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2022 Curriculum CFA Program Level I Fixed Income

Fixed-Income Markets: Issuance, Trading, and Funding

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Introduction

Global fixed-income markets represent the largest subset of financial markets in terms of number of issuances and market capitalization, they bring borrowers and lenders together to allocate capital globally to its most efficient uses. Fixed-income markets include not only publicly traded securities, such as commercial paper, notes, and bonds, but also non-publicly traded loans. Although they usually attract less attention than equity markets, fixed-income markets are more than three times the size of global equity markets. The Institute of International Finance reports that the size of the global debt market surpassed USD 253 trillion in the third quarter of 2019, representing a 322% global debt-to-GDP ratio (1 Institute of International Finance Global Debt Monitor, January 13, 2020).

Debt investors and issuers need to understand how fixed-income markets are structured and how they operate. Debt issuers have financing needs that must be met. For example, a government may need to finance an infrastructure project, a new hospital, or a new school. A start-up technology company may require funds beyond its initial seed funding from investors to expand its business and achieve scale. Financial institutions also have funding needs, and they are among the largest issuers of fixed-income securities.

Among the questions this reading addresses are the following:

  • What are the key bond market sectors?
  • How are bonds sold in primary markets and traded in secondary markets?
  • What types of bonds are issued by governments, government-related entities, financial companies, and non-financial companies?
  • What additional sources of funds are available to banks?

We first present an overview of global fixed-income markets and how these markets are classified. We identify the major issuers of and investors in fixed-income securities, present fixed-income indexes, discuss how fixed-income securities are issued in primary markets, and explore how these securities are then traded in secondary markets. We also examine different bond market sectors and discuss additional short-term funding alternatives available to banks.


Learning Outcomes

The member should be able to:

  • describe classifications of global fixed-income markets;
  • describe the use of interbank offered rates as reference rates in floating-rate debt;
  • describe mechanisms available for issuing bonds in primary markets;
  • describe secondary markets for bonds;
  • describe securities issued by sovereign governments;
  • describe securities issued by non-sovereign governments, quasi-government entities, and supranational agencies;
  • describe types of debt issued by corporations;
  • describe structured financial instruments;
  • describe short-term funding alternatives available to banks;
  • describe repurchase agreements (repos) and the risks associated with them.

Summary

Debt financing is an important source of funds for households, governments, government-related entities, financial institutions, and non-financial companies. Well-functioning fixed-income markets help ensure that capital is allocated efficiently to its highest and best use globally. Important points include the following:

  • The most widely used ways of classifying fixed-income markets include the type of issuer; the bonds’ credit quality, maturity, currency denomination, and type of coupon; and where the bonds are issued and traded.
  • Based on the type of issuer, the four major bond market sectors are the household, non-financial corporate, government, and financial institution sectors.
  • Investors distinguish between investment-grade and high-yield bond markets based on the issuer’s credit quality.
  • Money markets are where securities with original maturities ranging from overnight to one year are issued and traded, whereas capital markets are where securities with original maturities longer than one year are issued and traded.
  • The majority of bonds are denominated in either euros or US dollars.
  • Investors distinguish between bonds that pay a fixed rate versus a floating rate of interest. The coupon rate of floating-rate bonds is often expressed as a reference rate plus a spread.
  • Interbank offered rates, such as Libor, historically have been the most commonly used reference rates for floating-rate debt and other financial instruments but are being phased out to be replaced by alternative reference rates.
  • Based on where the bonds are issued and traded, investors distinguish between domestic and international bond markets. The latter includes the Eurobond market, which falls outside the jurisdiction of any single country and is characterized by less reporting, regulatory, and tax constraints. Investors also distinguish between developed and emerging bond markets.
  • Investors and investment managers use fixed-income indexes to describe bond markets or sectors and to evaluate performance of investments and investment managers.
  • The largest investors in bonds include central banks; institutional investors, such as pension funds, hedge funds, charitable foundations and endowments, insurance companies, mutual funds and ETFs, and banks; and retail investors, typically by means of indirect investments.
  • Primary markets are markets in which issuers first sell bonds to investors to raise capital. Secondary markets are markets in which existing bonds are subsequently traded among investors.
  • There are two mechanisms for issuing a bond in primary markets: a public offering, in which any member of the public may buy the bonds, or a private placement, in which only an investor or small group of investors may buy the bonds either directly from the issuer or through an investment bank.
  • Public bond issuing mechanisms include underwritten offerings, best-efforts offerings, shelf registrations, and auctions.
  • When an investment bank underwrites a bond issue, it buys the entire issue and takes the risk of reselling it to investors or dealers. In contrast, in a best-efforts offering, the investment bank serves only as a broker and sells the bond issue only if it is able to do so. Underwritten and best-efforts offerings are frequently used in the issuance of corporate bonds.
  • The underwriting process typically includes six phases: the determination of the funding needs, the selection of the underwriter, the structuring and announcement of the bond offering, pricing, issuance, and closing.
  • A shelf registration is a method for issuing securities in which the issuer files a single document with regulators that describes and allows for a range of future issuances.
  • An auction is a public offering method that involves bidding and is helpful both in providing price discovery and in allocating securities. Auctions are frequently used in the issuance of sovereign bonds.
  • Most bonds are traded in OTC markets, and institutional investors are the major buyers and sellers of bonds in secondary markets.
  • Sovereign bonds are issued by national governments primarily for fiscal reasons. These bonds take different names and forms depending on where they are issued, their maturities, and their coupon types. Most sovereign bonds are fixed-rate bonds, although some national governments also issue floating-rate bonds and inflation-linked bonds.
  • Local governments, quasi-government entities, and supranational agencies issue bonds, which are named non-sovereign, quasi-government, and supranational bonds, respectively.
  • Companies raise debt in the form of bilateral loans, syndicated loans, commercial paper, notes, and bonds.
  • Commercial paper is a short-term unsecured security that companies use as a source of short-term and bridge financing. Investors in commercial paper are exposed to credit risk, although defaults are rare. Many issuers roll over their commercial paper on a regular basis.
  • Corporate bonds and notes take different forms depending on the maturities, coupon payment, and principal repayment structures. Important considerations also include collateral backing and contingency provisions.
  • Medium-term notes are securities that are offered continuously to investors by an agent of the issuer. They can have short-term or long-term maturities.
  • The structured finance sector includes asset-backed securities, collateralized debt obligations, and other structured financial instruments. All of these seemingly disparate financial instruments share the common attribute of repackaging risks.
  • Many structured financial instruments are customized instruments that often combine a bond and at least one derivative. The redemption and often the coupons of these structured financial instruments are linked via a formula to the performance of the underlying asset(s). Thus, the bond’s payment features are replaced with non-traditional payoffs derived not from the issuer’s cash flows but from the performance of the underlying asset(s). Capital protected, yield enhancement, participation and leveraged instruments are typical examples of structured financial instruments.
  • Financial institutions have access to additional sources of funds, such as retail deposits, central bank funds, interbank funds, large-denomination negotiable certificates of deposit, and repurchase agreements.
  • A repurchase agreement is similar to a collateralized loan. It involves the sale of a security (the collateral) with a simultaneous agreement by the seller (the borrower) to buy back the same security from the purchaser (the lender) at an agreed-on price in the future. Repurchase agreements are a common source of funding for dealer firms and are also used to borrow securities to implement short positions.