Insider's Guide to Fixed Income Securities & Markets

University.

1

Introduction to Fixed

Income Securities and

Markets

For individuals relatively new to the fixed income business, just beginning to get an idea of the scale and complexity of these markets, trying to make sense of it all can seem a daunting task. However, the fundamental elements of debt securities and the structure of the markets wherein they are issued or traded are understandable for most if the information is presented in a simple, comprehensible way. That is the goal of this text.

Chapter One’s role in fulfilling that mission is to create a conceptual framework, making it easier to organize and interpret fixed income market related information and events. The foundation of that framework will be laid by introducing in detail the central fundamental concepts common to nearly all debt securities along with the related terminology. Building on that foundation, the structure of the fixed income markets will be described. The discussion will entail segmenting the market into sectors from a variety of perspectives (e.g. credit risk, issuer type, etc.) commonly used when analyzing or describing various aspects of fixed income investment performance or market conditions. That framework will hopefully lead to a more effective method for organizing and understanding the mass of detail in the subsequent chapters. Chapter One is designed to create the context into which the content from the following chapters can be uploaded in an organized fashion. Before starting construction of that framework in the next section a quick orientation to fixed income instruments and markets will provide handy reference points for laying the foundation.

Orientation to Markets and Instruments

A wide variety of instruments with diverse structures trade in the fixed income markets. Later chapters on individual market sectors will discuss in detail all of the major types of fixed income securities. But, from the simplest debt contracts to the most complex, the majority of fixed income instruments have a variety of shared contract features and related terminology in common. Let’s use the most basic type of debt security, a single issuer non-callable bond, to illustrate some of the fundamental characteristics of fixed income securities.

Bonds are financial claims issued (i.e. sold) by governments, government agencies, or private corporations to obtain funds. The proceeds are used for a variety of purposes: funding capital investment, meeting operating expenses, or repaying debt being retired, among other possible uses. Investors are buying the bonds, hoping to earn a reasonable rate of return on their invested funds.

The fixed income markets are a medium enabling issuers to raise funds and providing investors with a mechanism to invest in or trade securities. Indeed, the ability of the original investor to sell the bond during its life (there is no requirement to hold bonds to maturity) reduces the risk to the investor and so allows bond issuers to borrow at a lower cost. The markets where this action takes place are quite large, actually much larger than the equity (i.e. stock) markets of which the general public has a greater awareness.

Having a sense of their scale provides some insight into the importance of fixed income markets. How large are the fixed income markets?

Market size is often expressed relative to the real economy. This may not be the most apt comparison, though it is one commonly made. The size of the markets is a stock measure: what is the amount of securities outstanding at a given moment in time? Economic activity is a flow measure: what was the amount of production over some period of time? Simply contrasting the dollar sizes of the bond market and the real economy is problematic because it is not an apples-to-apples comparison. A simple ratio of the two magnitudes at any moment in time is likely not very insightful by itself. On the other hand, looking at this ratio over time for the bond market, or comparing this ratio for different markets (e.g. the stock market versus the bond market) and seeing how the relative value of the ratios for the two varies over time, likely does provide valuable insights. So, keeping in mind that caveat about using the economy as a benchmark for expressing the relative size of individual financial markets, let’s consider the numbers.

Using US data as of late 2015 the dollar value of outstanding fixed income securities was about $39.5 trillion compared to the estimate of approximately $17.9 trillion for 2015 gross domestic product. So the fixed income market is a bit more than twice the size of the real economy in the US at the time. That does not seem like an atypical ratio for the developed economies. Countries such as Japan, the UK, and Italy all have debt markets more than twice the size of their economies. In emerging economies fixed income markets tend to be less developed and thus tend to be smaller, relative to the size of the economies.

What’s a Bond?

So, exactly what is a bond? A bond is really nothing more than a loan that has been created in a fashion that allows for relatively easy assignment of the loan (i.e. sale) to another party. In other words, a bond is a loan whose contract provisions and original sale satisfy any legal or regulatory requirements so as to facilitate relatively easy transfer from the buyer at issuance to some subsequent investor.

In many respects, bonds and loans are essentially the same, though different terminology can mask those similarities to the uninitiated. Consider the language employed when describing or discussing bonds and loans. The two instruments share many features, although in some instances different words are used to describe features common to both.

Both bonds and loans entail an exchange between two counterparties. One of the parties receives funds and as a result incurs an obligation specifying the terms of repayment, normally with interest. The provider of funds in a loan is referred to as the lender, whereas in a bond offering it is investors that are providing the funds. The borrower is the party obtaining funds under the terms of a loan. An issuer is the receiver of the proceeds in a bond offering. Note the effective equivalence. In effect, the issuer of the bonds is borrowing the proceeds of a bond offering from the investors. The common features and divergent terminology of bonds and loans is shown in Exhibit #1-1.

Exhibit #1-1

Differences in the most common form of bond offerings versus loan originations also serve to obscure the effective equivalence of the two. That difference in form causes some fixed income market neophytes to make false distinctions between bonds and loans. The most common structures of bond issuance and loan origination are reflected in the top portion Exhibit #1-2 to highlight the differences. Often loans are conceived of as transactions between a single borrower and a single lender, while security offerings are borrowings by a single issuer from many investors. While these descriptions are generally true in the majority of instances, there are numerous exceptions. The bottom portion of Exhibit 2 illustrates some of those.

Exhibit #1-2

For example, a single lender might not want the concentrated credit risk exposure that a very large loan to a single borrower would entail. This situation is illustrated in the lower right hand portion of Exhibit 2. Say, Exxon-Mobil wanted to borrow $3 billion and inquired about the possibility of a loan from J.P. Morgan Chase. J.P. Morgan Chase might decide that a loan of that size is an excessive amount of exposure to a single corporate borrower if it were to fund the entire loan by itself. However, not wanting to forgo an opportunity to make money (and keep a client happy) J.P. Morgan Chase could syndicate the loan. In other words, J.P. Morgan would bring together a number of banks that would contribute to funding the Exxon-Mobil loan. In the corporate banking world, it is common to have large loans to a single borrower with many banks participating in the syndicate.

On the other hand, in a private placement of debt securities, sometimes an entire bond issue is placed with just a single institutional investor (Exhibit #2, lower left hand portion).

There are even fixed income securities in which the cash flows that are payable to investors come from many different borrowers. The cash flows are typically derived from a pool of loans or other credit instruments, which are obligations of many individual borrowers. This is the structure of mortgage-backed and asset-backed securities, debt instruments where claims against many obligors are packaged for resale in a single issue of securities.

Principal is a concept one encounters when considering either bonds or loans. However, principal does not necessarily carry exactly the same meaning for both instruments. For loans, principal represents the amount borrowed and the amount that would have to be repaid along with the contractual interest payments to pay off or extinguish the liability.

Confounding to many new to the markets, with bonds the connection between the principal and the amount borrowed is not so clear-cut. A bond’s principal is the amount that the security holder is to receive along with the contractual interest payments for the debt to be paid off or the liability to be extinguished. To that extent, principal has the same meaning for bonds and loans. However, while the principal is the amount due to the bondholder, it is not necessarily the amount that was borrowed by the bond issuer (the issue price of the bond). That is because bonds are often issued at prices other than par (i.e. prices other than 100% of the principal amount). The reason for an issue price other than par is a bit of bond market arcana that will be addressed later. But no matter the price at which a bond is issued, even if issued at a premium or discount (i.e. a price more or less than the principal amount), it is nonetheless exactly the principal amount (plus the contractual interest payments, of course) that has to be paid to the bondholder to extinguish the debt.

While the implication of principal amount versus amount borrowed can differ for bonds and loans, principal carries the same connotations for both regarding the other aspects of the contracts. Whether considering a bond or a loan, the periodic coupon or contractual rate of interest is payable on the principal amount. The same terminology applies with respect to the timing of principal payments. For a term bond or loan all principal is due in a single payment at maturity, at the end of the contract’s life. For an amortizing bond or loan principal is to be paid gradually according to a specified schedule over the life of the contract.

Exhibit #1-3 relates the common and divergent uses of terminology as it relates to the meaning of principal when used in connection with bonds and loans.

Exhibit #1-3

The party obtaining funds via a bond issue or loan will normally have to compensate the provider of those funds. Interest is the compensation the provider of funds receives for giving the issuer or borrower the temporary use of their monies. For loans, the cost of funds is typically referred to simply as interest, and can be expressed as an interest rate or in dollar amounts. The interest payments by a bond issuer are usually expressed in the form of a coupon rate, which is payable as a specific dollar amount to the holder of the bond. Here again one can see the effective equivalence of loans and bonds.

The timing of interest payments on loans or coupon payment dates on bonds can be structured in a variety of ways. For most intermediate to long terms loans, the interest will be payable over the life of the loan. The timing and amount (or method of determining the amount) of interest payments would be specified explicitly in the terms of the loan. With the majority of bonds, the interest is due the holder in the form of a periodic coupon payment. The frequency of coupon payments (compounding frequency in the parlance of the business) depends on the bond contract. Coupon frequency usually reflects market conventions (i.e. common practice) for that market sector and type of security.

Most loan agreements require payment of interest, and in some cases partial return of principal, over the life of the loan. While it’s possible a loan would require no payments of either interest of principal prior to maturity, that repayment schedule would be very uncommon for anything other than very short dated loans. Though much less common than bonds entitling the holder to periodic coupons, there are debt securities that provide the investor no payments prior to the ultimate maturity. The only payment due to the holder is the face amount or par value at maturity. That single payment represents both a return of the original investment as well as the interest on the investment. Short maturity instruments (generally ≤ 1 year) with that cash flow structure are known as discount securities. Longer maturity instruments are called zero coupon bonds or treasury strips.

The interest distributed to bondholders, the coupon payments, can be structured in a number of different ways. Most debt securities have fixed coupons. Therefore, the rate of interest earned is constant over the life of the bond. Naturally, securities can have much more complex coupon structures.

Some securities have coupon rates that float. That is to say, the coupon rate is adjusted over time. The bond contract specifies a formula that will be used to reset the coupon rate. Typically, the floating rate coupon is based on a reference index rate. An index rate is nothing more than a market interest rate that is being used as the basis for setting the coupons on an instrument whose rate varies over time. Libor, the London Interbank Offered Rate, is a common index rate, although many different interest rates are used as index rates. Most floating-rate instruments do not pay exactly the index rate or the index rate flat as it might be expressed. For most issuers the index rate would be adjusted by a differential that reflects the perceived credit risk of the issuer. For example, a coupon formula could be 90-day Libor plus ¾ of 1%. The cognoscenti would express that as L+75. Since L stands for Libor and 75 for .75% the interpretation is Libor plus 75 basis points in market jargon.

Other adjustments to the coupon rate are possible. While not common, some bonds have a coupon rate that varies according to a specified schedule. Such a feature is referred to as a stepped coupon or split rate coupon. The coupon is fixed at one rate for some period of time at issuance then resets at another, usually higher, rate one or more times over the remainder of the bond’s life. A coupon could also be reset as a result of some triggering event such as a credit rating cut.

Fixed Income Markets, Credit Markets, and the Capital Markets

To complement the previous introduction to the basic characteristics of fixed income securities it would be helpful to have an understanding of the markets in which they’re traded. A good start would be placing those markets in a broader context. Bond or fixed income markets are a subset of the capital markets. Using the capital markets as a starting point, consider the role fixed income markets play in the operation of the financial markets and the real economy.

Markets typically are a mechanism for bringing together buyers and sellers. That is generally true whether the market being discussed is a bond market, another segment of the capital markets, or for that matter, a farmers’ market or flea market. So one might imagine that capital markets are a medium for bringing together buyers and sellers of capital.

As it turns out, that is one of the primary functions of securities markets, of which the bond markets are a component. However, conceiving of capital markets only as a mechanism for channeling capital into real investment is a bit overly simplistic. In the majority of bond transactions the issuer is not receiving any money. Beyond that there is not necessarily an exchange of capital in all capital market transactions. There are certain types of derivative contracts and even some insurance contracts where no money would change hands at the time of the initial transaction even though the counterparties have entered into contracts that both are legally obligated to fulfill.

So, if capital doesn’t change hands in every capital market transaction, what is actually being exchanged between the two counterparties to a trade? No matter the nature of the trade, the risk profiles of the buyer and seller are impacted. Therefore, even though channeling wealth into real investment is perhaps the most widely appreciated function of the capital markets, a broader way of thinking of capital markets is to consider them as markets for exchanging (and pricing) risk. Capital does not necessarily change hands in all capital market transactions. However, capital market transactions will always impact the risk of the asset or liability portfolios of parties to the trade.

The phrase capital markets can have a range of connotations depending on the speaker or author. We will use what is perhaps the most common way of interpreting that phrase, which is the perspective reflected in most economics texts that broach the subject. Capital markets are a group of economic structures in which various types of financial claims are traded. To most, the phrases capital markets and financial markets are used interchangeably. Exhibit #1-4 shows the four broad segments of the capital markets that are often identified when explaining how the markets operate and the role they perform in the functioning of the economic system. The sectors are differentiated from one another by the nature of the financial claims traded in each.

Exhibit #1-4

We’ll start with the securities markets. These are the markets that are most directly focused on the channeling of wealth into real investment, which many think of as the quintessential purpose of capital markets. As indicated earlier, this is one of the most important (but only one of several important) functions performed by the securities markets. Several of the other important functions will be introduced later in the chapter when fixed income markets are explored in detail.

A second segment is the derivatives markets. The name derivative causes a lot of confusion about the nature of these instruments. Misunderstanding is fostered by the overly simplistic (typically misleading) way most books describe how markets price derivatives. Derivative markets in general perform a significantly different role than that performed by the securities markets. Derivative markets exist primarily to allow participants to manage risks that they would otherwise be exposed to in the normal course of their commercial or financial activities.

A third segment of the capital markets are the currency markets. These are the markets in which one currency could be exchanged for another. These markets allow for the financing of trade in goods and services between different countries as well as facilitating cross-border investments, such as foreign direct investment (FDI, i.e. acquiring nonfinancial assets such as factories or land) and portfolio investment (i.e. acquiring securities denominated in other currencies).

Finally, there are the insurance markets, which perform a function somewhat similar to the derivatives markets. Both derivative and insurance markets facilitate the creation of financial instruments for managing risk exposures.

Each of the broad segments of the capital markets can be divided into a number of subsectors. Derivatives market subsectors would be characterized by the different types of derivative contracts traded such as options, futures or swaps. For the currency markets, the sectors are composed of individual currencies pairs traded for and valued in terms of one another such as dollar/pound or Swiss franc/euro or dollar/yen. Insurance markets subsectors are delineated by the type of insurance product issued: life, health, property-casualty, etc.

Let’s return our attention to the securities markets wherein the bond market is located. Securities markets have two major subcomponents: the equity markets and bond or debt securities markets. Equity markets enable the issuance and trading of ownership interests, which are referred to as equity securities or common stocks. The terms bond and debt security are synonymous. Bond markets and debt securities markets are alternate ways of referencing the institutional arrangements that have evolved to facilitate the issuance and trading of debt obligations or credit instruments

Speakers and authors often use the terms bond markets, fixed income markets, credit markets and debt securities markets as if they are perfectly interchangeable. Treating the phrases as synonymous entails taking a certain amount of literary license as the phrases do not mean precisely the same thing if one is using narrow, technical interpretations of the different phrases. The authors or speakers treating the phrases thusly are simply trying to make their presentations more engaging by varying their words. Since the goal here is to establish a solid foundation, it is appropriate to be more precise. Two of the four phrases are synonyms of one another, but the other two imply something a bit different if the phrases are taken literally.

Which two are equivalent? Which is the largest most encompassing category? The largest category completely subsumes one of the remaining two and encompasses more than 95% of the third. What’s the distinction between credit markets, bond markets, debt securities markets, and fixed income markets?

The equivalent phrases are debt securities markets and bond markets, as bond and debt security are equivalent terms. Some might quibble here and assert bond means a long-term instrument where debt security isn’t maturity specific. While bond is often used to imply longer-term instruments, sometimes the word is also used as a general reference, just like debt security, with no specific implications about maturity. This discussion assumes the more general interpretation of bond. How are the remaining three categories—credit markets, fixed income markets and bond (or debt securities) markets, distinct from one another?

Consider credit markets first. What are credit instruments? Credit instruments are legal agreements that specify the transfer or payment of funds between two counterparties. Those two counterparties might generally be referred to as the obligor, the party that has a legal obligation to deliver funds, and the holder of the obligation to whom those funds are due. Each contract or instrument specifies the terms of payment, when principal is due as well as any interest due on that principal.

The bonds and loans discussed previously are examples of credit instruments. Those are but two examples from a multitude of credit instruments used in the economy. Credit instruments encompass a wide variety of things that run the gamut from personal checks to trade payables, to letters of credit. All debt securities are credit instruments, but not all credit instruments are debt securities. Exhibit #1-5 provides three examples of credit instruments: mortgage loans, credit card receivables and auto loans. Each of those credit instruments are created as a result of a commercial transaction, related to how the transaction was financed.

Exhibit #1-5

A purchase money mortgage is created when a homebuyer borrows some portion of the acquisition price of the property. Home sellers are normally paid in full. Buyers usually make a down payment of somewhere between 3 and 30% of the cost of the property and borrow the balance. In return for lending the funds to complete the purchase of the home, the lender requires evidence of their claim. The mortgage is a credit instrument specifying the terms of repayment of principal and payment of interest and gives the mortgage holder (the mortgagee) a claim against the mortgaged real estate known as a lien until the loan is paid off.

Credit card receivables are created as a result of any transaction paid for by use of a credit card. This example assumes the credit card holder is purchasing a restaurant meal. To pay for the food and beverages the diner uses her credit card. Processing that payment results in the restaurateur being paid by the credit card issuer. The diner now owes the price of that meal on her credit card account. In other words, a credit card receivable has been created.

The final illustration in Exhibit #5 is of an automobile purchase. In a typical auto transaction the car buyer, like a homebuyer, is usually putting some money down, but is likely borrowing some portion of the cost of the automobile. In return for receiving the funds to complete the purchase of the auto, the car buyer now owes the lender the amount borrowed plus interest, the evidence of indebtedness and terms of repayment reflected in a credit instrument known as an auto loan.

Exhibit #1-6 reflects the previous commentary about the range of instruments that comprise the credit markets. Credit markets are a way of generally referencing the areas of the economy wherein the creation (i.e. origination or issuance) and trading of credit instruments occur. It includes transactions ranging from individual borrower lender agreements to large issuances of securities.

Exhibit #1-6

A credit instrument is an agreement specifying the transfer of funds between two parties. As indicated earlier, all bonds (or debt securities) are credit instruments. However, there are many credit instruments that are not considered securities. Many credit instruments remain bilateral contracts, often held as interest earning assets by the original (originating) lender. In some instances the contract may be sold to another investor but remains a bilateral contract and thus would not be a security. Credit instruments not turned into securities (securitized) would not be considered part of the bond markets. So the bond markets—despite the large and important role they play in the operation of the global economy—are a subset of the still larger credit markets.

As indicated above, sometimes loans, receivables, or other bilateral credit instruments are turned into securities. That process is known as asset securitization. Though obligations like auto loans or mortgages are liabilities of the borrower, such credit instruments are initially assets of the originating lender. Asset securitization is the process of creating a collateral pool or asset portfolio that will generate future cash flows. Interests in the future cash flows will be sold to investors. While most asset securitizations are based on credit instruments, any pool of assets that would produce reasonably predictable cash flows could be the basis for creating structured securities, as these products are sometime called. A brief overview of the process might prove helpful.

Some firm will perceive a financial opportunity and decide to act as sponsor in a securitization of assets. The typical financial motives are either to profit from the structuring and sale of the securities, or to tap a cheaper source of financing than other funding alternatives, or even a combination of the two. The sponsor (if they are the original lender) will have, or acquire from others, title to the desired type of credit instruments to create the collateral pool. The title (ownership) of the credit instruments is transferred to a separate legal entity known as a special purpose vehicle (SPV). The SPV is then the legal owner of the instruments. Securities can be sold to investors entitling them to a share of the cash flows generated by the securitized assets held by the SPV.

Exhibit #1-7

The mortgage backed securities market is the oldest of the structured finance markets. The first mortgage securitization was a Ginnie Mae pass-through security based on 30-year residential mortgages in 1970. By the 1980s market participants realized that the structuring technology developed for mortgage loans, could be adapted for a variety of credit instruments.

Recognizing the opportunity, similar structures were developed for auto loans and credit card receivables in the mid 1980s. The investment characteristics and structural features of the various types of asset-backed securities differ to reflect the peculiarities of each market segment and the unique aspects of the particular credit instruments. Despite those differences, the general processes and structures devised for asset-backed securities are substantially similar to those developed for mortgage securitizations. Since then, securitization techniques have been applied to a wide variety of assets, including boat loans, equipment leases, legal settlements, lottery winnings and music royalties. However, auto loan and credit card receivable asset backed securities remain two of the largest segments of the asset backed securities market. Claims on the cash flows generated by pooled bilateral contracts are sold to investors as securities becoming part of the bond market.

Hopefully that discussion made a clear distinction between the bond (or debt securities) markets and the broader credit markets as well as how the former are a subset of the latter. What about fixed income markets? How do they differ from the other two? All bonds are fixed income securities, but not all fixed income securities are bonds.

That dichotomy results from a type of equity security known as preferred stock. The vast majority of fixed income securities are credit market instruments. Any debt security or bond, by the way the terms are defined, would be considered a credit instrument. Preferred stocks are considered fixed income instruments. However, preferred stocks are usually classified as equity securities, at least from a legal and accounting perspective. Regardless of their legal and accounting status, as investments preferred stock behaves a lot more like bonds than common equities.

Exhibit #1-8

Just like most bonds have fixed coupon rates, most preferred stocks have fixed anticipated dividend rates. Just as many bonds have credit ratings that assess the issuer’s ability to pay interest and principal in full on a timely basis, most preferred stocks have credit ratings that assess the issuer’s ability to pay the anticipated dividend in full and on time. Preferred stocks often have many other terms that are found in bond contracts. Both bonds and preferred stocks can be callable. Both bonds and preferred stocks can have a conversion feature that allows them to be converted into other securities.

Since preferred stocks have many bond-like features from an investing, trading and analytic perspective they are lumped together with bonds as fixed income securities. Consequently, when determining the asset allocation of a portfolio that includes debt securities, common stocks and preferred stocks, preferred stocks would be considered part of the fixed income allocation, not part of the equity allocation. However, since preferred stocks are not credit instruments, if one is being precise in the use of terminology, preferred stocks would not be considered credit instruments and therefore not part of the credit markets.

Primary Markets and Secondary Markets

Let’s delve into fixed income market structure by discussing the primary market and the secondary market. Securities markets are often segmented between these two when trying to describe or analyze the roles performed by the markets in the functioning of the real economy. There is a significant difference in the main tasks performed by the primary market and secondary market. Transactions in the two market segments differ in terms of the typical counterparties as well as the motivations of those counterparties. While distinct market segments, nonetheless the two have a complementary/symbiotic existence; the greater the efficiency of either, the more effective the performance of the other.

Primary markets are those markets where the sales of securities by, or on behalf of, an issuer are conducted. The role of the primary market is to help issuers raise funds. An issuance of securities can be structured in a variety of ways. The most common means is via a securities underwriting where a syndicate of brokerage firms and banks buy the securities from the issuer with the intention of reselling the securities to investors. The other most common method is via direct sales by the issuer to investors. While direct placement by the issuer is typical in private placements of securities, most issuers would not use them for public offerings. The major exception would be large frequent issuers such as major country governments that often make public offerings of issues sold directly to investors. Those two general methods on new issues are diagrammed in the top panel of Exhibit #1-9.

Exhibit #1-9

Secondary markets are the markets for trading previously issued (outstanding) securities. Secondary market trades are typically non-issuer transactions. It is possible that the buyer and seller in a particular trade are both investors, exchanging cash for securities. However, given the difficulty of matching, buying, and selling investors for securities that trade as infrequently as most bond issues, most secondary market trades will have a buying or selling investor on one side of the transaction with a bond dealer taking the other side of the trade. Those two types of secondary market trades are diagrammed in the bottom panel of Exhibit #1-9.

Though secondary market trades do not result in additional capital for the issuer, a thriving primary market cannot exist without a reasonably well functioning secondary market. Perhaps most importantly, the secondary markets give bondholders ongoing access to liquidity, that is, the ability to convert their securities holdings into cash. Nearly as important as the provision of liquidity, secondary trading provides ongoing updates regarding risks and expected returns. Secondary trading allows for continual re-pricing of securities as markets respond to new information. Besides liquidity and price information, secondary markets enable investors to pursue a variety of risk management and risk mitigation strategies. Let’s consider some of these market functions in more detail.

One of the most important functions of the capital markets is channeling wealth into real investment. Real investment refers to investment in tangible assets such as buildings and machinery or intangible assets like patents and trademarks. Real investments are actions that attempt to directly improve economic welfare through enhanced productive capacity. That outcome may result through either expanding the stock of physical assets or increasing the efficiency of existing assets. Buying securities is not considered real investment. Securities represent ownership of, or claims on cash flows generated by, real assets.

Simplified economic models have wealth accumulating in the household sector and real investment in plant equipment and new product or process development taking place in the business sector. The securities markets provide a mechanism for businesses to raise money from investors to fund real investments, providing investors securities as evidence of their claims on the issuing corporations. While lacking some significant details concerning the way fixed income markets operate in the real world, even such a simplified version of economic reality captures important elements of the nature of modern capital markets. The top portion of Exhibit #1-10 tries to capture the channeling of wealth into real investment aspect capital markets.

Exhibit #1-10

Individuals and families directly own only a very small percentage of the outstanding fixed income securities. Institutional investors are the actual holders of the vast preponderance of fixed income securities. The institutions also account for an even larger majority of trading volume. Institutional investors are entities such as mutual funds, pension plans, insurance companies and hedge funds to name but a few. Though institutions are the ones holding the financial assets that represent so much wealth, on whose behalf are the institutions acting? Mutual funds for their shareholders; pension funds for current and future retirees; insurance companies for the benefit of their policyholders; hedge funds investing for their clients. To a large degree, the institutions are acting on behalf of their clients or beneficiaries who, for the most part, populate the household sector.

Another shortcoming of the simplified economic model for capital markets regards issuers. Business corporations are significant issuers of debt as well as equity securities, but far from the only issuer of debt securities. The diverse levels of government (national, regional and/or local) as well as government agencies are also significant issuers of debt securities.

Some issuers of debt come to the market so frequently and sell such a large volume of securities that they are able to distribute securities directly to investors without assistance. Because these issuers come to market so often and sell so many securities, a large number of institutional investors and security dealers will be ready on short notice to buy all securities offered for sale. National governments of many countries and a very small number of other issuers use this method to raise capital.

Nearly all corporations, government agencies and even some national governments require assistance when issuing their securities. Most frequently, those offerings are structured as firm commitment underwritings. That name is quite descriptive because the manager and the members of the underwriting syndicate are making a firm commitment to buy the securities from the issuer. This means the underwriters will be liable for the purchase of any securities not sold to investors.

An underwriting syndicate is just a group of firms, typically comprised of banks and broker-dealers. The firms have joined together to accomplish a specific task; distributing securities on behalf of the issuer. Once that task is complete, the syndicate will be dissolved.

In a firm commitment underwriting, the manager and syndicate members are guaranteeing the issuer an agreed upon amount of money for the entire bond issue. That money is guaranteed to the issuer regardless of how successful or unsuccessful the resale of the bonds to investors. The manager and the syndicate members are hoping to resell the bonds to investors for more money than the amount promised to the issuer. Therein lies any profit to the underwriters. Securities’ underwritings of this sort usually go fairly well, which is why investment banking is often a high profit margin business. The diagram in Exhibit #1-11 illustrates some of those elements.

Exhibit #1-11

A recent offering by a widely known company should serve to illustrate this situation quite nicely. Apple Inc.’s first two bond sales were among the larger corporate bond offerings in history up to that time. Apple sold $17 billion worth of bonds in the spring of 2013 and another $12 billion worth of bonds in the spring 2014. Let’s take the second offering to illustrate a securities underwriting.

Deutsche Bank AG and Goldman Sachs Group Inc. co-managed the offering for Apple. While the underwriters were attempting to sell about $12 billion of bonds on behalf of Apple, investors placed orders for around $40 billion worth—more than $3 of bids for each $1 of bonds the syndicate had to sell. All of the bonds were easily sold. The greatest difficulty from the underwriters’ perspective was keeping their client’s happy. Obviously, not all orders could be filled in their entirety.

Naturally, in a competitive market there is no guarantee that offerings will go so smoothly. Indeed, the first time a corporation tried to sell $1 billion worth of bonds in a single offering the deal didn’t go quite as smoothly. By today’s standards a billion dollars is not a particularly large offering. Just think of the Apple offerings referenced in the previous paragraph. But back in 1979 a billion dollars was a very significant sum. The biggest corporate bond offering up to that time. Unfortunately for the underwriters trying to sell IBM bonds in that 1979 offering things went nowhere near as successfully as in the more recent Apple bond offering.

The underwriters priced the bonds too aggressively in attempting to win the underwriting assignment. That meant the securities were offered to investors at only a slightly higher rate than the same maturity US treasury notes. Market rates started rising during the underwriting. That resulted in the IBM bonds becoming even less attractive as the syndicate cannot adjust the price during the offering period. Ultimately, the syndicate was able to sell only about half of the bonds to investors. As it was a firm commitment underwriting, IBM received the issuance proceeds promised by the syndicate. To the underwriters’ misfortune, only about half of the funds came from investors, the other half came from members of underwriting syndicate who were obligated to buy all bonds not sold to investors.

The other segment of the fixed income markets to discuss is the secondary market. As was just discussed, the primary market facilitates the raising of funds for issuers, such transactions resulting in the origination (or in other words, the creation) of securities. The secondary market entails the trading of already outstanding (that is existing, previously issued) securities. For the most part secondary market trades are non-issuer transactions. The issuer of the bonds is normally neither the buyer nor the seller in secondary market trades.

In some secondary market trades, both the buyer and seller are investors exchanging money for securities. However, given the organization of the bond markets, usually a bond dealer will be the counterparty with which an investor is trading. Bringing together an investor looking to buy or sell a specific bond with another investor seeking to dispose of or acquire the same amount of the very same security at the same time is quite problematic. Financial intermediaries evolved to bridge the gap between buying and selling investors by making a market, standing ready to buy what others seek to sell or sell what others want to buy.

This is a structure known as a dealer market. Dealers (or market makers as they are sometimes known) are firms that hold themselves out to others as being willing to buy or sell certain bonds on a more or less continuous basis. Naturally, this is not a service dealers provide for free. The dealers participate in the market to make money and expect to be compensated for providing liquidity. When making a two-sided market, the dealer is quoting both a bid and an ask price. The bid is the price at which a dealer is willing to buy securities another market participant is seeking to sell. The ask is the price at which a dealer is willing to sell securities to another market participant seeking to buy. The bid price is below the ask price, so if a dealer makes a simultaneous buy and sell at those quoted prices, the dealer makes the spread, the bid/ask difference. A closer view of dealer activities comes later in the chapter. Here the focus is on the major economic functions performed by secondary markets.

Exhibit #1-12

Previously, channeling wealth into real investment was identified as one of the primary functions of the capital markets. A secondary market trade does not result in cash flowing to the bond’s issuer. The proceeds of the trade are going to a selling bondholder, not the issuer. Clearly, no wealth is being directly channeled into real investment as a consequence of a trade in the secondary market.

So how do secondary markets contribute to economic welfare? Though it might not be obvious, they do so in two significant ways. First, the secondary markets provide liquidity. Recall the earlier discussion of liquidity. Though liquidity has various implications in different contexts, in fixed income markets liquidity means the ability to convert a security holding into cash by selling bonds prior to their maturity. That ability to turn an investment into cash is an attractive feature. If bonds had to be held until maturity, many fewer investors would be able to buy intermediate or long-term securities. Most investors would be very hesitant about committing a significant portion of their investment capital to securities that required the funds be committed for 10, 20 or more years. Investments and life entail too much risk and uncertainty. That is true even for investors with long investment horizon. Our world is very unpredictable. Personal circumstances change. Expectations about the future change. The existence of markets that allow investors to obtain funds in exchange for securities prior to their maturity means a greater willingness to buy longer dated instruments.

While providing liquidity is perhaps the most obvious function of the secondary markets, each trade has an important byproduct, a price agreed between the buyer and seller. Perhaps the best estimate of an asset’s value is the amount that other market participants would be willing to pay for it currently, under normal market conditions. The interaction between buyers and sellers acting on the information gleaned from their research is a process sometimes referred to as price discovery. Prices in a market system are signals that provide information that generally enables more efficient allocation of resources and capital. Providing a mechanism for generating these price and interest rate signals is the other essential function of secondary markets. Primary markets price securities, but only once, at the time of the issuance. Secondary markets facilitate an ongoing reassessment of value.

Dealers or market makers will quote the values at which they would be willing to buy or sell securities. There are various ways security values can be expressed. To broach the subject from a more easily understood perspective, price quotes will be used to illustrate market making. While we won’t investigate it here in any detail, fixed income security values can also be quoted on a rate basis, or as it is sometimes said, on a yield basis. That means expressing the current market value on the basis of some interest rate. For bonds, the rates most commonly used rate would be either the yield to maturity or yield to call, as appropriate. Yields and yield quotes are explored in a later chapter.

Let’s consider bond quotes in context. Recall the earlier discussion of the secondary market for bonds. The structure was described as a dealer market. Bond dealers’ or market makers’ roles were briefly described as providing liquidity or as standing ready to buy or sell securities. A main source of a dealer’s hoped-for profits would be the difference between the prices at which a dealer is willing to buy and sell the securities, a difference referred to as the bid/ask spread, or sometimes simply the spread.

The bid is the price at which a dealer is willing to buy. The ask, also known as the offer, is the price at which the dealer is willing to sell. Assume a dealer is quoting a bid price of 95 and an ask price of 96. A simultaneous purchase and sale with different clients at the quoted prices would net the dealer the full spread, in this case the 1 point difference between the bid of 95 and the ask of 96. That situation is illustrated in Exhibit #1-13.

Exhibit #1-13

Be sure to interpret correctly the implications of the bid and ask prices as just described. They are the prices at which the dealer is willing, respectively, to either buy or sell. Naturally, the party getting a quote from the dealer will ultimately be on the other side of the trade should a transaction take place. This means an investor seeking to buy will have to buy at the price at which the dealer is willing to sell, the higher of the two quoted prices, the ask or offer price, 96 in this example. Conversely, an investor wanting to sell can only sell at the price at which the dealer is willing to buy, that is the lower of the two prices, the bid price of 95 in this case. In a sense, the counterparty trading with a dealer is always on the wrong side of the spread. Investors view the bid/ask spread as part of the cost of trading.

Fixed Income Market Sectors – Issuers of Fixed Income Securities

The two broad categories of fixed income issuers would be public and private. The public sector consists of debt issued by governments and government agencies. The majority of outstanding government debt issues are obligations of national governments or their agencies, though in some countries regional or local governments issue a significant amount of securities. The private sector would be comprised primarily of corporate fixed income securities and structured securities. Structured securities, or structured finance as it is also known, includes several categories of securities created by pooling a group of assets, usually credit instruments, then selling claims on the cash flows of the pooled assets. This process is referred to as asset securitization and is the mechanism for creating mortgage-backed securities, asset-backed securities and collateralized debt obligations, or using their acronyms MBS, ABS and CDOs. The specific contract features and investment characteristics of all the main types of securities will be covered in detail in later chapters. Here let’s consider the general characteristics of these broad categories.

Exhibit #1-14

First, public sector debt: National governments are almost always the largest single issuer of debt in any national market. Direct debt of a national government is also referred to as sovereign debt. Sovereign debt is generally considered as relatively safer than debt of other issuers. National governments are much less likely to go out of business than private corporations.

While that is generally true, sovereign debt is hardly risk free. Of all the countries that have been in existence for over a century, only a few have never defaulted. Some countries are serial defaulters, having defaulted multiple times. Nonetheless, most sovereign debt is relatively low risk compared to other issuers’ securities. Among fixed income sectors, sovereign debt is considered the safest, on average. Businesses ultimately have to be able to sell something to generate revenue. Governments have the ability to impose taxes and the police powers to enforce payment, normally a surer source of funds.

Many countries have a fallback position if tax revenues prove inadequate. Most countries operate their own monetary system. Where that is true, governments can create money. A country with an independent monetary authority would never have to default on debt denominated in the domestic currency as the government can create money to pay off its debt. Quantitative easing by the US Federal Reserve System is an example of money creation. The policy resulted in the Fed buying the majority of net debt issuance by the US Treasury during its 2014 fiscal year. Similar policies have been pursued to various degrees by the central banks of Japan and the UK among other national monetary authorities.

The phrases risk free security and risk free rate are sometime encountered in the context of the fixed income market when discussing sovereign debt. Those phrases are references to securities, or the interest rate on those securities, issued by the governments of the larger developed economies that have an independent monetary system. Understand that there is an unspoken word that is assumed to precede either of those phrases. Stated more fully, the phrases would be default risk free securities or default risk free rate. The combination of a large tax base and the ability to create money means such issuers would never need to default as long as there is a willingness to pay. The absence of default risk does not relieve holders of these securities from the other factors that cause returns to be uncertain. Holders of US treasuries or British gilts would still be exposed to numerous other uncertainties common to fixed income investments such as inflation risk, interest rate risk, etc.

Exhibit #1-15

As with other issuers, a national government’s credit rating will be a function of its ability to repay any borrowings. That in turn is largely a function of expected and potential revenues. The primary source of funds to service debt for most national governments are tax revenues, though for some countries natural resource ownership or royalties (on crude oil, for example) or the revenues of state owned enterprises are significant. A partial list of the more common revenue raisers would include sales taxes, value-added taxes, income taxes, wealth taxes, real estate taxes and tariffs (taxes on imports or exports).

Exhibit #1-16

While it’s hard to make accurate generalizations as tax circumstances vary significantly around the world, in general terms, developed country governments are likely to be more dependent upon sales or value added taxes and income taxes as such countries have the technological and financial infrastructure to more effectively track the activities upon which those taxes are assessed. Lesser-developed countries or emerging markets tend to rely more heavily on natural resource sales or taxes on exports or imports. Such items are easier to track than income or sales in less advanced economies where a much greater proportion of activity is related to small cash payments or barter. The creditworthiness of government debt would be a function of the specific sources of revenues and their stability, predictability or anticipated changes over time. These factors likely depend on the nature of the economic activity from which the revenues are derived.

In some national fixed income markets, government agencies are also significant issuers of debt. As with government debt, it’s hard to make accurate generalizations about government agency debt worldwide because specific circumstances vary dramatically from country to country. On balance, government agency debt is typically perceived as being just a notch below government debt regarding degree of creditworthiness.

Naturally, a given agency’s credit rating will be related to the strength or weakness of supporting revenues as well as the presence or absence of any guarantees. In some cases, agency debt will be guaranteed by the national government, likely causing such an agency debt to have the same credit rating as the sovereign. Absent such a guarantee, the stability, predictability, and/or expected rate of change of supporting revenues will be the primary determinants of credit risk.

Government agency revenues could come from a wide variety of sources. In some instances, that might be user fees or other charges the agency makes on those to whom it provides services. In some cases, agency debt may be funded via government budgetary allocations or may require specific legislative action. Aside from the foregoing, perhaps the most important criterion in assessing credit risk exposure is the degree to which the national government supports its agencies. Even where there is no legal obligation to honor an agency’s debt, many national governments will step in to avoid default by one of their agencies. The historic record of such support, or lack thereof, will influence the market’s assessment of the creditworthiness of agency obligations.

While not true across all nations, in some countries regional and/or local governments might also be significant issuers of debt. This is much more likely the case in countries using a federal structure such as Canada, Germany and the United States. In those countries and others with federal structures, the states, provinces, cities, other administrative entities or their agencies can be significant issuers of debt. In countries that do not have a federal structure such as the UK and Japan, markets in regional or local debt securities are not common.

Exhibit #1-17

On average, debt of regional and local governments or their agencies would be viewed as riskier than sovereign debt, though safer than corporate debt, on average being the operative consideration. Similar commentary to that made regarding the source of revenues to support national government debt applies to regional or local government debt issues. What are the primary and potential sources of revenue (types and level of taxes or other fees)? What economic activities are those revenue sources related to? How are those revenues expected to change over time? Is the debt backed generally by all sources of revenue to the issuer (e.g. full faith and credit) or only by revenues from designated sources? Some debt will be supported by one or more specified sources of revenue such as a special tax, user fees on designated activities or project revenues from the facilities built or acquired with the proceeds of the bond offering. If not backed by the issuer’s full faith and credit, it’s the economic strength or weakness of the designated revenue source or sources that will be the primary factor for determining credit risk.

Beyond the public sector are private sector debt issues. Let’s first consider corporate obligations. In the absence of other guarantees or credit enhancements, the credit risk of corporate securities would be related to the ability of the issuing corporation to service its debt. Unlike governments that can legally impose taxes and have police powers to enforce their payment, corporations have to be able to sell something to generate revenues. Ideally, businesses generate revenues selling goods or service produced at a profit. However, in some cases corporations will sell goods or services at a loss simply to generate revenues to meet various expenses including debt service. Corporations could also raise money by selling assets or issuing securities. The greater uncertainty regarding the ability of corporate issuers to meet their obligations means a credit risk assessment is usually an important element in the process of selecting corporate securities for investments.

Corporate fixed income securities are typically issued under the terms of a contract, often referred to as an indenture or trust indenture. Among other things, the contract specifies the rights of the holders and obligations of the issuer. Because of the primacy of credit risk related issues, many of the indenture provisions are designed to reduce investor concerns regarding credit risk and are referred to as protective covenants. Some protective covenants allay investor concerns about credit risk exposure by restricting company actions that might adversely affect the issuer’s credit standing. Examples of such restrictions would include placing limitations on dividend payments or making acquisitions. Alternatively, indenture covenants might require the issuer to do certain things that reduce issue related credit risk. Indentures intended to achieve that end might entail such things as pledging assets as collateral or retiring some portion of a bond issue prior to the final maturity.

Creditworthiness varies greatly across issuers in the corporate securities market. Consequently, fixed income analysts divide the market into different credit sectors. One common division of credit sectors is between investment grade securities and less than investment grade issues. The latter are often referred to as high yield securities or junk bonds. Securities rated BBB or above are considered investment grade, BB and below are less than investment grade or high yield. Those two broad credit sectors can be further subdivided to make finer distinctions regarding the relative creditworthiness of different issuers.

Exhibit #1-18

High yield securities trade at significantly higher yields to maturity than equivalent maturity investment grade issues. They trade at higher rates because, on average, high yield securities experience significantly higher levels of defaults over time. However, be careful not to read too much into the name junk bonds. Realize junk bonds is a name, not an accurate characterization of investment performance. Though high yield securities are at times outperformed by other sectors of the market, over holding periods of 5 or more years high yield portfolios typically outperform portfolios of investment grade corporate or government bonds.

The last of the issuer segments to consider is structured finance. The instruments traded in this sector are sometimes referred to as