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Lecture 3: Overview of Fixed Income MarketsTanweer Akram, PhD

Jan 23, 2018, SANEM, Dhaka, BANGLADESH

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IMPORTANT DISCLAIMER AND DISCLOSURE

• Disclaimer: The author’s institutional affiliation is provided solely for identification purposes. Views expressed are solely those of the author and the standard disclaimer applies. The views are not necessarily those of Thrivent Financial, Thrivent Investment Management, or any affiliates. This is for information purposes only and should not be construed as an offer to buy or sell any investment product or service.

• Disclosure: Tanweer Akram’s employer, Thrivent Financial, invests in a wide range of securities. Asset management services are provided by Thrivent Asset Management, LLC, a wholly owned subsidiary of Thrivent Financial for Lutherans.

Compliance Tracking # 1951997-111717

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FIXED INCOME MARKETS

• With fixed income assets, the investor does not have an equity (ownership) stake but has a claim to a stream of cash flows.

• The investor has provided the borrower with cash in return for some “fixed” flow of income going forward at specified future dates.

• This will be a discussion of the U.S. fixed income markets. It is the world’s most important fixed income market. Still!

• Other important fixed income markets: Japan, U.K., Italy, and in recent years China.

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OUTSTANDING DEBT SECURITIES IN THE U.S.: SIZE OF FIXED INCOME MKT

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SUBSECTORS OF THE U.S. FIXED INCOME MARKET

• Treasury• Agency debt• Mortgage backed securities (MBS): agency MBS• Asset-backed securities (ABS)• Corporate debt

• Investment grade• High yield

• Municipal market

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THE COMPOSITION OF THE U.S. FIXED INCOME MARKET (2011)

Source: Jha (2011)

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NEW ISSUANCE IN THE U.S. BOND MARKET

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THE LARGEST SECTORS

Largest sectors• Treasury• Mortgage• Corporate

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THE NATURE OF FIXED INCOME MARKETS

• Debt does not stay with the same investors • There is a secondary market for debt• Trading mostly occurs in Treasury securities and Mortgage-

backed securities (MBS)

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FIXED INCOME SECURITIES

• Treasury Securities: U.S. government• Agency debt (government sponsored enterprises)

• Freddie Mac (FHLMC)• Fannie Mae (FNMA)

• Mortgage-backed securities: collection of residential real estate loans to owners

• Asset-backed securities:• Credit card debt, auto debt, and so on

• Corporate debt• Investment grade• High yield

• Municipal debt: metro areas, local governments, special projects

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THE CENTRAL BANK, BANKING AND MONETARY SYSTEM

• The Federal Reserve is the U.S. central bank• The FOMC (Federal Open Market Committee) sets the policy rates (fed

funds target rate, discount rate, repo & reverse repo rates, return on reserves, and so on).

• Banks provide loans• Deposit create loans (widely believed), or loans create deposit (truth) in

a regime of modern (“fiat”) money!• Business cycles• Booms and busts existed before the era of modern central banking and

paper money.• Bank runs & contagion.

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THE FEDERAL RESERVE

• In the U.S., the Federal Reserve sets the feds fund target rate and other policy rates

• The policy rates in turn influence other interest rates. The mechanics are fairly complex! Keynes held that the central bank is the key driver of interest rates.

• Institutional features of the Federal Reserve• Board of Governors (7)• District Presidents from 12 districts• FOMC = Board of Government + Selected Presidents (5)

• What does the Fed do?• Interest rates• Balance sheet• Monetary policy• Bank regulation (in partnership with other agencies of the Federal government)

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THE EVOLUTION OF THE FED FUNDS TARGET RATE

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THE BALANCE SHEET OF THE FEDERAL RESERVE

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“MONETARY AGGREGATES” AND MONEY DEMAND

• H = High-powered money• M1 = cash + demand deposit+ travelers check+ checkable deposit• M2 = M1 + most saving account + money market account + money

market mutual funds + small denomination time deposits (certificates of deposit

• MZM = M2 – time deposits + money market funds

• Money Demand is a function of Income and interest rate and so forth• Md= F(Y,r;.)

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THE EVOLUTION OF MONETARY AGGREGATES IN THE US

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MONETARY POLICY SET UP

• Policy rates• Fed funds target rate and fed funds effective rate• Reserves are traded among banks (financial institutions)• Required reserves, excess reserves• Required reserves are not necessary (for example in Canada)• The Federal Reserve’s balance sheet• A=L+E• The asset side of the Fed’s balance sheet consists of assets that it has

purchased• The liability side of the Fed’s balance sheet consists of its liabilities

(reserves and notes issued by the Fed) and its equity (provided by the Treasury)

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MONETARY POLICY TOOLS

• Policy rates• Fed funds target rate and fed funds effective rate• Open Market Operations

• Buying securities => Increase in reserves, large balance sheet => Lower interest rates• Selling securities => decrease in reserves, smaller balance sheet => higher interest rates

• Reserve requirement (not really)• Balance sheet, Quantitative Easing, and Yield Curve control• Fed funds target rate and fed funds effective rate

• Liquidity of securities is importantly. Mostly (in usual circumstances) the Fed trades in Treasury securities, but also buys/sells agency MBS, specially for QE.

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TREASURY SECURITES

• One of the largest and most liquid financial product• Federal fiscal balance = Federal revenue - Federal expenditure• Federal Fiscal deficit = Net issue of Treasury securities• Deficit (flow), Debt (stock)• Public Debt --- Issued to the public (ie private sector = non government

sector)• Inter-goveenemnt debt --- Issued to government trust funds, special

funds• Marketable debt – can be traded• Nonmarketable debt --- cannot be traded (for example, savings bond)

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THE COMPOSITION OF U.S. GROSS FEDERAL DEBT AS A SHARE OF NGDP

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THE EVOLUTION OF TREASURY YIELDS

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US DEBT (TREASURIES)

• Bills ≤ 1 Year• 1 Year> Notes ≥10 Year• Bonds > 10 Year• TIPS varies with inflation• Bills: 4 week, 13 week, 26 week, 52 week• Notes: 2 year, 3 year, 5 year, 7 Year, 10 year• Bonds: 30 year• TIPS: 5 year, 10 year, 30 year• Treasury auction process: Broker dealers, direct, competitive bids, non-

competitive bids, Dutch auction process• Interest rates on Treasuries form the risk free rates• Constant maturity treasury rates

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US TREASURY AUCTIONS

• Non-competitive bids: Awarded to investors at pre-set prices.• Competitive bids: The Treasury work down the list of competitive bids,

accepting the highest bid prices until all the securities have been awarded.

• Dutch auction process:• “A Dutch auction is a public offering auction structure in which the price of the

offering is set after taking in all bids to determine the highest price at which the total offering can be sold. In this type of auction, investors place a bid for the amount they are willing to buy in terms of quantity and price.”

• Source: Investopedia. https://www.investopedia.com/terms/d/dutchauction.asp#ixzz54fPxs5BS

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STRIPS

• “Separate Trading of Registered Interest and Principal Securities” (STRIP)

• U.S. government does not directly issue zero coupon bonds• However, zero coupon bonds can be synthetically created by separating

coupon cash flows from principals.• P-STRIPS = principal• C-STRIPs = coupons

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TIPS: INFLATION-LINKED BONDS

• Treasury Inflation Protected Securities (TIPS)• Inflation risk• For nominal bond, principals stays fixed, but for TIPS principal grows

with inflation. Hence, risk of inflation is removed.• Coupon rate, however, stays fixed. Actual coupon payment varies. • TIPS provide protection again deflation. Principal does not sink below

$100. (Initial face value).• TIPS provide lower yield than nominal Treasuries. (Why? Because

principal is adjusted based on inflation.)

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TIPS: INFLATION-LINKED BONDS

• Nominal yield in Treasuries = real yield + Breakeven inflation• Breakeven inflation = Nominal Yield – Yields in TIPS• Breakeven inflation = market expectation of inflation over X years• TIPS use actual CPI inflation

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MORTGAGE-BACKED SECURITIES: MBS

• U.S. households’ residential real estate mortgage loan pools collected into MBS

• Different types of mortgage debt• 30 year fixed rate mortgage is the most popular in the U.S.• Securitization: similar loans are combined and packaged. Large pools

of mortgage combined to form a single security.• GSEs standardize mortgage loans.• Implicit U.S. Treasury backing of GSEs.• No default risk of MBS because GSEs are under government

conservatorship.• Homeowners have a choice to refinance or repay.

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MORTGAGES: REFINANCE OR REPAY

• Refinance: Prepay existing loans, obtain new loan at lower rate.• Asymmetry: if interest rate is lower then refinance, while if interest ate is

higher then stick with the current loan.• Investor in MBS is on the other side of the asymmetry.• Understanding the asymmetry is important.• In the standard bond, the investor knows when coupons are paid and

when the principal will arrive. But in mortgage bond the homeowner can prepay the existing loan, the principal can arrive any time.

• Uncertainty regarding maturity of the mortgage.• Effective maturity depends on the change of prepayment.

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AGENCY DEBT

• GSEs. Two biggest ones: Freddie Mac [Federal Home Loan Mortgage Corporation (FHLMC)], Fannie Mae [Federal National Mortgage Association (FNMA)]

• Debt of the GSEs: agency debt. Funding the portfolio of mortgage debt on the balance sheet

• Mandate of Freddie Mac and Fannie Mae is to support U.S. housing market.

• GSEs have implicit guarantees from the U.S. government => lower interest rate for agencies. Traded (before 2007) at a slight discount to Treasuries.

• Less liquid than Treasuries. Reverse inquiry• Agency debt is an important asset class for foreign central banks.

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CORPORTATE BONDS

• Corporations are important issuers of debt• Corporation obtain funds from equity and debt• Debt is a cheaper source of funding than equity• Debt is tax exemption for interest payment• Corporations however, cannot, suspend coupon payment. Okay, if they

do there are defaulting.

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CORPORTATE BONDS: VARIOUS TYPES AND AGENCIES’ RATINGS

• Two types of corporate debt• Investment grade• High Yield

• Rating agencies: S&P and Moody’s (two most important ones), Fitch,• Bonds above BBB- known as investment grade, those below are high

yields. High yield was formerly known as “junk bonds”.• Investment grade constitutes the bulk of corporate bond issuance.

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THE EVOLUTION OF CORPORATE BENCHMARK YIELDS

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CORPORATE BONDS

• Wide range of debt issues of corporations, including the following• Callable bonds• Convertable bonds• Fixed rate bonds• Floating rate bonds

• Fixed/floating• Steepening of the interest rate curve• Risk aversion toward issuing short-dated floating notes

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MUNICIPAL BONDS

• Issued by municipalities, local entities, metropolitan areas/cities, and state

• Fragmented and less liquid market• Two types of municipal bonds

• General obligation (GOs)• Revenue bonds (RBs)

• GO backed by full taxation power of the authorities• RBs funds specific projects• Tenor of municipal bonds: From Short-term paper to 30 year maturity• Generally those over 10 years are callable bonds• A unique character of munis: tax exempt!

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MUNICIPAL BONDS: INTEREST INCOME IS TAX EXEMPT

• The tax exempt nature of muni bonds makes it attractive for high net worth individuals with high marginal tax rates.

• Example, marginal tax rate = 40%• 1-M T-bill 2%• 1-M muni 2% x0.60 = 1.2%• Of course munis have higher credit risk than Treasury securities.

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SUMMARY OF LECTURE 3

• There is a wide variety of fixed income instruments.• There is no single “interest rate.” There are many different interest

rates.• Some key risks in fixed income investment:

• Interest rate risk• Prepayment risk• Tax risk

• There are strong connections among segments in fixed income markets. Indeed, there are strong connections among different assets in financial markets.

• Investment decisions depend on the investor’s view on interest rates, spreads, and assessment of risks.