Characteristics of fixed-income securities

Characteristics of fixed-income securities Angelo Ranaldo University of St. Gallen & University of Zurich Public Debt Management Fall term, University of Zurich

Table of contents 1. Asset valuation of debt securities 2. Characteristics of fixed-income securities 3. Risks 4. Swiss bond market 5. Current issues 1

Objectives of this lecture Understand the main characteristics of a wellfunctioning market and take a critical view Learn what is a primary and secondary market for government bonds Understand why bonds indices have became so popular and study the specific case of the Swiss bond indices Review the main characteristics of fixed income securities 2

Well-functioning market Efficiency Prices quickly adjust to new information so that prevailing price reflects all available information Timely and accurate information on current and past price / volume and on supply and demand. Liquidity Low transaction costs Depth: Is the market able to absorb any volume size? Breadth: The tightness of the market; the closeness between demand and supply Resiliency: Synonymous of elasticity or little trade impact Time: Is it possible to trade any time? 3

Well-functioning market How does liquidity and prices relate each other? The flow of liquidity through the economy is similar to the flow of blood. In the body of the economy, prices are the nervous system, signaling the needs of different parts of the body. Money is the blood that dispatches resources in response to those signals. Nobu Kiyotaki (Princeton) and John Moore (University of Edinburgh), Clarendon Lectures, 26 November 2001. 4

Well-functioning market Are financial markets efficient? Not always! For example: On-the-run (i.e. newly issued) Treasuries trade at lower yields than identical off-the-run Treasuries. Deviations from Covered Interest Parity Mancini and Ranaldo Limits to arbitrage during the crisis: funding liquidity constraints & covered interest parity, Swiss National Bank Working Paper. 5

CIP arbitrage: unsecured Lender L Borrower B 1W 1M OIS contracts Spot Forward FX Counterparty

CIP arbitrage: secured Lender L Borrower B Collateral Cash Cash Collateral ON / 1W REPO Hedge fund Spot Forward FX Counterparty

Replicating the CIP arbitrage Precise replication: Transaction costs pure profits Synchronicity no time bias Actual prices no mismeasurement Secured money market rates minimum risk z F B t... T 4, t A j, t... T 1 St R, B R, A 1 r r k, t... T

CIP profits: short USD 1M, unsecured

CIP profits: short USD 1M, unsecured Sept-Dec 2008: Huge deleveraging Sept. 2007: Northern Rock collapsed March 2008: Bear Stearns failure Sept. 2008: Dec. 2007: Fannie Mea & Freddie Mac Window dressing under conservatorship + 15. Sept. 2008: Lehman B. + AIG Aug. 2007: BNP Paribas suspended redemption of 3 funds

CIP profits: long USD 1M, unsecured

Well-functioning market Are financial assets liquid? Not always! And cross-sectional differences. Let us take what is supposed to be the most liquid market worldwide 12

Measuring liquidity Mancini, L., A. Ranaldo, J. Wrampelmeyer (2013): Liquidity in the Foreign Exchange Market: Measurement, Commonality, and Risk Premiums, Journal of Finance 68(5), 1805 1841. Data ICAP s Electronic Broking Services (EBS): major leading platform for spot FX interdealer trading. Sample: 1/1/2007 31/12/2009 on a one-second basis. Transaction price and volume; bid and ask quotes; precise trade direction. Measures: Price Impact, Return Reversal, Bid-Ask Spread, Effective Cost, Volatility. AUD/USD, EUR/CHF, EUR/GBP, EUR/JPY, EUR/USD, GBP/USD, NZD/USD, USD/CAD, USD/CHF, USD/DKK, USD/JPY and USD/SEK. 13

Time and cross-sectional variation 14

Issuance and trading How are securities issued? How are securities traded? Why are (bond) indices important? 15

Primary markets Primary The sale of new issues of bonds and preferred / common stocks Normally with the aid of an underwriter who provides: Origination (design, planning, registration of the issue) Risk bearing (purchase the securities thus guaranteeing price) Distribution (sale of the issue) Government bonds, municipal bonds, corporate / bond stocks 16

Primary markets Government bonds Sold at public auctions in US by the Federal Reserve in Switzerland by the Swiss National Bank Bills: 1-12 months Notes:2-10 years Bonds: 10 years up 17

Secondary markets Secondary market Where securities trade after their initial offering In US, the secondary market for treasuries is through 35 major dealers Bond indices Construct + track index portfolios; measure performance Equal-weighting vs Price-weighting vs Value-weighting More recent and complex than equity indices: broader universe, more changes (new issues, maturities), volatility, lack of continuous trade, 18

Bond Indices Tracking an index rather than investing in an individual security: Tracking and benchmarking the market Diversifying risk Enhancing liquidity Decreasing transaction costs More information Decreasing monitoring costs (instead security picking ) 19

Swiss Bond Indices (SBI) SBI-Family Each bond issue must have a remaining term to maturity of at least one year An original issue volume of at least CHF 100 million. Only fixed-rate bonds are included. Each bond must have a rating of BBB or higher. SWX applies composite rating, which is derived from the ratings of Standard & Poor s, Moody s and Fitch as well as those of four major Swiss banks. The SBI Family consists of the SBI Total and numerous subindices Domestic / Foreign issuers Rating categories Terms to maturity 20

Swiss Bond Indices (SBI) 21

SBI domestic government bond index SBI Domestic Government AAA BBB Total Return as of 2013 11 08 Name Nominal Amount Closing Accrued interest Capitalization (Total Return) Weight Admission Date Deletion Date Coupon 4.25 EIDG JN 97 17 5'760'060'000 114.83 1.806 6'718'317'982 7.58533 01.10.1998 01.06.2016 4.25 4 EIDG FE 98 23 4'557'650'000 126.76 2.967 5'912'487'420 6.67551 01.10.1998 01.02.2022 4 4 EIDG AP 98 28 5'612'455'000 133.58 2.333 7'628'074'670 8.6125 01.10.1998 01.04.2027 4 4 EIDG JA 98 49 1'367'970'000 160.04 3.356 2'235'202'181 2.52366 29.01.1999 01.01.2048 4 3.75 EIDG 01 15 4'539'270'000 106.00 1.542 4'881'606'609 5.51159 29.06.2001 02.06.2014 3.75 3 EIDG 03 18 7'035'968'000 111.78 2.500 8'040'704'230 9.07838 31.01.2003 02.01.2017 3 2.50 EIDG 03 16 6'903'847'000 105.90 1.639 7'424'320'348 8.38245 31.03.2003 02.03.2015 2.5 3.50 EIDG 03 33 3'632'660'000 132.30 2.042 4'880'175'986 5.50997 16.04.2003 01.04.2032 3.5 3 EIDG 04 19 5'999'094'000 114.26 1.467 6'942'551'512 7.8385 19.05.2004 01.05.2018 3 2.25 EIDG 05 20 4'700'870'000 110.82 0.763 5'245'348'268 5.92227 20.07.2005 01.07.2019 2.25 2 EIDG 05 16 2'966'780'000 105.93 0.144 3'146'995'402 3.55312 19.10.2005 01.10.2015 2 2.50 EIDG 06 36 3'503'040'000 116.89 1.667 4'153'087'454 4.68905 15.03.2006 01.03.2035 2.5 3.25 EIDG 07 27 2'028'940'000 123.38 1.183 2'527'301'204 2.85345 02.07.2007 01.06.2026 3.25 2 EIDG 10 21 4'018'251'000 109.25 1.056 4'432'354'087 5.00436 03.05.2010 01.04.2020 2 2 EIDG 11 22 2'856'837'000 109.18 0.906 3'144'964'881 3.55083 01.06.2011 03.05.2021 2 2.25 EIDG 11 31 1'618'365'000 111.29 0.850 1'814'834'511 2.04904 01.07.2011 03.06.2030 2.25 1.50 EIDG 12 42 3'445'335'000 97.51 0.783 3'386'534'615 3.82357 02.05.2012 01.04.2041 1.5 1.25 EIDG 12 24 2'441'870'000 101.33 0.510 2'486'810'581 2.80774 20.06.2012 01.06.2023 1.25 1.25 EIDG 12 37 2'630'559'000 93.38 0.455 2'468'381'384 2.78693 02.07.2012 02.06.2036 1.25 1.50 EIDG 13 25 1'062'730'000 103.05 0.433 1'099'748'428 1.24167 02.08.2013 01.07.2024 1.5 Source: SWX website. 24

SBI: market capitalization Source: SWX, see: http://www.six-swiss-exchange.com/index_info/online/bond_indices/sbi_rating_factsheet_en.pdf 25

Characteristics of fixed income securities Definition of FIS Obligation of a borrower to make periodic interest payments and to pay back the borrowed amount at a pre-specified future date. Agreement called indenture. Borrowers: private/public corporations, governments. Maturity Length of time until the loan contract expires It determines return (yield) and price volatility See above Par Value Amount the borrower promised to pay on or before the maturity date on the issue. 28

Characteristics of fixed income securities Coupon rate Rate multiplied by the par value gives the amount of interest to be paid by the borrower -> nominal rate Zero-coupon bonds Do not pay interest. Deep discount. Accrual bonds Although they pay their stated interest every period, payments are deferred to maturity and then disbursed with the par value. Set-up rates With coupons that increase over time at pre-specified rate 29

Characteristics of fixed income securities Floating rate Rate varies across time depending on the reference rate (e.g. Libor) to which you add / subtract a margin. Upper limit: cap; lower limit: floor; both: collar. Deleveraged floater: reference rate adjusted by a scaling factor. Dual-indexed floater: two reference rates. Range notes: coupon set equal to a reference rate if rr within a given range, otherwise zero coupon rate. 30

Characteristics of fixed income securities How to pay off the principal Bullet bonds: repay the entire principal in one lump sum Serial bonds: pay off the principal through a series of payments over time (e.g. Munis). Amortizing securities: make periodic principal and interest payments (e.g. MBS and ABS). Sinking fund provisions: proportion of bond issue in specified amount prior to maturity date. Call provision: give the right to the issuer to retire all or a part of an issue prior to maturity. (vs. noncallable). 31

Characteristics of fixed income securities Currency denomination The issuer can make payments to bondholders in any currency. Dual-currency bond: interest payments in one currency and principal in another one Financing the purchase of bonds Margin buying: borrowing funds from brokers or banks to purchase securities. Repurchase (repo) agreement: arrangement by which an institution sells a security with a commitment to buy it back at later date, at a pre-established price. 32

Repurchase agreement (REPO) Phase 1 (spot): Purchase Time Lender L Cash Collateral Borrower B As a protection against the risk that collateral securities lose their value, a margin or haircut is applied. If the margin or haircut is 10%, then Cash = 90% of Collateral Phase 2 (forward): Repurchase Time Lender L Cash + i Collateral Borrower B

Repo in U.S. JP Morgan Chase and Bank of New York Mellon act as clearing banks for repos Source: FSB (2012)