Session 2 - Fixed Income and Money Market Product Descriptions

This session looks at fixed income and money market products and provides descriptions and characteristics of these products. At the end of this session, you should be able to understand the difference between money market products and fixed income products and differentiate between them based on the issuer, structure and maturity.

Products

Money market securities are best defined as those cash products and securities issued with a maturity of less than one year. There are two broad categories of money market securities; cash or short term deposit type money market instruments and discount instruments.

Those securities with a maturity greater than one year include bonds and other types of fixed income securities such as subordinated debt, hybrids and structured products like residential mortgage backed securities (RMBS) and commercial mortgage backed securities (CMBS).

Term deposits fit into both categories:

Money market products - less than one year to maturity

1. Cash

References to cash usually refer to an ‘at call’ deposit with a bank or a short term deposit up to one week. This may be an ‘11am deposit’, a ‘24 hour call deposit’ or a very short term deposit.

An 11am deposit is a deposit where your money is available on the same day if notification of withdrawal is made prior to 11am. A 24 hour deposit requires 24 hours notice of an intention to withdraw the funds. All of these categories are bundled together and referred to as cash. The interest on cash is generally calculated using the simple interest formula and interest is paid at the end of each month, or at the maturity or withdrawal of the investment.

2. Term deposits

Term deposits currently offer better returns than cash and most other discount securities offered by banks, however, investors agree to part with their funds for a set period and penalties can apply for breaking the contracted term. Term deposit maturities range from one month to ten years and the term deposit may be partly fixed, partly floating and may offer inflation indexing on the interest, the principal, or both interest and the principal.

A term deposit is an agreement between the investor and the Authorised Deposit taking Institution (ADI). It is not a tradeable security.

3. Discount securities

Discount securities, of which there are a number of types, are negotiable securities issued at a discount to face value. Negotiable means that their ownership is transferred by their possession. More commonly the term negotiable is used to describe the ability to trade or resell the instrument. Discount securities are priced using a discount formula which is explained fully in Session 4. The full face value of a discount security is paid out on its maturity and the difference between the initial investment and the face value (the discount) is the return to the investor. The most common discount securities are treasury notes, bank bills, promissory notes and NCDs (negotiable certificates of deposit).

Figure 2.1 below depicts the cash flows of a discount security. At maturity the face value is repaid, in this case $100. When purchasing one of these instruments the investor pays a price less than the face value. The ‘discount to face value’ is equal to the amount of interest that will be earned over a 90 day investment period. In this case the amount invested (the purchase price) is $98.78. The investor earns $1.22 in interest, which is the amount of the discount from the period from when it is purchased to its maturity. The effective interest rate earned is 5.01%.

3.1 Treasury notes

Treasury notes are a common discount instrument. They are Commonwealth Government securities and are issued by the Australian Office of Financial Management (AOFM) on behalf of the Commonwealth Government. They are usually issued through periodic tender with maturities of five, 13 and 26 weeks (one, three and six months). Treasury notes are one of the liquidity tools used by the Reserve Bank of Australia (RBA). This means they are used to fund the RBA’s short term cash requirements and also for managing the amount of cash and liquidity in the overall financial system, among other things. As at 11 March 2011 there were $15.5bn of treasury notes on issue.

3.2 Bank bills

Bank bills are probably the most commonly known type of discount security. They are defined in the Bills of Exchange Act 1973 as shown below.

Bank bills are negotiable orders to pay a certain amount of money and usually mature within six months.

There are two types of bank bills; bank accepted bills and bank endorsed bills. A bank accepted bill is a bill of exchange where the issuing bank has the primary responsibility to pay the holder the face value of the bill at maturity.

Bank endorsed bills also have a 100% bank guarantee. In the event of default the first call for payment is back to the drawer. Then, if the drawer fails to pay, the holder will present it to the bank that has endorsed the bill for payment.

3.3 Promissory notes

The promissory note is another discount instrument that is defined in the Bills of Exchange Act.

Promissory notes have three main features:

• there is an unconditional promise to pay - additional terms or conditions may not be added
• there must be a payment of a certain amount of money 
• the payment must occur on a certain date

The certain amount of money is referred to as the face value and the date is called the maturity date. Promissory notes are issued in bearer form (negotiable) so that by holding the piece of paper or note the holder has a claim to it. In addition promissory notes are usually issued for 185 days or less. 

Promissory notes are also referred to as a single name paper or commercial paper. They are single name paper in that the only person promising to make payment is the issuer (name) on the note. There is no recourse to anyone else to make payment (unlike a bank bill), and as a result they are usually issued by semi-government authorities and very highly rated corporations.

3.4 Negotiable certificates of deposit (NCD)

A negotiable certificate of deposit is similar to a bank deposit, but instead of the ownership being recorded in a deposit account by the bank, the loan is evidenced by a transferable certificate. In practice, a certificate is not issued, but rather the holder’s details are maintained on a register. The NCD is negotiable and can be bought and sold during its life. Whoever holds the certificate at maturity owns the claim on the cash flow at maturity. The terms of an NCD can range over many years, but usually only those that mature within one year are referred to as money market securities.

The main advantage of NCDs is their relative safety and the ability to know your return ahead of time. Investors generally earn more with an NCD when compared with a savings account, depending on the shape of the yield curve.

These days most NCDs are issued in an electronic format and are known as Electronic Certificates of Deposit (ECD).

Fixed Income Products - greater than one year to maturity

1. Term deposits

While term deposits are often less than a year to maturity, it is possible for them to run to five years and sometimes up to seven years. 

2. Bonds

A bond is a debt security that pays a series of periodic payments called coupon payments (sometimes referred to as interest payments) for a given period of time (the term) and repays the face value of the bond at maturity. A bond is a loan from an investor to the issuer of the bond. Bonds can pay either fixed or floating rate coupons, or coupons linked to the Consumer Price Index (CPI).

The maturity range for bonds issued in Australia is usually one to 15 years with some extending further. The United States and European markets see a much greater variety in maturities, commonly out to 30 years. Bonds in Australia are priced using the RBA bond formula, which is examined in Session 4.

Bonds can be issued in three different debt classes – senior secured, senior unsecured and subordinated debt. Each has varying risk and reward attributes which are also influenced by the issuing entity’s credit rating. Most bonds follow the characteristics noted in table 2.5 below, however some have variable maturity, like Asset Backed Securities (ABS) for example Residential Mortgage Backed Securities (RMBS), and some use different pricing formulae.

Figure 2.2 below depicts typical bond cash flows for a bond issued at par. There is an investment amount then a series of periodic coupon flows, and at maturity, the face value is repaid together with the final coupon. 

Bonds can have a wide variety of maturities as well as a wide variety of issuers across the credit rating spectrum. They provide steady income (as well as the potential for capital gains or losses if sold prior to maturity). Bonds can be used to diversify investments in a balanced portfolio. Most bonds are traded over the counter (OTC) rather than through an exchange and have varying levels of liquidity.

2.1 Issuers of bonds

The primary issuer of bonds in Australia is the Commonwealth Government. For many years it has been the primary issuer of bonds through the AOFM (previously the function sat with the RBA).  The state governments are also major issuers of bonds, generally issuing bonds through their semi-government authorities such as the NSW Treasury Corporation. General corporate issuers, including banks and international issuers have also issued Australian dollar bonds over recent years. These include National Australia Bank, Australia Post, Telstra, Woolworths and Citigroup.

2.2 Floating rate notes

Floating rate notes (FRNs) are very similar to nominal bonds except that the periodic payments (coupon payments) are not equal. The rate used to calculate the interest payment is reset in line with a given benchmark, i.e. bank bill swap rate (BBSW) or London interbank offered rate (LIBOR) each period. This variable rate usually includes a fixed margin over the benchmark. The reference rate is usually 3 month BBSW. FRNs are examined in greater detail in Session 9. 

3. Hybrid securities

Hybrid securities are a broad classification for a group of securities that combine both debt and equity characteristics. Hybrids pay a predetermined (fixed or floating) rate of return or distribution until a certain date. At that date the holder may have a number of options including converting the security into the underlying ordinary share of the issuer. Therefore, unlike a share the holder has a known cash flow and, unlike a fixed interest security, there is an option held by the issuer to convert the security to the underlying equity.

Hybrid securities have a wide variety of maturities, structures and varying liquidity (which must be taken into account when assessing risk/return) as well as issuers across the credit rating spectrum. This allows an investor to invest in the particular hybrid that suits their investment objectives. Hybrids usually offer higher returns than those offered by more senior assets in the capital structure such as senior and subordinated debt (see Figure 1 in Session 1). While they have the highest risk of the fixed income securities, they are generally ranked above equities in the capital structure. 

4. Structured products

Structured products can reference almost anything but most commonly reference loans. Some are segmented into tranches in much the same way as our corporate structure diagram (see Figure 1 in the Session 1) where the lowest tranche bears the first loss position (known as the equity stake) and is the highest risk.

Structured products can provide a variety of rates of return.

They can be issued in fixed or floating formats, with prepayable characteristics, such that the principal of the security is paid back to the holder of the securitised product.

There are many different types of structured products including:

• securitisations - a process of pooling what would normally be non-tradeable financial assets and putting them into a fund, trust or vehicle which allows an issuer to create a reasonably determinable cash flow and then issue securities on the back of this cash flow. The most common example is residential mortgage backed securities (RMBS)
• collateralised debt obligations (CDOs) - are normally floating rate debt securities that pay a higher return compared to similarly rated securities in exchange for a higher risk profile. They are a type of asset backed security whose value and payments are derived from a portfolio of underlying assets and investors taking on a subordinated position

1. State government
2. Commonwealth Government
3. Corporations
4. Australian banks

In the wake of the global financial crisis in 2008 and 2009, structured products fell out of favour as investors high in the structure lost funds, in some cases all funds invested. In 2010 the market is beginning to normalise with banks successfully issuing residential mortgage backed securities (RMBS).

Conclusion

You should now understand the difference between money market instruments and fixed income investments and be able to differentiate between these products based on the issuer, the type of security and the length of the investment.

Review questions

1. Why is capital structure one of the most important factors to consider when buying a bond?

1. It lets investors know when they are going to receive their coupons
2. It lets investors know the order of priority of repayment if the company goes into liquidation
3. It helps investors understand the relative risk of the bond and if the reward being offered is enough to compensate for the risk involved
4. Understanding the capital structure allows investors to assess the range of securities available from a single issuer and where the relative value is across the capital structure

Possible answers

1. a & c
2. b & d
3. b & c & d
4. All of the above

2. There are two types of bank bills: bank______bills and bank______bills.

1. Endorsed, accepted
2. Accepted, sanctioned
3. Accredited, endorsed
4. Acquired, accepted

3. Treasury notes are a common discount security. They are issued by the Australian Office of Financial Management (AOFM) on behalf of the:

1. State government
2. Commonwealth Government
3. Corporations
4. Australian banks