IFT Notes for Level I CFA® Program
R43 Fixed Income Markets - Issuance Trading and Funding
This reading will cover:
- How the bond markets are classified.
- Who the major issuers of debt are and what types of bonds they issue.
- How new bond issues are introduced in primary markets and then traded in secondary markets.
- Sovereign bonds and non-sovereign bonds.
- Different types of corporate debt.
- The sources of short-term funding available to banks.
2. Overview of Global Fixed-Income Markets
2.1. Classification of Fixed-Income Markets
Fixed-income markets are often classified based on the following criteria:
Classification by Type of Issuer
Bond markets may be divided into four categories based on the type of issuers:
- Non-financial corporates
- Financial institutions
Classification by Credit Quality
Investors face credit risk, i.e., the risk of loss if the issuer fails to make timely payments of interest and principal as they come due. Rating agencies like Moody’s, S&P, and Fitch assign credit ratings to bonds. Bonds with a rating of BBB or above are considered investment grade. Bonds below this rating are considered junk bonds.
This differentiation is important as certain investors such as banks and life insurance companies may not be allowed to invest in junk bonds but only in investment grade bonds.
Classification by Maturity
Fixed-income securities can also be classified by the original maturity of the bonds when they are issued:
- Money market securities: They are issued with a maturity at issuance that ranges from overnight to one year. For example, T-bills issued by the US government or commercial paper with short maturities issued by the corporate sector.
- Capital market securities: The original maturity is usually longer than a year.
Classification by Currency Denomination
Fixed-income securities can also be classified based on the currency in which they are issued. The bond’s price (and cash flows) is affected by the interest rates of the country whose currency the bond was issued in.
Classification by Type of Coupon
Bonds can be classified into the following based on the coupon rate:
- Fixed-rate: In a fixed-rate bond, the coupon rate and coupon payment are fixed.
- Floating-rate: In a floating-rate bond, the coupon payment is linked to a floating rate, which is usually a reference rate plus a spread.
There are two parts to a floating rate: a reference rate and a spread.
The reference rate is reset periodically at the coupon date. As a result, the coupon rate more or less reflects the market interest rates. The reference rate contributes to most of the coupon rate and is usually an interbank offered rate. The most commonly used interbank rate is Libor.
Interbank offered rates are the average interest rates at which banks may borrow unsecured funds from other banks. The rates differ for different periods ranging from overnight to one year. Examples of interbank offered rates include Libor, Euribor (Euro interbank offered rate), Mibor (Mumbai interbank offered rate), etc. The respective currencies for Euribor and Mibor are the Euro and Indian rupee.
The spread, on the other hand, is fixed at issuance and is a function of the issuer’s credit quality or creditworthiness. The higher the quality, the lower the spread and vice versa. It is a small component of the coupon rate.
Classification by Geography
Fixed-income markets may be classified based on where the bonds are issued and sold (we saw this in detail in the previous reading):
- Domestic bonds: Bonds issued in a country in that country’s currency. The issuer is domiciled in that country. For example, Ford issuing U.S. dollar denominated bonds in the U.S.
- Foreign bonds: Bonds issued by an entity domiciled in another country. For example, Toyota issuing dollar denominated bonds in the U.S.
- Eurobonds: International bonds sold outside the jurisdiction of any single country.
- Investors further classify bonds into those issued by developed economies and emerging economies.
Among other classifications, we have tax-exempt bonds and inflation-linked bonds.
- Tax-exempt bonds: Bonds whose interest/coupon payments are not taxable. For example, munis or municipal bonds issued by local governments in the United States are tax-exempt bonds.
- Inflation-linked bonds: Bonds whose coupon and/or principal are indexed to inflation. The objective is to give some protection (hedge) to investors against high inflation and offer real returns in a high inflation environment.
2.2. Fixed-Income Indices
Fixed-income indices are used by investors for two purposes: to evaluate the performance of investments and investment managers and to describe a given bond market or sector. The index construction – security selection and weight of each security in the index- varies from index to index.
The most popular fixed-income indices include Barclays Capital Global Aggregate Bond Index, J.P. Morgan Emerging Market Bond Index, and FTSE Global Bond Index.
2.3. Investors in Fixed-Income Securities
Major categories of fixed-income investors include:
- Central banks: They use fixed-income securities as a tool to implement monetary policy. Purchasing domestic bonds increases money supply. Similarly, selling bonds decreases money supply. Central banks also buy and sell bonds denominated in other currencies to manage the value of their currency and foreign reserves.
- Institutional investors: They are the largest group of investors in fixed-income securities. This includes pension funds, hedge funds, endowments, charitable foundation, insurance companies, and banks. Unlike equities that trade in primary and secondary markets, bonds primarily trade over-the-counter. Many issues are not liquid and tradable, making them out of reach for retail investors, but are preferred by institutional investors.
- Retail investors: Unlike central banks and institutional investors, retail investors primarily invest in bonds through mutual funds or ETFs. Many retail investors prefer to invest in bonds because of the certainty of income in the form of interest payments and principal payment at maturity. Also, fixed-income securities are not as volatile as their equity counterparts.