Module 4 – Debt securities and markets - CA Sri Lanka 4 – Debt securities and markets 1 ......

Module 4 – Debt securities and markets 1

© University of Southern Queensland

Module 4 – Debt securities and markets

Introduction

We now turn our attention to the workings of the financial markets, commencing with the

markets for debt securities. In this module, we shall examine debt securities including money

market securities and the markets for them.

We explore the institutional features of the money markets. The money market is the market

for debt securities issued with the original maturities of less than one year and a high degree

of liquidity. They are usually sold in large denominations and have low default risk. The

module shows why money markets are needed and their purpose to the government, firms,

financial institutions, and individuals. The money market is an interim investment that

provides a higher return than holding cash or money in the bank but less than what is usually

expected from long-term investments.

Learning objectives

On the successful completion of this module you will be able to:

● describe primary and secondary market processes

● describe the markets for debt securities in Australia

● outline the essential features of bonds, both corporate and government

● explain the operations and methods of Australian Office of Financial Management and

the Reserve Bank of Australia in the market for debt securities

● explain the role of credit rating agencies and their methodologies

● understand the role of securitisation and functions of the asset backed securities market.

● explain the role of the money market

● describe the participants in the money market, and the role played by each

● describe the various money market securities

● demonstrate how discount securities are priced

● explain the role of the central bank in the money market.

2 FIN8202 – Financial markets and instruments


Resources

Text

Valentine, T, Ford, G, O’Hara, L & Sundmacher, M 2011, Fundamentals of financial markets

and institutions in Australia, Pearson, Frenchs Forest, New South Wales (chapter 2).

Mishkin, FS & Eakins, SG 2012, Financial markets and institutions, 7th edn, Pearson

Education Limited, Edinburgh Gate, England (chapter 11).

Note: This material is contained in module 4 of your custom publication: FIN8202 Financial

markets and instruments.

Selected reading

Reading 4.1: Bodie, Z, Kane, A & Marcus, AJ 2005, Investments, 6th edition, Mc Graw-Hill,

pp. 474–6.

4.1 Primary and secondary market processes

In module 1 we distinguished between primary and secondary markets. As all financial

markets have both primary and secondary market aspects, it is appropriate that we examine

these further before we consider the money market.

● Primary market processes. These are concerned with the issue of new securities. Thus

the primary market will involve the contractual arrangements for issuing securities,

methods of sale, ratings agencies to provide risk assessment, and settlement and clearing

mechanisms.

● Secondary markets. The trading and settlement arrangements for securities already

issued are referred to as the secondary market. Important functions of secondary markets

are the provision of liquidity and price discovery, whilst trading may be either exchange-

organised or through a system of competing dealers i.e. dealer markets.

4.2 Debt markets

Broadly speaking, debt markets may be divided into three levels, according to the maturity

of the instruments traded:

● Cash market – this deals in very short-term deposits and advances. The cash market

includes the interbank market in exchange settlement funds, with the typical instrument traded being the 24 hour (overnight) deposit.

● Money market – this deals in short-term securities, with maturities of less than 12 months.



● Fixed-interest market – this trades in long-term debt securities, where the original term

to maturity exceeds one year.

For our purposes, however, the cash market will be treated as part of the money market.

Due to several unique features of the money market securities, their issuance and trading, we

discuss them in detail in module 6.

4.3 Essential features of bonds

A bond is technically a medium- to long-term instrument with a maturity usually greater than

one year. These instruments are used by government and corporate borrowers to raise funds.

For many years bonds were viewed as rather dull investments that produced current income

and little else. No longer is this true; instead, bonds today are viewed as highly competitive

investment vehicles that provide the potential for attractive returns.

A bond is a negotiable, long-term debt instrument that carries certain obligations (including

the payment of interest and the repayment of principal) on the part of the issuer. Certain

distinctive characteristics need to be highlighted in relation to bonds:

1. Bond interest and principal – In the absence of any trading, a bond investor’s return is

limited to fixed interest and principal payments. This is because bonds involve a fixed

claim on the issuer’s income (periodic income payments) and a fixed claim on the assets

of the issuer (equal to the repayment of the principal at maturity). As a rule, bonds pay

interest every six months. The amount of interest due is a function of the bond’s coupon

rate, which defines the annual interest income that will be paid by the issuer to the

bondholder. The principal amount of a bond (also known as the face value or par value) is

the amount of capital that must be repaid to the investor at the maturity date of the bond.

Bonds can be issued at different face values, however, in Australia, bonds typically have

a unit face value of $100.

2. Maturity date – Unlike shares, all debt securities have limited lives and will expire on a

given date in the future, referred to as the maturity date. The final coupon and the face

value of the bond are paid to the investor on its maturity date.

3. Call provision – Some bonds, notably perpetual bonds, have a call provision attached.

This provision gives the issuer the right, but not the obligation, to buy back the bonds

from the investors at a particular point in time at a certain price. Such features are often

placed on bonds for the benefit of the issuers. They are used most often to replace an

issue with one that carries a lower coupon, and the issuer will then benefit by realising a

reduction in annual interest cost. In an attempt to compensate investors who find their

bonds called out from under them, a call premium is added to the bond and paid to investors, along with the issue’s face value, at the time the bond is called.



4.4 Government debt

The government sector in Australia includes the Commonwealth Government, State

governments, local governments and semi-government authorities. Like any individual or

company, the government sector has to borrow money when it spends more that it receives

in income, that is, when it runs a budget deficit. One of the ways in which the government

sector borrows money is through the issue of debt securities. Securities issued by the

government are sold in Australia and overseas. The accumulated sum of borrowings by

governments (which corresponds broadly to the amount of securities on issue) is known as

the public debt. That part which is owed to overseas lenders forms part of Australia’s foreign

debt.

While the Commonwealth Government has borrowed some funds from overseas, it has

borrowed the bulk of its debt by issuing Australian dollar securities on the domestic market.

Different types of securities issued are discussed below.

4.4.1 Treasury bonds

These are longer-term securities, issued with a fixed maturity (mainly three to ten years) and

semi-annual coupon payments. The bulk of the Government’s outstanding debt is in this

category, with the emphasis being on meeting the Government’s full-year financing needs.

Investors who buy the bonds are in effect lending their money to the government for a fixed

period of time and at a fixed rate of interest.

Alternatives to the normal fixed interest Treasury bond include the capital-indexed bond and

the interest-indexed bond. Capital-indexed bonds are usually longer-term securities

(normally between ten and forty years). They are similar to Treasury bonds but their rates of

return vary with the rate of inflation by linking the capital value of the bond to movements in

the consumer price index (CPI). A fixed real rate of interest is paid on the adjusted capital

value and, at maturity, investors receive the inflation-adjusted capital value on their

investment. Interest-indexed bonds are longer-term bonds that have an adjustable (floating)

interest/coupon rate. The coupon rate is periodically reset by reference to movements in the

Australian Bank Bill Swap Reference Rate (BBSW).

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4.4.2 Semi-government bonds

State governments borrow in domestic and overseas capital markets to help fund investment

in public sector infrastructure such as electricity generation, water and drainage. A variety of

debt instruments are used, including bonds, promissory notes, leases, trade credits and

deferred payment arrangements. Issues of longer-term fixed interest bonds are the major form

of capital raising (otherwise known as semi-government bonds).



4.4.3 Corporate bonds

The corporate bond market is concerned with the raising of medium-term, fixed-interest debt.

The major borrowing groups in this market comprise banks, government business enterprises

(e.g. Telstra), finance companies and large corporations.

The debt instruments issued in this market have the following characteristics:

● a fixed or variable rate of interest, with the coupon usually paid on a semi-annual, in-

arrears basis

● a typical term of between two and ten years

● usually initially issued by way of competitive bidding among a dealer group, private placement or prospectus to the public

● can be bought and sold through stockbrokers (see module 5).

As figure 8.1 on page 214 of your prescribed text shows, until 1996, growth in the Australian

corporate bond market had been fairly minimal. However, a competitive interest rate

environment, declining government issues, and increasing demand from investors for assets,

has seen the re-emergence of the corporate bond market.

Corporate bonds can be categorised as either debentures or unsecured notes, depending on the

security offered by the instrument. Both provide the payment of periodic interest (coupon)

payments during the term of the loan, together with the repayment of the face value at

maturity. However, a debenture offers security attached to the bond, whereas an unsecured

note is a bond that is issued with no underlying security attached.

4.4.4 Credit rating of bonds

Government bonds are free of default risk. However, bond issued by companies and state

governments are not risk-free. Bond default risk also known as credit risk is assessed by

rating companies such as Moody’s Investor Service, Standard & Poor’s and Fitch. Bonds are

broadly rated as Investment grade or Speculative grade. Within these categories, letter grades

are given to reflect the rating agency’s assessment of the issue.

The factors used by rating agencies to assess credit risk are as follows:

● Coverage ratios

● Leverage ratios

● Liquidity ratios

● Profitability ratios

● Cash flow to debt.

Many bonds are issued with indentures – a contract between the issuer and the bond

holder – to protect the interests of the bond holder.

● Protection against default

● Sinking funds



● Subordination of future debt

● Dividend restrictions

● Collateral.

These are described in detail in selected reading 4.1.

Reading activity

Selected reading 4.1: Bodie, Kane & Marcus 2005, pp. 474–6.

4.5 Asset backed securities markets

The securitisation industry is an important component of the debt market. Improvements in

information technology and, in particular, the availability and frequency of publication of

credit information, have made the securitisation of financial assets a cost effective means of

acquiring funds.

Asset backed securities are simply securities which have been backed by a pool of assets.

There are various underlying assets used: property mortgages, hire purchase loans, credit card

receivables, and accounts receivables. The most prevalent form of asset backed security in

Australia is the mortgage backed security (MBS) – here the underlying assets are a pool of

mortgages.

The development of the MBS market in Australia, whilst slow compared to its American

counterpart, was assisted by state governments, especially in Victoria and New South Wales.

Governments promoted the development of the secondary mortgage market as this allowed

further funds to be injected back into residential development (since mortgage pools are

mostly made up of residential mortgages). Hence the clear objective of securitising financial

assets is to convert the financial assets into cash for reinvestment back into the underlying

business.

4.5.1 Securitisation

Securitisation is the process of pooling and repackaging financial assets (which cannot be

traded in their original form) into securities which can then be sold to investors in capital

markets. In other words, securitisation transforms an otherwise liquid asset into a security

which is tradable and therefore liquid.

Investors in the resultant securities receive payments that are supported or backed by the

underlying financial assets or the assets’ cash flows. Hence the term asset backed security. In

the case of MBSs, payments to investors are supported by the cash flows from the underlying

mortgages.

Although investors’ payments are supported by the underlying asset, the degree of liquidity,

and therefore marketability of the security, depends upon:

● structure



● credit enhancement.

Structure

The way the securitisation process is effected will result in different security structures. In

general, either a debt or equity instrument will result. Particular types of securities have

inherently different risks making them more or less easily traded than other types of

securities.

A simple model of securitisation of loans is given below.

Figure 1: Simple model of securitisation of loans

(Source: Hunt & Terry, C 2007, Financial institutions and markets, 5th edn, Thomson, Southbank, Victoria,

chapter 3, page 6.

Credit enhancement

This is where investors receive a guarantee from either a financial institution or an insurance

company that principal and interest payments on the MBS will be made. Credit enhancement

thus enables the securitisation process to work effectively by making a complex security

much simpler to sell through decreasing the potential for default risk and increasing the level

of liquidity.

Securitisation, through providing liquidity, allows MBSs to be traded and thus facilitates the

operation of the secondary mortgage market.

4.6 Types of mortgage backed securities

Four types of MBSs have emerged out of the secondary mortgage market:

● pass-through certificates

● mortgage backed bonds/bullet (MBBs)

● pay-through bonds



● collateralised mortgage obligations.

As an illustration, we will examine pass-through certificates in greater detail.

4.6.1 Pass-through certificates

A pass-through certificate represents direct ownership in a portfolio of mortgage loans that

are similar in term to maturity, interest rate, and quality. Pass-throughs are therefore equity

instruments.

The portfolio or pool of mortgages is sold, usually to a trustee, and investors purchase equity

interest in the assets and their subsequent cash flows. The loan’s originator is then able to

remove the mortgages from its balance sheet but will continue to service the mortgage

portfolio (for a fee). Servicing involves the collection of principal and interest payments and

‘passing through’ these payments to the investors. The diagram below represents a simplified

pass-through structure.

4.6.2 Structure of a pass-through certificate

Figure 2: Structure of a pass-through certificate

4.6.3 Market participants

There are several parties involved in the MBS market. These can be listed as follows:

● mortgagors – borrowers of the original funds

● mortgagees/originators – the original lending institutions

● issuers of the security

● mortgage insurers/credit enhancers

● trustees



● MBS investors/holders e.g. insurance companies and superannuation funds.

Self assessment 1

Revision questions 1, 3, 4, 8, 9, 10 & 11 from Valentine et al., chapter 2.

Answers are in the solutions manual.

4.7 Role of money markets

The money market serves various roles in the financing of companies and financial

institutions.

● The money market provides companies and financial institutions with an alternative

source of funds. Companies raise funds through banker accepted bills (BABs) and

commercial paper and banks raise funds through the issue of CDs. The market also

provides fund managers with a low risk asset class, which held to maturity are capital

stable. The market also provides ADIs with the opportunity to hold liquid assets.

● The market assists banks to manage their liquidity risk in two main ways. First, banks

invest and withdraw funds on an overnight basis to meet their day-to-day exchange

settlement (ES) requirements and second banks invest in eligible securities that can be used in repurchase agreements with the RBA.

● Banks borrow funds in the market through CDs, they enable other companies to borrow

funds through BABs and they invest in money market securities. Hence the market assists

banks to both borrow and lend and to earn acceptance fees while being an alternative source of funds for borrowers.

● The money market assists the RBA in three important ways. First, it provides the Bank

with its monetary policy instrument; the target cash rate for the inter-bank market.

Changes in the target cause all interest rates in the market to move as well as other

interest rates that are based on the target rate. Hence it is the link between monetary

policy and the cost of funds within the economy. Second, it assists banks to manage their

ES funds and so assists the RBA perform its responsibility for the payments system.

Finally it allows ADIs to manage their liquidity needs without relying on the RBA.

In Australia the main reference rates of money markets are the as bank-accepted bill rate

(BAB rate) and bank bill swap rate (BBSW) for specified periods, such as 30, 60, 90 and 120

days. They are commonly used in floating-rate loan agreements to identify the interest rate to

use at the start of each quarter. Allowance is made for each borrower’s credit risk by adding a

risk premium to the reference rate to specify the exact rate for each quarter.



4.8 Money market participants

The Australian money market is an over-the-counter market conducted by professional

dealers. That is, there is no specific forum where trading takes place. Instead, the market is

essentially an electronic communications system with trading being conducted mainly over

the telephone.

The money market deals in large sums and serves mainly wholesale borrowers. Accordingly,

we may identify the following main participants in the market:

● The Reserve Bank, which uses the market both as a source of short-term financing for government, and also in the implementation of monetary policy.

● Depository institutions, such as banks and building societies, use the market in the

management of liquidity.

● Funds managers for superannuation funds, life insurance offices and cash management trusts, are the main investors.

● Companies, which have either built up liquidity to meet anticipated outflows, or are in need to short-term funds.

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4.9 Pricing money market securities

Debt instruments issued in the money market are known as discount securities. Such

securities are issued at a price below face value, with a promise to pay the face value at

maturity. Accordingly, the face value payment in effect includes interest.

In the Australian money market, trading is on the basis of yields. Thus, given an interest rate

quote, the price of the security may be found from the following equation:

1

FP

rt

(6.1)

where: F is the future amount, or face value;



Example: A 180-day security, with up face value of $100 000, is purchased at 8.75%. What

is the price?

100 000

1(0.0875 * 1

80/365)

$95 863.43

P

Equation (6.1) may be rearranged to give the yield to maturity:

1

F diyr

P d

(6.2)

This may be restated as:

or 1

sell

buy

F P diyr

P d

(6.3)

4.10 Money market segments

The Australian money market is not a single market as such, but can best be thought of as

consisting of a number of broad sub-markets trading in particular securities.

● Treasury notes: These are issued by weekly tender conducted by the RBA on behalf of

the treasury, and are for terms of 5, 13 or 26 weeks. The secondary market in treasury notes has not been particularly active in recent years.

● Commercial paper: Promissory notes issued by large companies, with good credit

ratings, are generally referred to as ‘commercial paper’. The credit rating of the issuer is

important as commercial paper is often unsecured.

● Negotiable certificates of deposit (CDs): These are similar to commercial paper, but are issued by banks, typically for periods of less than three months.

● Commercial bills: The process of bill issue and acceptance was described in the reading

from chapter 5 of the prescribed text, referred to earlier. Suffice it to say, therefore, that the bank accepted bill is the dominant security in the Australian money market.

● Intercompany and interbank lending: There is also short-term lending between

companies, and from one bank to another. The lending of surplus exchange settlement

account funds is a significant aspect of the interbank market.



4.11 Repurchase agreements

A repurchase agreement (repo) involves two transactions which are entered into

simultaneously by two parties. The first transaction involves party A selling party B a

financial security for an agreed consideration. The second transaction which occurs in a short

time (generally less than a few days) entails Party B selling the security back to party A. The

second transaction is at a higher price which provides a return for B.

4.12 Role of the central bank

As we saw earlier, the RBA has responsibility for the sale of T-notes. In general, however,

central banks participate in the money market for two reasons: the pursuit of monetary policy

and the management of liquidity.

In Australia, monetary policy is largely implemented through the RBA’s so-called ‘cash rate’,

also known as the ‘interbank overnight rate’. The cash rate may be thought of as an official

rate. Changes in this rate have an effect on other money market rates, with a spillover to

securities with longer maturities.

Liquidity management involves the provision of funds to, or the removal of funds from, the

banking system so as to achieve a smoothing effect. To this end, the RBA makes use of short-

term government securities and repurchase agreements (repos).

RBA uses repos and foreign exchange swaps in conducting open market operations (OMOs).

RBA prefers to use repos in conducting OMOs. The main reason is that repos provide a great

degree of flexibility in carrying out monetary policy. From the RBA’s perspective it expands

the potential pool of investors (as investors are not required to permanently buy/sell existing

securities), it reduces risk as the RBA is not obligated to hold large parcels of riskier private

sector securities in its portfolio for extended periods of time, and it allows the RBA to better

manage the cash position into the future (i.e. if the cash position is expected to be in surplus

in 14 days time, the RBA could ensure its maturity of repos bought today also ends in

14 days time).

4.13 The international money market

Many of the financial instruments described earlier in this module also have an international

dimension. For example, interbank lending may take place between domestic and foreign

banks. Similarly, commercial paper and certificates of deposit are offered on the international

market. Much of this activity takes place in the Eurocurrency markets.

Self assessment 2

Questions 3, 5, 6, 7, 14 & 15; Quantitative problems 2, 5, 6, 8, & 9 from

Mishkin & Eakins, chapter 11.

Answers are in the solutions manual.



Additional self-assessment

Weekly on-line tutorial – see USQStudyDesk.

Conclusion

In this module we presented an overview of debt securities and the markets for them. In the

next module, we elaborate on interest rate risk management (module 5).

Module 4 – Debt securities and markets - CA Sri Lanka 4 – Debt securities and markets 1 ......

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