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IFT Notes for Level I CFA® Program

R43 Fixed Income Markets - Issuance Trading and Funding

Part 3


 

5.  Non-Sovereign Government, Quasi-Government, and Supranational Bonds

5.1. Non-Sovereign Bonds

Non-sovereign bonds are bonds issued by the local governments such as states, provinces, and cities, and not by the national government. The characteristics of non-sovereign bonds are as follows:

  • Credit rating is usually high as rate of default is low. However they have a higher credit risk than sovereign bonds and therefore demand a higher yield.
  • The source of revenue for these bonds is the local taxing authority and the cash flows from the project once it is commissioned.
  • Funds raised from non-sovereign bonds are used for public projects such as highways, bridges, dams, airports, metro, sewage systems, and schools.

5.2. Quasi-Government Bonds

Quasi-government bonds are bonds issued by non-government entities, but they are usually backed by the government. The characteristics of these bonds are as follows:

  • The credit risk is low.
  • Taxes are not a source of revenue. They fund specific projects and cash flows from the project/entity are used to service the debt.
  • Examples are bonds issued by Federal National Mortgage Association (Fannie Mae), Federal Home Loan Mortgage Corporation (Freddie Mac) in the U.S.

5.3. Supranational Bonds

Supranational bonds are bonds issued by international organizations such as the World Bank, IMF, EIB, ADB, etc. They are usually plain-vanilla bonds. Sometimes callable or floaters are also issued.

6.  Corporate Debt

We now shift our focus from sovereign debt to corporate debt. Companies borrow primarily from banks and only 30% of their financing needs come from the financial markets.

6.1.     Bank Loans and Syndicated Loans

There are two types of bank loans: bilateral and syndicated.

  • A bilateral loan is a loan from a single lender to a single borrower.
  • A syndicated loan is a loan from a group of lenders, called the syndicate, to a single borrower.

Most bilateral and syndicated loans are floating-rate loans, linked to a reference rate such as Libor. For highly rated companies, both bilateral and syndicated loans can be more expensive than bonds issued in financial markets.

6.2.     Commercial Paper

A commercial paper is a flexible, readily available, and low-cost instrument issued by companies to meet their short-term needs. They are issued for a short period, typically between 15 days and one year.

A commercial paper may be regarded as the corporate equivalent of a T-bill because it is short-term in nature. In a CP, since companies may borrow directly from the market, the cost of borrowing is less than that of banks.

Companies use commercial paper:

  • For working capital and seasonal demands for cash.
  • As a source of bridge financing: CPs serve as an interim source of funding if market conditions are not temporarily favorable to arrange permanent funding.

The characteristics of a commercial paper are as follows:

  • The yield on commercial paper is greater than the yield on short-term sovereign bonds because investors are exposed to credit risk. Credit risk varies from entity to entity.
  • Historically, the rate of default of CP is very low as they are short-term in nature, and when CPs mature, they are usually rolled over into new CPs. It is called rolling over the paper. The old CP is paid with the proceeds from the new CP. But what if the issuer is unable to issue a new CP? This risk is called rollover risk. Rollover risk can be mitigated by what is called backup lines of credit. These are backup funds from the banks to ensure there is enough money to pay off a maturing CP.

US Commercial Paper vs. Eurocommercial Paper

The US commercial paper (USCP) market is the largest commercial paper market in the world. Commercial paper issued in the international market is known as Eurocommercial paper (ECP). The differences between the two are summarized in the table below:

USCP vs. ECP
Feature US Commercial Paper Eurocommercial Paper
Currency U.S. dollar Any currency
Maturity Overnight to 270 days Overnight to 364 days
Interest Discount basis Interest-bearing basis
Settlement T+0 (trade date) T+2 (trade date plus two days)
Negotiable Can be sold to another party Can be sold to another party

The key difference between a USCP and ECP is in the way interest is paid. USCP, like a zero bond, is sold at a discount. The par value is paid on maturity. ECP, on the other hand, is sold at par and the interest is paid along with the par value at maturity. The example below illustrates this difference for a $100 million CP issued at 4% for 90 days.

$100 million, 90-day at 4% commercial paper
USCP: issued by U.S. Bank ECP: issued by a French company
Interest: 100,000,000 x 0.04 x 90/360

= $1,000,000

100,000,000 x 0.04 x 90/360

= $1,000,000

At issuance, money received by bank/company Interest discounted from par:

100,000,000 – 1,000,000=$99,000,000

Par value: $100,000,000
Bank/company pays at maturity: Par value = $100,000,000 Par value + interest = 10,000,000 + 1,000,000 = $101,000,000
Return on investment for 90 days 1,000,000/99,000,000 = 1.01% 1,000,000/100,000,000 = 1.00%

6.3.     Corporate Notes and Bonds

Corporate bonds may be categorized based on several characteristics such as maturities, coupon payment structures, and contingency provisions that we will discuss in this section.

Maturities

Short-term, medium-term, long-term: There is no formal categorization of what constitutes a short-term, medium-term, and long-term security. But we will go with the classification below based on common practice.

Classification of Corporate Bonds Based on Maturity
Original maturity Term What are they called?
Five years or less than five years (≤ 5) Short-term Notes
Greater than 5 and less than 12 years

(> 5 and ≤ 12)

Medium-term
Greater than 12 years (> 12) Long-term Bonds

Medium-term note (MTN): The term ‘medium’ in an MTN is a misnomer because the maturities range from 2 years to greater than 30 years.

  • MTNs are continuously offered through dealers or agents.
  • MTNs can be broadly classified into short-term, medium to long-term, and structured notes.
  • Yield on an MTN is higher than a comparable bond, but liquidity is lesser.
  • They primarily serve to bridge the funding gap between commercial papers (short-term) and long-term bonds.

Coupon Payment Structures

Coupon payments for corporate notes and bonds vary based on the type of bond:

Note: We have seen most of these in the previous reading, so we will just skim through them

  • Conventional coupon bond/plain vanilla bond: pays fixed-rate coupon periodically.
  • Floating-rate note: Coupon payment linked to a reference rate.
  • Credit-linked coupon bond: Coupon payment linked to issuer’s credit quality.
  • Zero-coupon bonds: Pays no coupon; one payment equivalent to par value at maturity.
  • Deferred coupon bonds: Pays no coupon initially and a higher coupon later.
  • Payment-in-kind coupon bond: Pays coupon in the form of securities, not cash.

Principal Repayment Structures

Broadly speaking there are three types of principal repayment structures. These are outlined below:

  1. Serial maturity structure: The bond matures in parts on several dates throughout the bond’s life. The principal is repaid in parts instead of paying a lump sum at maturity. For example, if a company issues $50 million for 5 years, then traditionally it repays the principal of $50 million at once on maturity date. But in the case of a serial bond issue, assume $20 million matures after two years, $10 million in the third year, and so on. Which bonds will be retired at what date, is defined at issuance.
  2. Term maturity structure: The bond’s entire principal is paid at once on maturity. It carries more credit risk.
  3. Sinking fund arrangement: The issuer sets aside funds so that it can retire specific amounts of the principal each year. This is done in two ways: by repaying principal to a certain percentage of bondholders each year, or the issuer may deliver bonds to the trustee equal to the amount that must be retired that year.

Asset or Collateral Backing

Unlike highly-rated sovereign bonds that carry almost no default risk, all corporate bonds have varying amounts of default risk. The objective of asset or collateral backing is to protect investors in the event of a default. Secured debt, i.e., debt backed by collateral, is not completely insulated from losses, but it is considered better than unsecured debt.

Contingency Provisions

Contingency provisions are clauses defined in a bond’s indenture to protect the bondholders. These provisions specify under what conditions a bond may be redeemed or paid-off before maturity. Some provisions benefit the issuer while some benefit the investor. The three contingency provisions are call provision, put provision, and a convertible bond.

Issuance, Trading, and Settlement

Major points with respect to issuance, trading, and settlement are given below:

  • New bond issues are sold by investment banks who act as underwriters/brokers.
  • They are settled through the local settlement system, which in turn is connected to the two primary Eurobond clearing systems: Euroclear and Clearstream.
  • Bonds are traded through dealers who make a market. Dealers interact with bondholders and with other dealers. So, it is essentially an over-the-counter market.
  • The settlement now happens electronically. For a secondary bond, settlement could take anywhere between T + 3 to T + 7 days while issuance of a new bond takes several days.
  • Bond prices are quoted in basis points.


Fixed-Income Markets: Issuance, Trading and Funding Part 3