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Authors: Keith Dickinson
Financial Markets Operations Management (5 page)
Commercial paper
(CP) is a short-term unsecured instrument issued by corporate entities. As CP does not normally pay interest, it is issued at a discount to its face value and on maturity the holder receives the full face value. The discount represents the investor's interest.
Although CP is negotiable and can be sold in the secondary market, most CP is held to maturity.
There are two major markets for CP:
- The US dollar domestic market (US-CP), and
- The Euro commercial paper market (ECP).
The market price of US-CP is quoted as a discount rate. This is the rate of discount to face value at which the CP is being issued or sold. At a 7% per annum discount rate, US-CP with a one-year tenor would be issued at 93.00 (100% less 7%). At a discount rate of 7% per annum, US-CP with a 180-day tenor would be issued at 96.50 (100 minus 7.00 x 180/360).
Most ECP issues are denominated in US dollars and range in maturities from 7Â days to 12Â months, with 90 days being typical. ECP is priced on a discount-to-yield basis (like CDs) and not on a discount to par, as with US-CP. The day-count convention for non-GBP ECP is actual/360; it is actual/365 for sterling.
The cost of ECP will be the face value discounted by the yield and the tenor of the CP.
Treasury bills (T-bills) are issued and guaranteed by governments as part of their debt-financing activities. T-bills are issued on a regular basis by auction with maturities out to 52 weeks and priced at a discount from the face value.
T-bills are not interest-bearing, and the difference between the face value and the purchase cost represents the interest earned on the bill.
There are four terms of T-bill that investors can bid for.
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These are shown in
Table 2.12
together with cash management bills.
TABLE 2.12
US Treasury bills auction frequency
| Term | Auction Frequency | |
| 4-week | Every week | Competitive bid (investor specifies the discount rate) or non-competitive (investor accepts the discount rate determined at the auction). |
| 13-week | Every week | |
| 26-week | Every week | |
| 52-week | Every four weeks | |
| Cash management bills | No regular schedule; CMBs are auctioned as required. |
For example, if a USD 1,000 26-week bill were to sell at auction for a 0.145% discount rate, the purchase price would be USD 999.27, a discount of USD 0.73. The purchase price can be determined from the following formula:
Where:
- P
= Price - F
= Face value - d
= Rate of discount - t
= Days to maturity
During periods when Treasury cash balances are particularly low, the Treasury may sell
cash management bills
(or CMBs). These are sold at a discount and by auction just like weekly Treasury bills. They differ in that they are irregular in amount, term (often less than 21Â days) and day of the week for auction, issuance and maturity.
Treasury bills are zero-coupon bearer government securities issued in minimum denominations of GBP 5,000 at a discount to their face value for any period up to one year. Prices
are based on a money market yield to maturity calculation priced around prevailing General Collateral (GC) repo rates, adjusted by a spread reflecting recent Treasury bill tender results and, if applicable, any specific supply and demand factors.
Although they are usually issued for 3 months (91Â days), they have occasionally been issued for 28Â days, 63Â days and 182Â days.
They are issued:
- By allotment to the highest bidder at a weekly (Friday) tender to a range of counterparties;
- In response to an invitation from the Debt Management Office
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to a range of counterparties; - At any time to government departments (non-marketable bills only).
The secondary market in Treasury bills has, in recent years, become illiquid and representative rates are no longer obtainable other than those for the most recently issued 91-day bills.
Now that we have seen the money market instruments and noted that the tenor of these instruments tends to be at the short end with a maximum tenor of typically 12 months, we will turn our attention to the capital markets by looking at the various debt instruments. The word “debt” simply means “loan” and loans can be subdivided into three types:
- A bilateral loan is where, for example, a customer borrows cash from its bank.
- A syndicated loan is where a corporate customer borrows not from one bank but from a group of banks.
- A securitised loan is represented by the issuance of a bond. This bond is divisible into smaller portions of the total loan and can be bought and sold by other investors.
It is the third type of loan that we are interested in; we will not be covering bilateral or syndicated loans in this book.
A bond is a security that represents the indebtedness of the issuer of the bond (i.e. the borrower) to the holder of the bond (i.e. the investor). The issuer has an obligation to service its indebtedness by paying interest on a regular basis and repaying the debt when it falls due.
It should be noted that the holders of bonds do not have any voting interest in the issue unless the situation arises where the issuer is in a distress situation and is unable to service the debt. Bondholders are creditors to the issuer and rank senior to investors who own shares in the issuer.
Bonds can be issued by a variety of entities including:
- Governments and government agencies;
- Sovereign states;
- Corporations;
- Supranational institutions;
- Public authorities.
Government bonds tend to be issued through an auction process. Depending on the market, either market makers only can bid for these bonds through a competitive process or market makers can bid competitively along with other investors who can bid non-competitively.
By contrast, other types of bonds can be issued through an underwriting process where a syndicate of banks and securities houses buys the issue of bonds and sells them to other investors. A smaller group within the syndicate, known as book runners, will act as adviser to the issuer and arranger of the bond with direct links to the syndicate and other investors.
With government bond issuance, under the auction process, potential investors will bid for the bonds and will either be successful or not. The difference from the other types of bonds, which are syndicated, is that the book runners take the risk of the whole issue onto their books until such time as they can sell the bonds to other investors.
We refer to this activity as bond issuance in the primary markets; once the bond has been issued (and the issuer has received the cash) it automatically goes into the secondary markets until such time as the bond is repaid. So the primary markets are for the new issuance of bonds and the secondary markets for the subsequent trading and investment activities.
There are various ways to categorise bonds, including:
- Domicile
- Interest rate
- Maturity.
From the point of view of the issuer, bonds can be issued either in their domestic currency or in a foreign currency. We can classify these bonds into one of three types:
- Domestic bonds:
These are bonds issued in the country of the issuer, the currency of the issuer and using a syndicate of domestic banks and investors. - Foreign bonds:
These are international bond issues underwritten by a syndicate of banks primarily from one country, denominated in that country's currency and sold principally in that country. The issue, however, is domiciled outside of that country. For example, if the European Investment Bank wishes to raise US dollars in New York, the issue will be called a foreign dollar bond. Foreign bonds are usually referred to in terms of some local characteristic, for example, a US-dollar-denominated bond issued by a non-US entity in
the US market is referred to as a Yankee bond. Other foreign bonds include Samurai (Japan), Bulldog (UK) and Matrioshka (Russia) to name but a few. - Eurobonds:
Like foreign bonds, Eurobonds are international bond issues, but they differ from other types of international bonds, in that they are underwritten by an international syndicate of commercial and investment banks and they are sold principally in countries other than the country of the currency in which they are denominated. For example, if the European Investment Bank wishes to raise dollars outside of the USA, the issue will be underwritten by the international syndicate of banks and will be sold on initial distribution in countries outside of the USA. From an investor's point of view, the differences between Eurobonds and foreign bonds are largely technical. The main differences relate to the composition of the underwriting syndicates and the selling features.
Also known as a
coupon
, this is the rate of interest that the issuer pays to the bondholder. The term “coupon” refers to the fact that when bonds are in paper form (certificated), the bondholder has to remove (or “clip”) a coupon from the bond certificate and present it to the appropriate paying agent in order to receive the interest. Depending on the type of bond, coupons are usually paid on a semi-annual or annual basis.
When the bond is issued, the coupon rate can be set at a rate that will not change during the life of the bond. This is a
fixed-interest bond
. Conversely, there are bonds where the coupon rate changes periodically. These are
floating-rate bonds
. The most common type is a
floating-rate note
(FRN), which usually pays coupons on a semi-annual basis but can also pay quarterly.
This refers to the date on which the issuer is obliged to repay the principal amount. Bonds, which are long-term securities, typically have maturities greater than seven years. Traditionally, most bonds have a term in the 25- to 30-year period, but there are bonds which have been issued with 50 years' maturity and there are even some bonds issued with no maturity at all. These are known as
undated
,
perpetual
or
irredeemable bonds
.
- Principal:
This is the amount on which the issuer pays interest and repays the loan at the end of the term. Repayment is usually the principal amount (at par). The term “principal” is synonymous with the terms nominal, par value and face amount; please note that the principal amount is not the same as the market value; we will look at this in more detail later on. - Yield:
The yield is the rate of return received from investing in a bond. There are two types of yield:- current yield (running yield) â this is the annual interest payment divided by the current market price of the bond;
- yield to maturity (redemption yield) â in addition to the current market price, this yield also takes into account the amount and timing of all remaining coupon payments and the length of time to maturity.
- current yield (running yield) â this is the annual interest payment divided by the current market price of the bond;
- Market price:
The market price of a bond is quoted in percentage terms and is calculated by considering all future cash flows (i.e. coupon payments and maturity payment) and
converting them into a net present value (NPV). This NPV is the market price of the bond. Whilst the market price is, in fact, a percentage, it is quoted as a number to four decimal places.
For example, the UK Treasury 4.5% 2042 bond has a price of 115.4500 and a yield to redemption of 3.64%. You will notice that whilst this bond pays a coupon of 4.5% per annum, the yield is only 3.64%. This is because the price is above par (i.e. 115.4500) and has the effect of reducing the impact of the interest rate. We will look at this relationship between yield and price in more detail in Section 2.4.8.
There are many types of bond, but we will concentrate on some of the major types. The descriptions that you will see below are not mutually exclusive and any particular bond might have more than one type associated with it.
- Fixed-rate bonds:
The interest rate is set when the bonds are first issued and stays the same throughout the life of the bond. (Please note that the term “coupon” is synonymous with the term “interest”.)
- Floating-rate notes (FRNs):
The interest rate varies periodically and is linked to a reference rate of interest such as LIBOR or EURIBOR. Depending on the creditworthiness of the issuer, the bond might also have an additional margin, for example the coupon rate might be fixed linked to six-month LIBOR plus 0.15%. In this particular case, the interest rate would be recalculated (re-fixed) every six months.
- Zero-coupon bonds:
These bonds do not carry any coupon and are issued at a substantial discount to par value. For example, if a zero-coupon bond is issued at a price of 80%, it will be repaid at par (i.e. 100%). The gain of 20% is treated as interest rather than capital for tax purposes. - High-yield bonds:
So-called because these bonds earn a higher yield due to the fact that they are rated below investment grade by the credit-rating agencies.
- Convertible bonds:
These bonds have a fixed coupon rate, maturities usually between 10 and 15 years and are structured so that there is the right to convert the bonds into ordinary shares of a company. Typically, it is the bondholder that has this right and the ordinary shares are those issued by the issuer of the bond. There are convertible bonds, however, that give the bond issuer the right to convert and it is possible to convert the bond into shares of another company other than the issuer. The conversion price and the conversion period are fixed at the time of issue.
Traditionally, bonds would be issued in the form of certificates. It is more usual today for bonds to be issued with a single global certificate with deliveries and receipts reflected in a book entry format.
Domestic and foreign bonds together with government bonds tend to be in registered form, where the bond issuer (through a third-party organisation known as a
registrar
or
transfer agent
) keeps a record of the investors and all movements on to and away from the register. Interest on these bonds is usually payable half-yearly, but note that with some FRNs, interest is paid quarterly depending on the terms of the issue.
Eurobonds are always issued in bearer form with no corresponding bond register and the bondholder is presumed to be the owner of the bond. Interest on Eurobonds is usually paid annually and is paid gross without deduction of withholding tax or any other taxes.
Bond prices are quoted as a percentage of par, to which must be added accrued interest where appropriate.
Bonds are usually issued in multiples (denominations) of 1,000 units of currency; however, depending on the terms of issue, the denominations could be smaller (e.g. UK gilts are transferable in denominations of GBP 0.01) or larger (e.g. in denominations of USD 10,000 or more). A small denomination can be helpful to an investor who wishes to invest a set amount of cash rather than purchase a set denomination of the bond, as the following examples illustrate for an investor who has USD 10,000.00 in cash to invest (see
Tables 2.13
and
2.14
).
TABLE 2.13
Example 1: Bond denomination is USD 0.01
| Cash Available | Bond Price | Principal Amount of Bond Purchased |
| USD 10,000.00 | 97.1250 | USD 10,296.01 |
TABLE 2.14
Example 2: Bond denomination is USD 1,000
| Principal Amount of Bond Purchased | Bond Price | Cash Paid |
| USD 10,000 | 97.1250 | USDÂ 9,712.50 |
| Cash available to invest: | USD 10,000.00 | |
| Uninvested cash: | USDÂ Â 287.50 |
In Example 1 (
Table 2.13
), the investor is able to spend USD 10,000 and the amount of bonds purchased reflects the price of the bond to the nearest cent.
In Example 2 (
Table 2.14
), the investor could only buy the bond in multiples of 10,000, which would have left the investor with USD 287.50 uninvested.