Organization of Fixed Income Markets Study Notes

Organization of Fixed Income Markets

Overview of Fixed Income Markets

  • The Fixed Income (FI) market is divided into two main categories:

    1. Money Market

    2. Bonds (or long term instruments)

  • The division is primarily based on maturity:

    • Instruments with 1 year or less of maturity are classified as money market instruments.

    • All other instruments with a maturity greater than one year fall under the bond market.

Money Market

  • Defined as short-term loans with a maturity time of less than one year, typically around 3 months.

  • Characteristics:

    • Highly liquid; many investors consider them equivalent to a savings account.

    • Generally regarded as very safe due to their short maturity.

  • Instruments commonly found in money markets:

    • Treasury Bills (T-bills):

    • Maturities of 4, 13, 26, and 52 weeks.

    • Available in denominations as low as $1000 and sometimes $100.

    • Considered zero-coupon bonds, issued at a discount from face value, and are exempt from state and local taxes.

    • Commercial Paper:

    • Unsecured loans made to corporations.

    • Very short terms, rarely exceeding 3 months.

    • Issued only by well-known, respectable companies.

    • Minimum denomination is $100,000.

    • Peak issuance was $2 trillion in 2008, now around $1 trillion.

    • Repurchase Agreements (Repos):

    • Involves a short-term sale of securities with a commitment to repurchase them at a higher price.

    • Majority of repos are overnight transactions, but some can extend up to 1 month.

    • Denominations are large, typically in the millions, and are considered collateralized loans.

    • Certificates of Deposit (CDs):

    • Time deposits at banks, not available on-demand, but large denominations may provide on-demand access.

    • Insured by the FDIC.

    • Available in any denomination, with interest rates varying with the market.

Bond Market

  • Recognized as the largest component of the fixed income market.

  • Municipal Bonds:

    • Provide coupon payments that are exempt from federal taxes and potentially state taxes (depending on the issuer).

    • Typically have lower yields to maturity due to these tax advantages.

    • Two primary types:

    • General Obligation Bonds: Backed by the issuing municipality's full faith and credit.

    • Revenue Bonds: Secured by specific revenue sources.

  • Agency Bonds:

    • Issued by Government-Sponsored Entities (GSEs) aiming to subsidize specific activities.

    • Notable GSEs include Fannie Mae and Freddie Mac, which enjoy implicit backing from the U.S. government.

Over-the-Counter (OTC) Markets

  • Unlike equities, which are mainly traded through organized electronic exchanges (like the NYSE or Nasdaq), fixed income markets tend to operate mainly in the OTC space.

  • Dealers' Role: Critical in ICT markets as they act as intermediaries and facilitate trading.

  • The FI market consists of primary and secondary markets:

    • Primary markets: Where new issuances occur, including auctions conducted for Treasury securities.

    • Secondary markets: Where existing securities are traded.

Primary Markets – Treasuries

  • For Treasury debt, the primary market is characterized by auctions conducted by the New York Federal Reserve.

  • The types of securities sold vary, and interested parties can refer to a public auction calendar.

  • Participation is limited to primary dealers, which consists of a group of 20+ financial institutions with direct access to the Fed, necessary for maintaining listings.

  • Functions of Primary Dealers:

    • Must provide information to the Treasury and Fed and are surveyed about economic expectations prior to Federal Open Market Committee (FOMC) meetings.

    • Engage in trading activities with the Fed during open market operations.

Primary Markets – Corporate

  • Role of Dealers: Serve as underwriters; they purchase securities from issuers before selling them to investors.

  • Public Bonds must be registered with the Securities and Exchange Commission (SEC), where issuers need to file financial statements (10-K reports).

  • Private Securities under Rule 144A do not require SEC registration, having minimal filing requirements and can only be sold to qualified institutional buyers managing assets over $100 million.

Interdealer Brokers

  • Practicing within OTC markets can make it challenging for dealers to conceal their trading activities, with the risk of successful strategies being reverse-engineered.

  • Interdealer Brokers Function:

    • Gather and synthesize quotes without disclosing the identity of participating dealers.

    • Charge fees for their services to facilitate trading and enhance transparency.

Electronic Platforms

  • As trading practices have evolved, interdealer brokers have transitioned to electronic platforms.

  • In 1990, major dealers and brokers established GovPX, the first electronic quotation system for Treasury securities.

  • Today, platforms like Tradeweb (previously e-Speed) are quite prominent, offering fully electronic limit order books for efficient Treasury trading.

  • The competition is intensifying as more traders adapt to exchange systems; for example, the CBOE launched its own trading platform to mitigate existing challenges within the market.

  • There has been a notable shift in fixed income trading towards electronic systems, fostering liquidity and reducing trade impact, especially focusing on the largest segment of the market: Treasuries, particularly on-the-run Treasuries.

Treasuries

  • An on-the-run Treasury refers to the most recently issued Treasury security of a specified maturity.

  • Subsequent issuances result in the previous ones being categorized as off-the-run, which often experience decreased liquidity.

  • Observations show that the prices of on-the-run Treasuries tend to be slightly elevated compared to their off-the-run counterparts, indicative of a liquidity premium.

  • Investors may strategize to sell short an on-the-run Treasury and purchase an off-the-run to capitalize on yield discrepancies, which might be termed arbitrage, though this valuation needs careful scrutiny.

Matrix Pricing

  • Matrix pricing is an approach used to estimate the market price of inherently illiquid securities.

  • It answers questions about finding market prices for securities that do not trade actively, using a systematic approach:

    1. Identify multiple bonds with similar credit quality that frequently trade.

    2. Calculate their Yield to Maturity (YTM).

    3. Linearly interpolate the YTM of the illiquid bond.

    4. Compute the price using the interpolated YTM.

  • Example:

    • To price an illiquid 5-year bond with a 3.5% coupon rate, consider the following similar risk bonds:

    • Bond A: Maturity 3 years, Coupon Rate 3.3%, Price 97.48784

    • Bond B: Maturity 3 years, Coupon Rate 2.7%, Price 96.90879

    • Bond C: Maturity 6 years, Coupon Rate 3.6%, Price 93.31222

    • Bond D: Maturity 6 years, Coupon Rate 4.1%, Price 94.88661