. This market is quite small in the UK, but is well developed in the US, France
and Germany. A certificate of deposit, or a CD, is a receipt for an interest-bearing
deposit in the wholesale market, issued by a bank. This is a flexible instrument for
both borrowers and lenders. The term is fixed, and the certificate can be re-sold,
meaning that if lenders require the money at short notice, the borrower’s repayment
is not affected. The yield on a CD is consequently lower, as a premium must be paid
for the additional liquidity in the market that this makes possible.
Commercial paper is the instrument for corporations to borrow short-term. This is
regulated by the central banks for the currency, as it is a deposit-taking activity
offered by commercial banks. In the UK, a company is required to be publicly
quoted and have at least GBP 25M on their balance sheet before it can make use of
commercial paper, which is denominated in units of GBP 100,000. Commercial
paper is an alternative to a straightforward loan from a bank, with the advantage that
it is tradable. If a company announces that it is to issue a certain amount of
commercial paper, it will typically do so over a period of years and up to a
maximum figure, repaying the notes as the come due. This differs from a bond issue,
in which the entire amount would be placed as part of the issue. Banks act as brokers
to match sellers and buyers of CP, taking a commission in the process, the
counterparty may be another bank, or it may be another corporation. One final
advantage of commercial paper is that as the actual deal is struck directly between
counterparties, the interest rate may actually be lower than the interbank rate. An
alternative method for a company to raise money in the short term is to sell trade
debt at a discount to money market participants. The margin in this type of trading
reflects the bank taking on the risk of default of the company, as a “bill of exchange”
is a promise to repay the debt. Bank bills are preferable to trader bills because of
this.
The central banks operate in the money markets by a variety of means, other than
regulatory. They function as “lender of last resort” to commercial banks, who must
maintain working balances at the central bank, in case of short-term liquidity
problems. The interest rates throughout the entire market are influenced by the rate
at which the central bank lends money to the commercial banks. The central bank
can discount bills of exchange for other banks, within a certain quota for each bank,
at a “discount rate” below the standard rate. The “Lombard rate” is an emergency
lending rate, usually higher than money market rates, secured against top-quality
securities, for short terms not exceeding three months. A central bank may limit the
liquidity it offers to commercial banks to make it harder for them to offer credit to
their own customers. The central bank may choose “open market operations”,
buying securities from banks to increase liquidity (money supply) or selling bills to
reduce liquidity. One method is the sale and repurchase agreement, known as the
“repo”, in which the central bank will buy securities and hold them for a short
period, after which the commercial bank must buy them back, plus interest.
The “yield” on an instrument is the annual return on investment, expressed as a
percentage of the nominal, or “par” value of the instrument. The yield varies for
fixed income securities, because the price paid for the security is not necessarily the
same as the par in the secondary market. The face yield of a bond reflects the credit
rating of the issuer, an issuer with an excellent “AAA” credit rating has a low risk of
default, therefore must pay only a small premium above market rates to place the
bond. An issuer with a low credit rating must pay a higher interest rate, to attract
buyers and compensate them for the risks they are taking. If the market rate of
interest drops after the purchase of the bond, then the market price for the bond will
go up, as a higher rate of interest is available to the bearer, bringing the yield back
into alignment with market conditions. Similarly, if the interest rate goes up, the
market price of the bond will go down, as a market participant could get a better rate
of interest by accessing the market directly. The face rate of interest on a bond is
called the “coupon”.
The price the market will pay for a bond is based on the assumption that the bond
will be held until redemption, at which point the par value will be repayable to the
holder. If the market price of a bond is below the par, then when redemption is due,
a buyer who obtained the bond for below par in the secondary market will see a capital gain. When this is factored in to the yield, the result is the “gross redemption
yield”. This is the net present value of the discounted cash flow of the future stream
of revenue receivable by the holder throughout the remaining lifecycle of the bond.
Consequently, the closer in time the redemption time is, the closer the market price
will move to the par price, and the less the prevailing interest rate will matter. The
final factor influencing the price of a fixed-income security is the timing of the
interest payments. When a bond is sold, the seller receives the “accrued interest”,
that is the annual interest adjusted for the length of time that the bond was held.
Accrued interest is quoted separately, except in a few cases such as convertible
bonds. The price without accrued interest is called the “clean price”. A seller will
receive the accrued interest, but a buyer must pay it. The exception to this is a cut-off
time at which whoever is holding the bond actually gets paid, known as the “ex
dividend period”, or “XD”. During this period, the seller pays interest.
References:
- Introduction to Global Financial Markets, Stephen Valdez, Palgrave 2000
- Reuters Financial Glossary, Pearson 2000