Chapter 6 - Foundations

Federal Debt Bonds

• virtually no liquidity risk

• if you want to sell a US government bond, you can typically find a buyer quickly because there’s a deep, active market for these securities

Us Government Debt

• lack of default risk/ repayment risk, credit, default risk

• when an issuer cant make required interest or principal payments often because of bankruptcy

• this rarely happens because the federal government can create its own currency through the federal reserve

• treated as AAA (highest bond rating)

• full and direct backing of the federal government often considered the “gold standard” for credit quality

US Department of Treasury

• manages the finances of the US government

Treasury Bills

• weekly auction

• short term, zero coupon debt issued by the Treasury

• since they’re short term

• mature in one year or less, classified as money market debt securities (money market instruments)

treasury bonds

• interest paying long term US government bonds

• issued monthly

• issued at par, pay semi-annual interest, and mature within 30 years of issuance

Treasury bond vs Treasury note

• main difference is the maturity period

• T - note : 2,3,5,7,or 10 years ; typically lower (shorter commitment) and immediate term investment

• T-bond : 20 or 30 years ; typically higher (rewards long term locking of cash), long term investment

STRIPS

• stands for separate trading of registered interest and principal of securities

• long term ( up to 30 years), zero coupon bonds issued by the US government

• issued at deep discounts and mature at par

• ex. 30 yr strips are offered for 400. you buy the security, hold it for 30 years, and then receive 1000 at maturity - your total return over 30 years is $600 which = $20 per year in interest.

• def not suitable for anyone seeking current income bs all the interest is paid at maturity which usually is decades after purchase

treasury receipts

• creates by banks and investment firms

• long term, zero coupon bonds

• they resemble STRIPS but have a different issuer

• since they ae created by private financial institutions they don’t have the same default risk

Phantom tax

annual taxation from using STRIPS and Treasury Receipts even if the cash isn’t received until maturity

Outpacing Inflation

• one way to address inflation is to keep part of a portfolio in stocks, which tend to outpace inflation over long periods.

TIPS (treasury inflation protected securities)

• long term US government debt securities that pay semi annual interest.

• unlike standard treasury bonds, TIPS are designed to increase payments when inflation rises.

• ex. 30 year TIPS issued with 1000 par, 3% fixed coupon and semi annual interest payments of $15

  • initially the bond pays 3% of the par value, but lets say the CPI rises by 2% over 6 months, then the par value adjusts to 1020. The coupon doesn’t change however, just the principal which in return increases the interest paid semi-annually.

• at maturity the investor receives the greater of the OG par value or the adjusted par value

• TIPS avoid purchasing power risk - the main advantage

Callable securities

All US Treasury Securities are non-callable

credit risk

the issuer might not pay you back

default risk

type of credit risk - the issuer fails to make interest or principal payments

Marketability risk / liquidity risk

its difficult to sell an investment

purchasing power risk

the risk that inflation will erode the value of money returned on an investment.

yield

return an investor earns on a bond

• at issuance the coupon rate = yield

treasury note maturity (medium)

2-10 years

treasury bond maturity (very long)

30 years

treasury bill maturity (very short)

up to 1 year

TIPS

5,10, or 30 years (also long) but it adjusts for inflation

Price volatility

• the longer the maturity and the lower the coupon, the more volatile the bonds price The sensitivity of a bond's price to changes in interest rates, which increases with longer maturities and lower coupon rates.

Strips vs treasury receipts

• The main difference is the issuer backing, meaning where the investment is coming from

• Strips are backed by the US Treasury and Treasury Receipts are from a private financial institution

federal farm credit system

Offers easier-to-obtain loans to farmers across the US

• Use this system for short-term financing ( at harvest) and long-term, to buy farming equipment

• So they issue bonds to the public, and then whatever money is raised is then loaned to farmers at favorable interest rates. This structure helps keep borrowing relatively cheap and accessible to many farmers.

why do Ginni Mae, Fannie Mae, and Freddie Mac Exist

• support the US housing market

• increase availability of mortgage loans

• help keep mortgage interest rates lower

• provide liquidity to bansk so they can make more home loans

Goverment wants bansk to keep lending money to homebuyers

Fannie Mae

• purchases mortgages from lenders

• creates mortgage backed securities (MBS)

Freddie Mac

• purchases mortgages from lenders

• creates mortgage backed securities

Ginnie Mae

• Does NOT buy mortgages

• Guarantees MBS backed by FHA, VA and other government-insured loans

• backed by the full faith and credit of the US government

Secondary Mortgage market

Fannie Mai and Freddie Mac exist in this market

they do not lend out mortgages to homeowners they can only buy loans that banks have already made

Primary mortgage market

banks operate in this market

they are the ones directly lending out money to homeowners for a mortgage

How does the whole mortgage process work

1. The homeowner buys the mortgage from the bank lets’s say for 500k - so now the homeowner receives 500k, and the bank is down that money.

2. to continue handing out mortgages the bank needs to gain some cash flow or else it will go bankrupt waiting for the cash to come in since the maturity dates are long (like 30 years) - so Fannie Mae and/or Freddie Mac buy the loan off of the bank

3. now the bank gains 500k again and Fannie Mae/Freddie Mac get the payments (principal + interest) from the homeowners

4. Now banks make more mortgage loans and Fannie Mae and Freddie mac collect hundreds of thousands of dollars from these mortgages

5. they use this money to issue out MBS (mortgage backed securities)

6. basically after pooling in all the money, investors can buy a MBS which is like 1% of all the mortgages together and get a payment.

7. usually fannie mae and freddie mac keep a portion and then the rest is given out to investors depending on how much percent they own

8. MBS = fixed income security

Pass Through Certificate (PTC)

• a type of mortgage backed security

• investors receive monthly interest and monthly principal

• the mortgage payments are “passed through” from homeowners to investors

why do banks sell mortgages

• banks receive cash immediately so they sell that cash to make more mortgage loans, increase lending, and improve liquidity

Prepayment risk

occurs when homeowners pay off mortgages earlier than expected

• usually happens when interest rates fall, and investors lose on higher-yield mortgages and have to reinvest at lower interest rates.

• not good

Extension risk

occurs when homeowners keep mortgages longer than expected

• usually happens when interest rates rise

• Nobody wants to refinance a higher-rate mortgage, investors dislike it because they remain stuck with an older, lower-yield mortgage for longer than expected

interest rates rise (MBS)

• extension risk for the investor

interest rates fall (MBS)

• homeowners are going to want to refinance their loan

• prepayment risk (homeowners are selling off their mortgage → lots of money going to investors, which can be invested at a lower rate instead of high, unfortunately)

• reinvestment risk (money is being invested in lower rate - losing out on future cash growth)

asset backed security

a fixed income security backed by a pool of loans or other income-producing assets

• instead of one borrower making payments to you, many borrowers make payments - those payments are then passed through to investors

  • auto loans, credit card receivables, student loans, and mortgages `

is an MBS an ABS

yes - mortgage backed seucirties are a type of asset backed security

why doesnt abs have a fixed maturity

because borrowers may :

• pay off loans early

• refinance

• sell the collateral

the investment is based off of the loan/mortgage so if the homeowner for example for a mbs decides to refinance then the maturity date is cut short - so there is no fixed maturity date because it isnt guaranteed

Ginnie Mae

government guarantees the company -if something goes wrong, it tells investors that the US government stands behind these securities

• this is why it is considered the safest

• considered to have essentially no default risk

Fannie Mae

buys mortgages from banks such as FHA loans, VA loans, and -

• Conventional mortgages :regular mortgage that is NOT insured by the government

Freddie Mac

also buys mortgages but it mainly buys conventional mortgages

treasury securities taxation

• federal tax, no state tax

MBS taxation

• fully taxable - federal and state tax

which agency has the direct backing of the US government

ginnie mae (GNMA )

• no default risk

  • backed by the full faith and credit of the US government

Fannie MAE vs Freddie Mac

fannie mae : purchases FHA, VA, and conventional

freddie mac : purchases conventional mortgages

sallie mae

a private company that specializes in student loans

is sallie mae government backed

since 2004, sallie mae has been a private, publicly traded company with now US government backing.

which organization has direct us government backing

Ginnie Mae

what yield does an investor require with higher risk

higher yield

what risk does an investor require with a lower yield

lower risk which typically results in more stable returns.

competitive vs noncompetitive treasury bids

Competitive —> institutions (hedge funds, mutual funds, insurance companies) ; specify amount and yield ; may receive none or only part

Noncompetitive (retail investors) ; accept auction yield wtv it may be ; guaranteed full amount requested (up to the limit)

where do treasury securities trade after issuance

over the counter (OTC)

treasury quotes

quoted in 32nds of par

• ex. 95 - 8 : 95 + 8/32 = 95.25% * 1000 = 952.50

how are treasury bills quoted

by discount yield, not price

higher yield = lower price

competitive bid

• institutional investors (like hedge funds, etc)

• specify amount and desired yield

• not guaranteed the securities

noncompetitive bid

• retail investors

• guaranteed allocation (up to the max allowed)

• accept the auction yield

how does the treasury decide winners

• accepts lowest yields first bcs the government wants the lowest rate possible because it means paying less interest

• the highest accepted (winning) yield becomes the yield for all winning bidders

corporate bond quotes

quoted in 1/8ths

single price auction

even thought bidders bid low yields - whatever was the highest yield to be accepted becomes the yield for everyone

what is the federal reserve

central bank of the united states

• the fed controls how much money is flowing through the economy

what is the federal reserves dual mandate

• promote maximum employment (economic growth)

• maintain stable prices (control inflation)

during a recession, what monetary policy does the FED use

expansionary (loosening) monetary policy

what happens to the money supply during expansionary monetary policy

it increases

what happens to interest rates when the money supply increase

it lowers/decreases

lower interest rates cause what?

• more borrowing

• more spending

• more business expansion

• more hiring

• higher GDP

why can low interest rates eventually create inflation

more money chasing the same amount of goods increases demand, which pushes prices higher

• the suply doesn’t change but the amount of disposable income each person has increases which tends to dirve the price of goods and services up, hence inflation

during high inflation, what monetary policy does the FED use

contractionary (tightening) monetary policy

what happens to interest rates during contractionary monetary policy

they increase as the Federal Reserve raises rates to curb inflation

higher interest rates cause what ?

• less borrowing

• less spending

• slower economic growth

• lower inflation

what is gdp

gross domestic product - the total value of goods and services produced within the US

how are money supply and interest rates related

money supply increases → interest rates decrease

money supply lowers → interest rates increase

how are interest rates and inflation related

lower rates → more borrowing → more spending → inflation tends to rise

higher rates → less borrowing → less spending → inflation tends to rise at a slower pace or even fall

Monetarist theory

argue that the Fed’s control of the money supply is the primary driver of the economy.

what is the federal funds rate

the interest rate banks charge other banks for overnight loans to meet reserve requirements

• bank → bank

who sets or charges the federal funds rate

it is charged by banks to other banks, not by the federal reserve

what are reserve requirements

rules requiring banks to keep a certain amount of deposits available as reserves to help ensure they can meet customer withdrawals

what is the discount rate

the interest rate the federal reserve charges banks that borrow directly from it

why is the federal reserve called the lender of last resort

because banks borrow directly from the FED only when they cannot borrow from other banks

which is usually higher fed funds rate or discount rate

• the discount rate, which is done to encourage banks to borrow from each other first with fed funds rate

what is the broker loans rate

the IR banks charge broker-dealers, who use the borrowed funds to make margin loans to investors

what is a margin account

A: An account that allows investors to borrow money from a broker-dealer to purchase securities.

What is the Prime Rate?

The interest rate banks charge their most creditworthy corporate customers.

Match each rate with the lender and borrower.

• Federal Funds Rate: Bank → Bank

• Discount Rate: Fed → Bank

• Broker Loan Rate/ call money market rate: Bank → Broker-Dealer

• Prime Rate: Bank → Best Corporate Customer

what are the feds 4 monetary policy tools

• discount rate

• open market operations

• reserve requirements

• margin requirements (regulation T)

DORM

which fed tool is used most often

open market operations

what happens when the fed lowers the discount rate

Banks borrow more from the Fed, increasing the money supply and lowering interest rates

what happens when the Fed raises the Discount rate

banks borrow less, decreasing the money supply, and raising interest rates

what happens when the Fed raises the Discount Rate

Banks borrow less, decreasing the money supply and raising interest rates

What happens when the Fed buys securities?

Banks receive cash, increasing the money supply. This is a repurchase agreement (repo)

What happens when the Fed sells securities?

Banks pay cash to the Fed, decreasing the money supply. This is a reverse repurchase agreement.

Which Fed committee conducts Open Market Operations?

The Federal Open Market Committee (FOMC)

What happens when reserve requirements are lowered?

Banks can lend more, increasing the money supply.

what happens when reserve requirements are raised

banks must hold more reserves and can lend less decreasing the money supply

what is regulation T

A Federal Reserve rule that sets the initial margin requirement, generally requiring investors to deposit 50% of the purchase price when buying securities on margin.

what happens if regulation T is lowered

Investors can borrow more to buy securities, increasing the money supply

what happens if regulation T is raised

investors must use more of their own money and borrow less, decreasing the money supply

which action loosen monetary policy

• lower discount rate

• buy securities

• lower reserve requirements

• lower regulation T

which actions tighten monetary policy

• raise discount rate

• sell securities

• raise reserve requirements

• raise regulation T