fixed income 4: Fixed-Income Markets for Corporate Issuers

Why do corporations use short-term financing?

• To meet cash needs during the cash conversion cycle

• preserve liquidity

• take advantage of supplier discounts.

What are the three common forms of external short-term bank financing?

• Uncommitted lines of credit

• Committed lines of credit

• Revolving credit agreements (revolvers)

What is an uncommitted line of credit?

A flexible bank credit line where the bank may refuse funding requests at any time.

advantages/disadvantages of uncommited line of credit

• Interest charged only on amount used.

• Flexible and low cost under normal conditions.

• No commitment fee.

• Usually unsecured.

• Least reliable funding source.

• Bank may refuse borrowing request.

• Cannot be relied upon during economic stress.

What is a committed line of credit?

formal bank commitment to lend up to a specified amount over a defined period.

Advantages / disadvantages of commited line of credit

• More reliable than uncommitted lines.

• Often syndicated among multiple banks.

• Usually unsecured and prepayable.

• Used as backup liquidity for other financing sources.

• Usually short-term (often 364 days).

• Require commitment fee on full or unused amount.
  

What is a revolving credit agreement (revolver)?

A multiyear committed credit facility that allows repeated borrowing and repayment.

features of revolving credit agreement

• Most reliable bank funding source.

• Include covenants restricting borrower actions.

• Similar borrowing rates and fees as committed lines.

• May include medium-term loan features.

What is a secured vs unsecured loan?

secured: backed by collateral

unsecured: not backed by collateral

What is assignment of accounts receivable?

Using receivables as collateral for a loan while the company still collects the receivables.

What is factoring?

• Receivables sold to a factor at discount.

• Factor handles collection and credit process.

• Provides immediate cash flow.

What is commercial paper (CP)?

ort-term unsecured note issued by highly rated companies

• to finance working capital or temporary funding needs.

What is rollover risk in commercial paper markets and how is it mitigated?

• Risk that issuer cannot issue new CP to repay maturing CP.

• Mitigated with backup committed credit lines.

• Defaults are relatively rare due to short maturity.

What is Eurocommercial paper (ECP)?

Commercial paper issued in the international (Eurobond) market.

what are short term funding options for banks?

1. Deposits

• Primary bank funding source.

2. Demand Deposits

• Checking accounts with no stated maturity - can be withdrawn whenever

• Pay little or no interest.

• Stable funding source under normal conditions.

3. Savings Deposits and CDs

• savings deposits: held for non-transactional purposes and often have a stated term

• CDs: Fixed maturity and interest rate

difference between negotiable and non-negotiable CDs?

• Non-negotiable CD: cannot be traded; early withdrawal penalty applies.

• Negotiable CD: can be sold in the market before maturity.

What is the interbank market?

• Banks lend and borrow short term among themselves.

• Can be secured or unsecured.

• Maturities range from overnight to one year.

What is the central bank market and funds rate?

• Banks with excess reserves lend to banks with shortages.

• Interest rate = central bank funds rate.

• Central bank targets policy rate through operation

What is discount window lending?

• Central bank acts as lender of last resort.

• Usually requires collateral.

• Borrowing cost higher than policy rate.

• May involve increased regulatory oversight.

What is asset-backed commercial paper (ABCP)?

• Secured form of commercial paper.

• Loans transferred to a Special Purpose Entity (SPE) → off the balance sheet

• SPE issues ABCP to investors.

• Bank often provides backup liquidity line.

benefits of ABCP

• Off-balance-sheet financing

• Lower capital requirements

• Investors gain access to loan cash flows

ABCP and the Global Financial Crisis

• ABCP market grew rapidly before crisis.

• Many issuers funded long-term assets with short-term notes.

• Failure to roll over ABCP caused SPE failures during crisis.

• Post-crisis market shifted toward shorter-term, higher-quality assets.

What is a repurchase agreement (repo)?

• sale of a security with agreement to repurchase later.

• Seller receives cash today and repurchases security at future date and price.

• Repurchase price includes interest.

• Repo rate = implied interest rate on the loan.

• Economically, repo = collateralized short-term borrowing.

Repo Mechanics

Security seller = cash borrower.
Security buyer = cash lender.

At initiation:

• Seller delivers security

• Buyer provides cash

At maturity:

• Seller repurchases security

• Buyer returns security

Seller retains:

• Ownership benefits

• Coupon payments

Buyer earns repo interest.

repo characteristics

• Usually short-term transactions.

• Can be overnight or term repos.

• Collateral usually high-quality sovereign bonds.

What is a general collateral repo?

• A repo where any security within a predefined collateral class may be delivered.

• Uses broad category of acceptable securities

• Trades at general collateral repo rate

What is initial margin in a repo?

Excess collateral posted above the cash exchanged to protect against collateral value declines.

initial margin formula

$$\frac{\text{security price}_0}{\text{purchase price}_0}$$

What is a haircut in a repo transaction?

The reduction of the loan amount relative to the collateral value.

haircut formula

$$\text{haircut}=\frac{\text{security price}_0-\text{purchase price}_0}{\text{security price}_0}$$

What is variation margin?

Additional collateral (or collateral release) required to maintain agreed margin levels as collateral values change.

variation margin formula

$$\text{Variation margin}=\left(\text{initial margin}\cdot_{}\text{purchase price}_{t}\right)-\text{security price}_{t}$$

What legal agreement typically governs repo transactions?

A master repurchase agreement

What are the three primary uses of repos?

1. Finance ownership of securities

2. Earn short-term secured interest income

3. Borrow securities to facilitate short selling

how are repos used for short selling

1. hedge fund borrows the security in exchange for cash

2. simultaneously sells the security in the secondary market and receives cash.

3. purchases the security in the secondary market and pays the current market price.

4. simultaneously delivers the security at the pre-agreed repurchase price for cash to settle the repo.

Profit occurs if price falls more than repo cost.

What is a reverse repo?

A repo viewed from the perspective of the cash lender/security buyer.

5 Factors affecting repo rates

1. Money Market Rates

• Repo rates move with short-term interest rates.

2. Collateral Quality

• Higher-quality collateral → lower repo rate.

• Riskier collateral → higher repo rate.

3. Repo Term

• Longer maturity → higher repo rate.

4. Collateral Uniqueness

• High demand for specific securities lowers repo rate.

• On-the-run sovereign bonds often have lowest rates.

• Special repo rates may become negative.

5. Collateral Delivery

• Undercollateralized repos have higher rates.

1. Default Risk

• Counterparty may fail to meet obligations.

• Collateral may lose value during liquidation.

2. Collateral Risk

• Collateral may become illiquid or correlated with borrower risk.

3. Margining Risk

• Collateral values may change rapidly.

• Large margin calls can force liquidations.

4. Legal Risk

• Difficulty enforcing repo contract rights.

5. Netting and Settlement Risk

• Problems offsetting obligations or transferring collateral/cash.

What is a bilateral repo?

A repo executed directly between two counterparties.

What is a triparty repo?

• Third-party agent manages collateral and settlement.

• Agent may be custodian or clearinghouse.

What are 3 advantages of triparty repos?

• Operational efficiency

• Better collateral management

• Access to larger collateral pools

Why do repos create rollover risk?

Most repos are very short-term and require constant renewal.

loss of confidence may cause:

• Refusal to renew repos

• Liquidity shortages

• Forced asset sales

• Bankruptcy risk

IG VS High yiels

1. credit quality

2. default risk

3. yield spread

4. typical maturity

5. covenants

6. collateral

7. flexibility

8. monitoring

9. cash flow certainty

10. callable features

Feature	Investment Grade (IG)	High Yield (HY)
Credit Quality	Strong	Vulnerable
Default Risk	Lower	Higher
Yield Spread	Lower	Higher
Typical Maturity	Up to ~30 years	Usually ≤10 years
Covenants	Few	Extensive
Collateral	Usually unsecured	Often secured
Flexibility	High	Limited
Monitoring	Minimal	Significant
Cash Flow Certainty	Stable	More uncertain
Callable Features	Less common	More common